The health care industry continues to see a growing number of transactions, driven by private equity and strategic acquirers in sectors like physician practices, surgery centers, and medical spas. Buyers are attracted to the steady revenue and growth these businesses offer. However, as the transactions become more frequent, a common challenge arises: aligning on practice valuation. When buyers and sellers cannot agree on price, an earnout can bridge the gap. By tying part of the purchase price to future performance, earnouts balance risk and reward for both parties. Below, we explore the mechanics of earnouts, common structures in health care transactions, and key operational and legal considerations for structuring them effectively.
What is an earnout?
An earnout is a contractual clause that allows a seller of a business to receive additional compensation if the business meets specific financial targets in the future. Common in health care private equity transactions, earnouts tie part of the purchase price to the future performance of the acquired business. They offer flexibility in bridging the valuation gap between buyers and sellers by tying part of the sale price to post-sale success.
It’s important to differentiate earnouts from a couple of other common deal points in transactions. Two other mechanisms to manage risk and ensure both parties meet their post-transaction obligations are the holdback and escrow. A holdback involves withholding a portion of the purchase price for a specified time, often to address potential future liabilities or to ensure the seller meets certain contractual obligations post-closing. An escrow is similar to a holdback, but the funds are held in a third-party account to cover indemnification claims or other contingencies, providing security for the buyer. While all three mechanisms aim to mitigate risk, they differ in their purpose: an earnout ties payment to performance, a holdback ensures specific conditions are met, and escrow provides a buffer for potential claims or disputes.
How do earnouts work?
In an earnout arrangement, the seller receives an initial payment at closing, with additional future payments contingent on meeting specific performance milestones. These milestones often include financial targets such as revenue, profitability or Earnings Before Interest, Taxes, Depreciation, and Amortization (“EBITDA”), but they can also include non-financial goals like patient retention, service expansion, or launching new initiatives
Consider a medical spa being acquired: the seller might agree to an earnout where additional payments are triggered if the med spa achieves a specified annual revenue increase over the next three years. Similarly, in a surgical practice sale, the seller could earn additional compensation if the practice successfully introduces a new service line, such as Botox or other cosmetic treatments, within the earnout period. Another example could involve a surgery center, where payments are tied to the successful expansion into additional markets. These examples illustrate how earnouts can be structured to align with the specific goals and operational needs of health care businesses.
Common Types of Earnouts
Revenue-Based Earnouts
This type of earnout ties future payments to the business’s revenue. It is particularly useful in industries with predictable revenue streams, such as health care practices with recurring patients. For example, in the U.S. aesthetics industry, non-surgical patient spending reached $15 billion in 2023, while the number of medical spas grew by 17%. These metrics highlight the potential for predictable revenue growth, making revenue-based earnouts an attractive option in similar sectors.
Profit-Based Earnouts
Profit-based earnouts, often tied to EBITDA, focus on the profitability of the business after accounting for operating costs. This structure ensures that payments are tied not just to revenue growth but to efficient management of expenses as well.
Milestone-Based Earnouts
In some cases, earnouts are based on non-financial milestones, such as patient retention in a health care practice or launching a new service. These milestones can be important for businesses where success is measured by more than just financial metrics.
Considerations for Buyers and Sellers
Earnouts can be an effective way to bridge valuation gaps and close a transaction, but their success relies on careful planning and clear terms. To ensure a mutually beneficial arrangement, buyers and sellers must consider a variety of factors that can influence the outcome. From defining measurable performance metrics to addressing operational and legal complexities, each element of an earnout plays a critical role in achieving the intended goals. Below are highlights of some considerations both sellers and buyers should keep in mind.
Performance Metrics
Performance metrics must be measurable and clearly defined to prevent future disputes. Buyers should align these metrics with the expected value of the business post-sale, while sellers should ensure the targets are realistic and achievable within the agreed timeframe. For example, in high-growth markets like aesthetics—where non-surgical patient spending increased by 4% to $15 billion in 2023—clear revenue or profitability targets illustrate how measurable metrics can drive success. This principle applies across other health care sectors and underscores the importance of working with advisors to establish attainable goals, creating a shared understanding and increasing the likelihood of a successful deal.
Operational Changes
Post-sale decisions by the buyer—such as changes to staffing or marketing—can influence whether performance targets are met. Ensuring adequate support and resources during the earnout period is crucial for hitting those goals. On the seller’s side, you will want to consider negotiating protections that ensure operations are maintained to maximize the chance of receiving the earnout. As a post-closing obligation, in most deals, the buyer is now managing the seller’s practice. Making sure the buyer understands the seller’s business and how to run a profitable practice will be key to the seller meeting the earnout. The seller should spend the time understanding the strategy the buyer will deploy, and make sure it aligns with the seller’s ability to receive the earnout.
Time Frame
The length of the earnout can impact both parties. A buyer may prefer a longer timeframe to ensure continued performance and retention of its employees, but this also exposes the deal to external risks like market changes. A seller, on the other hand, might push for a shorter earnout period to limit risk but may also have fewer opportunities to achieve the required milestones within a shorter window.
Legal and Regulatory Considerations
Both buyers and sellers must ensure the earnout complies with relevant laws, especially in regulated industries like health care. Care must be taken to avoid triggering legal issues, such as fee-splitting prohibitions in certain states, which restrict how future revenues are shared. For example, a New York court ruled that an earnout based on future revenue violated fee-splitting laws, making the agreement unenforceable (Advanced Dental of Ardsley, PLLC v. Brown). Legal advice is critical to ensure the structure of the deal adheres to state and federal regulations, such as fee-splitting or anti-kickback laws.
Tax Implications
Earnout payments can have significant tax implications for both buyers and sellers. Both parties should seek tax advice to understand and mitigate potential tax liabilities.
ByrdAdatto Can Help Structure a Clear and Compliant Earnouts
Earnouts provide a flexible solution for bridging valuation differences in business transactions, particularly in industries like health care, but they also introduce complexities that are important to know. Both buyers and sellers should work closely with advisors to structure earnouts that are clear, compliant with legal standards, and designed to protect their interests.
At ByrdAdatto, we work with businesses during the buying and selling season to help them navigate these types of transactions. Our legal team can help you understand earnouts to protect your interests as you prepare to buy or sell a health care practice. If you have specific questions about earnouts or need assistance with structuring your transaction, contact ByrdAdatto.
