Earnout illustration

Earnouts - How derivatives can be effectively employed in price negotiations

By Walodja1987 at

TL;DR: Earnouts are conditional payment arrangements used in negotiations when buyers and sellers can't agree on a price. DIVA Protocol is democratizing the access to this powerful tool through smart contracts, allowing users to create custom conditional payment agreements peer-to-peer.

Often, when buyers and sellers want to complete a deal but can’t agree on the price, they employ a strategy called an “earnout”. An earnout is a contingent payment that the seller only receives from the buyer when specific performance targets are met.

The buyer pays a portion of the cost of the business upfront, and the remainder of the cost is dependent upon if future performance targets are met.

Example: Bob seeks to sell his business. Alice is willing to pay $800’000, but Bob is confident in the company's future growth potential and asks for $1’000’000. To bridge the gap, the two parties agree to implement an earnout arrangement. That is, Alice agrees to pay $800’000 upfront and the remaining $200’000 only if the company reaches $150’000 in sales within a three year window.

The earnout eliminates uncertainty and limits the downside for the buyer, as they only pay a portion of the sale price upfront and the remainder based on future performance. The seller receives the benefits of future growth.

🐘 Big Players Embrace Earnouts

Major players like eBay and Google have employed earnouts in their acquisitions. When eBay purchased Skype in 2005, 40 percent ($1.1bn) of the purchase price was tied to specific performance targets, including net revenue, gross profit margin and active users. Similarly, Google’s acquisition of dMarc Broadcasting in 2006 featured a small upfront payment of $102m and a substantial $1.14bn contingent on achieving certain milestones.

🦎 Smaller scale examples

Earnouts aren't just for corporate giants; they can also be applied on a smaller scale. Consider a scenario where Bob wants to sell $10’000 worth of an illiquid token over-the-counter (OTC) at $0.2 per token. Alice offers an upfront payment of $7’500 and the remaining amount contingent on the token's average price over a 12-month period exceeding $0.3.

This concept can be applied in any service-based context: Bob offers marketing services and promises to increase sales by 100% within 12 months due to his activities. To make Bob live up to his claims, Alice pays $10’000 upfront and ties the remaining $5’000 to actual sales growth within the next 12 months.

But how would you implement such a conditional payment agreement in the traditional financial world without involving a bank or some other trusted entity that holds the contingent amount and releases it based on the reported outcome? Short answer: You can’t! DIVA Protocol solves that.

⛓️ Introducing DIVA Protocol

DIVA Protocol is a smart contract-based system for creating and managing custom conditional payment agreement peer-to-peer. It revolutionizes the concept of earnouts by making them accessible to anyone in the world in a permissionless manner.

Users can select virtually any metric as the underlying and choose from a wide array of customizable payoff profiles to fit their specific needs. Further, DIVA Protocol allows to accommodate any oracle for outcome reporting, including trusted individual accounts, multi-signature wallets or trustless decentralized oracle solutions such as Tellor, offering flexibility in setup.

But that's not all - DIVA Protocol stands out as one of the first DeFi protocols that tries to bridge the gap between DeFi and traditional finance. The protocol achieves this by implementing an optional compliance feature that allows traditional financial institutions to restrict the transfer of derivative assets to predefined NFT token addresses, such as KYC NFT tokens, and with that ensure compliance with regulatory KYC and AML requirements.

Last but not least, DIVA Protocol is secure as it requires full collateralization of the derivative positions upfront, thereby eliminating the inherent risk of buyers failing to honor their payment commitment - an issue often associated with conventional earnout arrangements.

🌔 Conclusion

Thanks to DIVA Protocol, the powerful tool of earnouts is now within everyone’s reach. If you're curious about this approach and eager to delve deeper, we invite you to join our Discord community and ask your questions.

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