An earn-out is part of the price made conditional on how the business performs after the deal. It reduces the buyer’s risk by transferring it to the seller, at the very moment the seller loses control over operating decisions. It makes sense where the parties genuinely disagree about the future. It does not make sense as a way of papering over a gap in price.
What an earn-out is
The buyer pays part of the price at closing and the rest only if the business hits agreed results. Usually that means EBITDA or revenue over one, two or three years after the deal. If the result arrives, you get the top-up. If it does not, you get nothing.
In SME transactions an earn-out typically covers ten to thirty per cent of the price. Above that it starts to dominate the whole structure, which is a good moment to ask whether the parties actually agree on what the company is worth.
When an earn-out works
In three situations. First, the company has just entered a new segment or signed a large contract and there is no track record behind it yet. Second, last year’s result was markedly better than the years before and the buyer cannot tell whether that is a trend or an exception. Third, you are staying on and genuinely influence what happens next.
In all three the earn-out solves a real problem: the parties disagree about the future, not about the past.
When an earn-out is a trap
When it is used to close a gap in price. The buyer offers less than you expect, adds an earn-out, and the headline number looks acceptable. The real value of the deal drops, because part of the price is conditional and the condition depends on somebody else.
The second trap is loss of control. After closing it is the buyer who decides on pricing, costs, investment and how group overheads are allocated. Any of those decisions can reduce the figure your top-up depends on, and any of them can have a perfectly sound commercial justification.
What the agreement has to contain
- Definition of the measure. Not “EBITDA” but EBITDA calculated on stated rules, with a list of exclusions: group costs, licence fees, integration costs, one-off items.
- Rules for running the business during the earn-out period. No moving customers to other group companies, no changing pricing policy below an agreed threshold, no loading the company with head-office costs beyond an agreed cap.
- Access to data. A right to monthly reporting and to have the calculation verified by an independent expert.
- Dispute mechanism. Who decides if you disagree about the result, and within what deadline.
- Acceleration. What happens if the buyer sells the business on, or materially changes its model, during the earn-out period.
Alternatives worth considering
If the gap in price is small, it is simpler to split it. If the buyer needs security, a vendor loan, which is deferred payment without a performance condition, or an escrow covering a specific risk, are both easier to enforce, because neither depends on how somebody else runs the company.
See also
- Earn-out, vendor loan and escrow in the glossary
- Frequently asked questions about selling a company, valuation and due diligence
- Red flags: 12 areas every buyer examines
About the author
Łukasz Brzyski runs Brzyski & Partners Management Consulting. He advises on the sale and purchase of companies valued between PLN 10 and 50 million, and sold two companies he co-founded before he started advising others. More about the author