How Does an Earnout Deal Impact Equity Investor's Ownership Levels?

October 04, 2023

by an member from University of Western Ontario in London, ON, Canada

What are common deal terms for equity financing when raising capital for an acquisition? And in a situation where the total purchase price includes an earn-out based on future performance, how does that impact the investor's ownership of the company? For example: If you close a deal for $8M cash upfront with a $2M earnout and $4M in equity raised, do the investors own 50% or 40% of the company?

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Reply by a searcher
from Hofstra University in Melville, NY, USA

You can negotiate earnouts in many different ways. I would acquire 100% of the stock or 100% of the assets into a new SPE without having the previous owner retain 20%, while buying him down over time. That is unless he brought tremendous value to the operation, but I would then prefer to have a consulting agreement. They can excerpt too much negative controls in my opinion. Of course you can differ the class of shares etc., but its making the deal much more complicated for a 'small' deal.

Assuming the the person has a right to earn x when y happens its just a contract and conditional debt. Conditional on x happening for the y payout. This is all negotiation. Sometimes its simple like For every dollar of GP they get 10 cents, but it can get very intricate and have floors, ceiling different ratios for different trances etc. Either way, its debt on future earning on the company that your investor partners need to be aware of and pay for with you (out of company earnings).

If your earnout is structured as conditional debt it typically should not affect investors %, unless they are also charging some Preferred %, then its a consideration. Its all a negotiation at the end of the day. Please consult an attorney before implementation of any of the above. This is meant to get you asking the right questions and seeing other alternatives if you hit a roadblock in your negotiations.

Reply by a professional
from American University in Irvine, CA, USA

Be careful not to conflate the rights of the acquisition vehicle with the individual rights of investors in the acquisition vehicle. Once the vehicle has contracted with a Seller to make the acquisition, and if there are earn-out, indemnification or other post-closing financial terms owed to the Buyer (acquisition vehicle) under the Purchase Agreement, those rights and claims belong to the entity which was the Buyer (usually a corporation or an LLC). Investors in that entity have an ownership interest in a percentage of the total stock or membership interests issued by the acquisition vehicle to its founders and investors. They hold their ownership rights individually, and the percentage of interest that those rights represent reflect their individual rights in the P&L of the acquisition vehicle (absent some other contractual allocation of P&L). So, if A owns 20% of the acquisition vehicle, and the acquisition vehicle has $1 Million of cash claims against the Seller due to an earnout or breach of the agreement, then that $1 Million goes into the acquisition vehicle, but A only receives 20% of every dollar distributed out to the equity owners based upon their ownership, and that percentage of interest doesn't change unless A subsequently buys more equity, or sells some of his to another person..

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