What Is an Earn-Out in a Business Sale

What Is an Earn-Out?

In a business transaction, an earn-out is a clause that ties some of the purchase price to the future successes of the acquired company. The buyer can pay a sum more than the amount agreed at closing if the company achieves certain financial or operational milestones.

How an earn-out works in a business sale

If the transaction price is divided into two components when an earn-out is used in a commerce, one is paid at the close of the sale and the other contingent on prospect performance. The buyer makes the first consideration when the contract closes, which is followed by the second that based on agreed criteria afterward.

The arrangement helps the buyer mitigate the risk of paying a higher valuation in full if they are unsure about the upcoming performance. Meanwhile, the seller can also have an economic interest in the company's future without being a shareholder.

Why buyers and sellers use earn-outs

The main reason for using an earn-out is to resolve a difference in valuation expectations.

One person might think the business has a lot of potential going forward, and the other person might not be willing to invest in that potential prior to its actual fruition.

This mechanism can offer a compromise. The buyer pays for value at closing and agrees to make more payments if the value created by the seller is verified by additional results.

How Is an Earn-Out Structured?

The structure sets when money is due and how much it will be. Wording matters here. Even one small tweak to a phrase can move the final bill.

Earn-out payments and calculation methods

The parties should agree precisely how the contingent payment will be determined. It can be a monetary limit, percentage of money raised over a certain limit, or a formula based on business performance.

This earn-out agreement should also contain the time when the calculation will take place, when the payment will be made, and what will happen if the company only reaches part of the target.

Then there's the cap question. A cap tells the acquirer the most it will ever owe. Without one, the vendor could collect a large reward if the firm grows unusually fast.

The earn-out period

The earn-out period is the time during which the agreed performance targets are measured. It may last several months or, more commonly, one to several years depending on the nature of the enterprise and the transaction.

Match the length to what's being tracked. Recurring sales or customer growth can be judged quickly. Building a product, entering a new market or delivering long-term contracts takes longer.

What Is Included in an Earn-Out Agreement?

The agreement will be more effective than just setting a target and possible reward. This section looks at the terms that spell out each side's rights and duties while the arrangement runs.

Key earn-out provisions

The performance goals, measurement methods, dates, payment dates, accounting rules, reporting requirements, and dispute resolution processes are typically included in an extensive earn-out agreement.

It should also provide an explanation on how extraordinary occurrences are addressed. The number of things that could happen to move the numbers, and the final number along with it.

The parties may wish to agree whether or not the firm has to be carried out in a certain manner during the measurement period. Likewise, the seller could be liable for some obligations in the case of working or managing.

Dispute resolution and seller protections

The parties often disagree on the method of calculation. The contract should, therefore, include a provision for disputes.

The earn-out provisions could include an independent accountant to look at disputed calculations. Otherwise, the parties can resort to arbitration or court action as per the transactions and applicable laws.

Vendors can also be protected from maneuvers that are designed to make the result smaller.

Common measures include restrictions on unusual transactions, changes in accounting treatment, too high a management fee or diverting opportunities to the acquirer's other holdings.

Benefits and Risks of Earn-Outs

While this approach can be beneficial to both parties, they also present potential threats that need to be considered before entering into the agreement.  

Benefits and risks for sellers

For sellers, it can make possible to obtain a higher total sale price than the buyer would otherwise accept at closing. It can also reward the seller for later growth that was not fully reflected in the initial consideration.

The main threat is that the additional payment may never become payable. The person who sold may also have little say over what drives results once the transfer is done.

That bites hardest when they keep working in the firm but no longer control budgets, hiring, pricing, investment or strategy. A well-drafted document should address how much influence they retain over the metrics that count.

Benefits and risks for buyers

Purchasers cut upfront costs and tie some of the outlay to real results. It can also encourage key sellers or managers to remain involved during the transition.

However, this mechanism can create administrative burdens and future disputes. Buyers may need to operate the business while simultaneously complying with contractual obligations designed to protect the seller’s potential payment.

It pays to think through practical effects when planning financing, integration, restructuring or any change to the acquired firm's operating model.

Final Thoughts

An earn-out may be a good tool to close the gap between buyer and seller valuation and to connect a portion of the sales price with upcoming performance. But it's highly dependent on the contract provisions.

The headline target should be agreed as should be the method for calculating the target, who is responsible for the reporting, the accounting treatment, who will take control of the firm, how the firm will be paid and how any disputes will be resolved.

Make the terms specific enough to cover realistic situations after closing. A clear period and a clear way of measuring results give everyone more certainty.

Ultimately, understanding what is an earn-out means looking beyond the additional purchase price. It is a contractual mechanism that allocates future performance risk between the parties, and its success depends on whether that allocation is clearly documented and commercially workable.