Earn-out agreements are used in M&A deals to enable sellers to benefit from a business's future performance and to protect buyers from overpaying.
This guide explores what earn-out agreements are and their benefits to both the seller and buyer. It also breaks down the clauses that safeguard the parties in the agreement, while helping you discover the strategies for negotiating a better earnout.
An earnout is a contractual agreement wherein the buyer of a company agrees to pay the seller the entire purchase price (or a portion of it) in the future once the target company achieves predefined operating milestones or financial metrics after the transaction has closed.
Earnouts are an effective tool for mitigating risks and bridging the valuation deadlock that sellers and buyers usually get into and are forced by circumstances to kill the M&A process.
Earnouts connect both the seller’s and buyer’s expectations in the business after an initial sale. It benefits both parties financially and strategically.
Here’s how:
Earn-outs in the M&A process can be challenging. That’s why you should consider working with professionals to ensure you get the best value for your company.
At Exitwise, we can help you interview and manage an exceptional team of M&A experts who will ensure you get the best deal structure and highest valuation price possible. Book a free consultation today to build your M&A dream team and maximize your exit value.
Earnouts are not suitable for every M&A transaction.
They are best used when:
Earn-out payments can have varying tax implications, depending on how you structure the business sale agreement:
Federal income taxes apply to installment sales, depending on whether the maximum possible selling price and the earn-out period can be determined.
The tax implications of an earn-out system can be complex and daunting, not to mention sometimes unfavorable to you as the business seller. Be sure to consult your tax advisor before you agree on an earn-out payment plan.
At Exitwise, we can help you find the best M&A tax accountants. Schedule a free consultation with our advisor to get started.
Earn-out structures are designed to enable the seller to walk away with a higher total price while protecting the buyer from paying a high price based on future growth projections that may never be realized.
Here are the most widely used structures in contingent payments:
If structured properly, earnouts can align the buyers' and sellers' interests, reducing potential deal risks by breaking negotiation deadlocks throughout the transaction.
Here is a step-by-step guide to help you structure an effective earnout:
These can be financial performance metrics, such as net income, revenue, or EBITDA, or operational performance metrics agreed upon by the seller and buyer. They must be easy to track and aligned with the business’s growth drivers.
Typically, earnouts last 1 to 5 years. Choose a payout window that balances sellers' expectations and buyers' concerns. A 1 to 2 year duration is considered ideal for businesses with a strong, clear revenue trajectory, while 3 to 5 years may work better for businesses that require significant changes after purchase.
To avoid post-close disputes, payment must be structured to benefit both parties and be legally binding.
Commonly used structures:
Earnouts should be protected from changes that could alter the outcome, such as operational decisions or accounting changes. For instance, scenarios where the buyer may sell the business or alter financial accounts to avoid paying earnouts.
In earnout arrangements, sellers often need some level of involvement in the business post-closing. Buyers, on the other hand, want to take full control of their new entity. To avoid conflict and protect the interests of both parties, roles should be clearly specified.
Disputes often arise in earnouts due to various reasons, for instance, if the accounting methods are manipulated or parties don’t agree on how performance metrics are measured. A clear dispute-resolution plan can help settle disagreements faster and more non-contentiously, while protecting deal value.
Here are the advantages and disadvantages of the earn-out payment system from the seller's perspective:
While we have only examined the pros and cons of an earn-out to the seller, note that it also has advantages and disadvantages for the buyer. The buyer will want to maximize their benefits, which could lower yours.
Here are several key components when structuring an earnout agreement:
The buyer and seller agree on a specific timeframe, usually 1 to 5 years, during which the business's performance is measured. Short periods tend to favor the seller by reducing the time their money is at risk, while long periods favor the buyer by giving them adequate time to evaluate business viability.
This is the earnout amount paid to the seller if the agreed business targets are met or exceeded. It is the difference between the upfront paid amount and the total purchase price. To help reduce future disputes, this payment can be secured through an escrow account.
Also known as the total deal value is the baseline figure that represents a business valuation. Think of it as the full valuation amount the seller and buyer agree on, comprising the upfront amount and the contingent payment tied to the business's future performance.
The earnout amount, which is usually performance-based, is calculated as a percentage of this amount.
An upfront payment is the amount the buyer pays to the seller immediately upon closing the deal. It is not based on future performance. Often calculated as the percentage of the total purchase price. It signifies the buyer's confidence in the business's current state and reduces sellers' risk by ensuring they walk away with a tangible amount before the earnout agreement takes effect.
This component specifies how payouts are layered, from upfront cash to contingent payments. It often includes the maximum payout and minimum guaranteed payment. Payments are structured based on the negotiated M&A terms, that is, quarterly, annually, or at the end of the earnout period.
These are clear, measurable targets that determine whether the seller will receive their earnouts.
They include:
This outlines how performance is tracked and how payments are made. It defines the reporting standards, frequency, and format used, as well as who has the right to verify audits and the timing of payouts.
This component specifies the exact amount to be paid to the seller for acquiring specific targets. For instance, the agreement might outline that the predefined payment of $1.5M will be paid if the company generates $8M in revenue in the first year. This ensures that both the seller and buyer understand the stakes, eliminating misinterpretations of metrics.
Earnout clauses are provisions that legally link part of the purchase price to a future outcome.
Below are the clauses meant to protect both the buyer’s and the seller’s interests:
You can never base earnouts on the numbers in a sales and purchase agreement (SPA).
The payment you ultimately receive depends on how the business performs after the deal closes, which is influenced by a mix of factors that you control and some of which you don’t, such as:
Buyer’s decisions after the sale determine your earn-out outcome. If they alter the business model, delay implementing key initiatives, or lay off key sales teams, the business will likely not achieve the performance targets you agreed to. You’ll have to forfeit all or part of the payment. On the flip side, if they focus on growing the business, chances are you’ll hit your earn-out targets.
Earnouts are more commonly used in industries with high but uncertain growth potential, such as healthcare, tech, accounting, and law. Businesses operating in these industries tend to face sales fluctuation. Due to the cashflow uncertainties, a substantial portion of the purchase price is structured as an earnout.
Retaining the company’s critical employees prevents disruptions that could directly jeopardize business operations, increasing the odds of achieving post-closing financial targets. Conversely, if key staff leave, then the performance drops, directly impacting earnout payments.
The earnout duration can range from 1 to 5 years, depending on the nature of the business and the specific goals of both the buyer and the seller. A longer earnout period offers adequate time to achieve required metrics, but is riskier to the seller due to market volatility. A shorter duration may reduce seller uncertainty but make it hard for them to achieve the targets. Striking a balance between the earnout period and achievable targets may yield the best outcome for both the buyer and the seller.
Larger businesses with a stable customer base and diversified, consistent revenue streams are less likely to have earn-out structures. They are utilized mostly in SME transactions. Such businesses are considered more vulnerable to disruption, as they often operate in volatile industries and have unpredictable growth potential.
Recessions, regulatory shifts, and other industry-specific changes can make it difficult for the seller to meet agreed targets, leading to missed payouts. To mitigate such risks, sellers negotiate protections when major market conditions make it difficult for them to meet targets.
KPIs link the earnout payment to tangible results. That means that if the seller does not meet the set EBITDA target, revenue target, or operational milestones within a specified period, they may receive little or no payment. Regardless of the metric used, earnout payments follow a tiered structure. The seller is paid more for exceeding targets, while the buyer pays less or nothing for underperformance.
Securing a fairer earnout deal starts by anticipating where disputes might arise and building executable structures that protect your financial interests.
Here is what it really looks like in practice:
Ask the buyer to place the contingent payment in an escrow to ensure it will be available for disbursement to you when the earn-outs are due once the set metrics are achieved.
Ask the buyer to retain the management team and other key employees to safeguard your interests. They will ensure the buyer acts in good faith when running the business and doesn't terminate the company for flimsy reasons.
Reduce the earn-out duration and clear the contingent payment faster by asking the buyer to accelerate the earn-out payments. You can make this request if the buyer sells the business during the period, breaches your agreement, fires key employees without good cause, or your company achieves the performance targets early.
If you remain in the company under the acquirer, ask to maintain your independence as the founder or CEO so it's easy to make decisions toward success and reach the set performance targets.
As a seller, having operational control is one of the best ways to secure earnout payments. That’s because you can directly influence the business's performance, making it easier for you to meet the required targets without the buyer’s interference.
Earnouts bridge the gap between the buyer’s and seller’s proposed valuation but transfer significant risk to the seller. They are based on post-closing performance, which can be affected by factors beyond the seller's control. Asking for more upfront payment ensures the seller receives the core part of the valuation, which protects the seller's interests regardless of what happens after the sale is closed.
Consider the metrics used to determine your payout. Attaching your earnouts to metrics that matter most to a business gives you the assurance you’ll get paid. For instance, opting for revenue-based metrics over net income. That means your payments won’t be affected by buyers’ decisions that often shrink profits, such as hiring a new workforce. You should also have the right to cross-check the revenue numbers.
A steady, periodic payment throughout the earnout period helps minimize buyer risk and ensure sustained performance. Sellers who push for this structure are better placed to negotiate for a maximum value for their business.
Securing contingent payments through escrow ensures the funds are available and accessible whenever targets are met. This protects the seller from potential dispute risks, such as future payment defaults or allegations of the buyer's intentional mismanagement.
The acceleration provision requires the buyer to pay the seller the remaining earnouts immediately upon changes that threaten the seller's ability to achieve the agreed performance targets. For instance, if the buyer sells the company or a portion of the business, terminates the seller’s contracts, or breaches the contract during the earnout period.
Let's end the discussion with some FAQs on earn-outs in M&A:
A seller note is a financing option in which the seller loans the buyer up to 25% of the purchase price with interest over three to five years.
Unlike an earn-out, a seller note doesn't rely on the business achieving set performance targets. Instead, the seller receives part of the purchase price through several debt payments.
Earn-out arrangements are common in high-growth industries that cannot easily predict future profitability and revenues.
These industries include healthcare, advertising, technology, and marketing.
Yes, you can apply earn-outs to cross-border transactions. However, the complexity of the transaction increases.
You'll have to consider additional aspects such as applicable laws, fluctuating exchange rates, monetary devaluation, and applicable accounting procedures.
Typically, the earn-out period is 1 to 5 years, depending on the industry and the complexity of achieving the performance milestone required to prove the business's viability.
Businesses operating in industries with long sales cycles can use longer earn-out periods, 3 to 5 years, to account for the extended time it may take to achieve performance milestones. Those operating in industries with faster performance cycles can choose short earn-out periods of 1 to 2 years.
Earn-out disputes are often triggered by disagreements over:
If you structure an earn-out agreement correctly, it can help you resolve valuation or pricing differences with the buyer instead of abandoning the deal.
It's a win-win situation that protects the buyer from downside risk and gives you a higher purchase price than ordinarily possible.
But to ensure a favourable earn out deal, you’ll need expert advisors on your side.
At Exitwise, we can help you recruit and work with your dream M&A team to ensure you get an advantageous deal structure and the highest sale price possible. Reach out to us today for a free, no-obligation consultation.
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