Earn-outs — bridging the gap on price

Buyers and sellers of a business often agree on almost everything except the price. The seller points to a strong recent year and a growing pipeline. The buyer points to the risk that growth will not continue once the owner has gone. An earn-out is a way to let both sides be right: part of the price is paid only if the business performs as the seller expects.

What an earn-out is

An earn-out is an arrangement in a sale agreement where some of the purchase price is contingent on the business reaching agreed targets after settlement. The buyer pays a fixed amount at completion, and further payments later if the targets are met.

The targets are usually financial, such as revenue, gross profit or EBITDA, measured over one or more periods after the sale. Sometimes they are non-financial, such as retaining a key customer contract.

Why earn-outs are used

Earn-outs tend to appear when:

the parties disagree on value. The seller believes in a higher figure; the buyer will only pay it if the results arrive.
profit depends on the seller. If customers are loyal to the owner personally, an earn-out encourages the seller to help hand those relationships over.
recent results are unusual. A sharp rise in profit in the year before sale is hard to value. An earn-out lets the next year prove whether it was lasting.
funding is tight. Deferring part of the price, subject to performance, reduces what the buyer must fund on day one.

A worked example

Here is an illustration. The figures are examples only.

A seller wants $1,200,000 for a business. They say EBITDA will reach $350,000 this year. The buyer is only confident in $280,000, which they believe supports about $1,000,000.

They agree:

$1,000,000 paid at settlement
up to $200,000 more, paid 12 months after settlement, if EBITDA for the first year reaches $350,000
a sliding scale: if EBITDA reaches $315,000, half the earn-out ($100,000) is paid; below $280,000, nothing is paid

If the business performs as the seller predicts, the seller receives their price. If it performs as the buyer feared, the buyer has not overpaid.

Designing a fair earn-out

Earn-outs work when the terms are clear enough that both sides can calculate the outcome without arguing. Your lawyer should draft the clauses; your accountant should help define the numbers. Points to settle include:

The measure. Revenue is simple to measure and hard to manipulate, but it ignores margin. Profit measures reflect the business better but are easier to dispute because they depend on costs the buyer controls. Gross profit can be a sensible middle ground.
The definitions. If the measure is EBITDA, define it precisely, including how the buyer's own salary, head office costs, new hires and one-off integration costs are treated.
The accounting basis. State that the earn-out accounts will be prepared on the same basis as the historical accounts, so the measure is consistent.
The period. Shorter periods reduce uncertainty for both parties. Longer periods give more time for results but increase the room for disagreement.
The shape. All-or-nothing targets create cliff edges and arguments over a few dollars. Sliding scales are usually fairer.
A cap. Set a maximum earn-out amount.
Payment timing. When the figures will be prepared, who prepares them, how long the seller has to review them, and when payment is due.
Dispute resolution. A process for resolving disagreements, often referral to an independent accountant as an expert.

The seller's concern: control

Once the business is sold, the buyer controls it. A seller worries that the buyer will make decisions that reduce the earn-out, such as cutting prices, moving staff, or loading costs onto the business. Sellers often ask for protections, for example that the business is run in the ordinary course and broadly consistent with past practice during the earn-out period.

Buyers need to be careful here. You are buying the business to run it your way. Agreeing to restrictions that stop you making sensible changes can be costly. The balance is a matter for negotiation, with your lawyer's input.

The buyer's concern: paying for their own work

Buyers worry about the opposite problem: paying the seller extra for growth that came from the buyer's own effort or investment. If you plan to invest heavily, add new services or merge the business with another, think about how that affects the measure. Clear definitions and, where needed, separate tracking of new initiatives help avoid paying twice.

Earn-outs and the seller's ongoing role

Many earn-outs run alongside a period in which the seller stays on, as a consultant or employee, to support the transition. This can work well, but it mixes two relationships: seller and buyer, and employee and employer. Keep the employment or consultancy terms separate from the sale agreement, and be clear about what happens to the earn-out if the seller's role ends early.

Tax and accounting points

Earn-outs raise specific tax questions for both parties, including how the contingent amount is treated for capital gains tax purposes. Australia has particular rules for some earn-out arrangements, and whether they apply depends on how the arrangement is structured. Get advice on this before the terms are finalised, because the structure can change the tax result for both sides.

Earn-out or vendor finance?

An earn-out is contingent: the buyer pays only if targets are met. Vendor finance is a fixed debt: the buyer owes it regardless. Earn-outs address disagreement about value; vendor finance addresses a funding gap. Some deals use both. See vendor finance explained.

Common sources of dispute

Earn-out disagreements usually come from a handful of places:

vague definitions of the measure
changes in accounting policies after the sale
costs moved into or out of the business
the seller leaving or being removed before the period ends
delays in preparing or sharing the earn-out accounts

Each of these can be reduced with careful drafting at the start.

An earn-out only bridges a price gap if both sides can read the contract and calculate the same answer. Precision in the definitions is worth more than optimism about the outcome.

Is an earn-out right for your deal?

Consider an earn-out if the price gap is driven by genuine uncertainty about future results and the seller will stay involved for a period. Think twice if the measure will be hard to separate from your own changes, or if the relationship with the seller is already strained. Strong financial due diligence beforehand narrows the gap in the first place; see our financial due diligence checklist.

How we can help

Kainos Consultants helps buyers and sellers define earn-out measures that can be calculated cleanly, model possible outcomes, and prepare the earn-out accounts when the time comes, working with your lawyer on the drafting. Read about our business sales and purchases service, or contact us to discuss your deal.

This article is general information only and does not take into account your circumstances. Speak to a qualified adviser before acting on it.