Earn-outs explained: how they work in a business sale and the pros and cons for each side

What is an earn-out, how does it work, and what does it mean for you as a buyer or a seller? In short, an earn-out makes part of the purchase price conditional on the business hitting financial targets after completion. It is the standard way to bridge the gap between what a seller thinks the business is worth and what a buyer is prepared to pay. It also creates more disputes than almost any other clause in a share purchase agreement, which is why both sides need to understand it before they sign.

What is an earn-out?

An earn-out is a contractual provision in the share purchase agreement, the main contract between the buyer and the seller of a business. It states that part of the purchase price is only payable by the buyer to the seller if the target business meets specific financial targets.

Rather than paying the entire purchase price on completion, the buyer pays part of it later, say over a period of two years. The payments over those two years are contingent on the target business meeting the agreed targets, which are typically based on profit levels. If the targets are hit, the money is paid. If they are not, it is not. The targets, the period and the calculation method are all negotiated and written into the agreement, which is why the drafting matters so much.

The main reason earn-outs are used is to bridge a valuation gap. Typically a seller values their business higher than a buyer is willing to pay for it. An earn-out is a good way to close that gap: the difference between what the buyer is prepared to pay and what the seller wants can be structured as an earn-out, so the seller gets their number if the business performs as they say it will, and the buyer only pays for performance that actually materialises.

Earn-outs for buyers: advantages

• Less money up front. The buyer pays less on completion and therefore risks less money. If the business does not perform, the buyer has not overpaid for it.
• Better cash flow management. Deferred payments typically need to be financed by the target business itself. If those payments are contingent on the business meeting its targets, the pressure on cash flow eases: if the business can pay, it will pay, and if it cannot, it will not.
• A motivated seller. If you are planning to keep the seller in the business for the early period after completion, the earn-out keeps them motivated. They want the business to do well so that they receive the additional sums, so they will not slack off or try to move clients elsewhere.

Earn-outs for buyers: disadvantages

• Administrative burden. Earn-outs add complexity to the deal and to the negotiations. They require more documentation to evidence the mechanism and the calculations used to decide whether an earn-out payment is owed. That tends to increase professional fees.
• Restrictions on running the business. The seller will typically want the share purchase agreement to restrict what the buyer can do with the business during the earn-out period, to stop the buyer doing things that would result in the seller missing their earn-out. The buyer is therefore restricted in how it runs its own business for that period.
• Disputes are more likely. The calculations themselves may be disputed, as they can be with completion accounts. The bigger source of disputes is the buyer's conduct during the earn-out period. It is not uncommon for a seller to be unhappy with what the buyer is doing with the business, because it affects whether they get paid. For example, if the targets are profit-based but the buyer is reinvesting heavily and incurring a lot of cost, that may be good for the business over the long term, but in the short term it reduces profit and therefore the seller's earn-out payments.

My tip for buyers is to clarify exactly how the earn-out is to be calculated, and to discuss internally what your plans are for the business once you take it over. Then make sure the seller does not include provisions in the agreement that would stop you carrying out those plans. If you intend to invest, restructure or integrate, you need the earn-out drafted around that, not against it.

Earn-outs for sellers: advantages

• A higher valuation. The first big advantage is the opportunity to be paid more than the buyer was initially prepared to pay. The earn-out is how a seller gets their price when the buyer will not commit to it on day one.
• More control during the earn-out period. In mergers and acquisitions it is very unlikely that the entire purchase price is paid on completion. Some part is almost always paid over time. With an ordinary deferred payment, which is not an earn-out, the seller is very unlikely to have any say in how the business is run after the sale. With an earn-out, it is quite acceptable for the seller to introduce restrictions on what the buyer can do during the earn-out period. That gives the seller more control over the profitability and performance of the business they have sold, and makes it more likely they will be paid.
• Possible tax planning opportunities. I am not a tax adviser, but receiving money over a period of time may open up tax planning opportunities for the seller. That is a point to raise with your tax adviser.

Earn-outs for sellers: disadvantages

• Less certainty. Nothing is ever really guaranteed, but earn-out payments are only made if the business meets its financial targets, so they are the least certain part of the price. Meeting those targets is not entirely within the control of the buyer, the seller or the company. Outside influences such as the wider economy or new government policy can affect performance.
• Less control than completion money. Compared with money received on completion, the seller has less control over earn-out payments and is less likely to receive them.
• Disputes are more likely. As a seller you have a vested interest in the business during the earn-out period, so you are more likely to be unhappy with what the buyer does with it and to scrutinise the buyer's actions far more closely than you otherwise would. That is where disputes come from: the seller is watching every decision through the lens of whether it costs them money.

My tip for sellers is to include restrictions in the share purchase agreement on what the buyer is allowed to do with the company during the earn-out period. The main things to consider stopping the buyer from doing are, for example, taking out large loans or declaring profits in a way that affects the targets. The earn-out is only as good as the protections around it. Without them, the buyer can run the business in a way that is perfectly sensible for them and still leave you with nothing.

Getting the earn-out right

Both sides want the same thing from an earn-out: a fair price for a business whose value is uncertain. The problems come when the mechanism is vague, the targets are easy to manipulate, or the buyer's freedom to run the business collides with the seller's need for the targets to be hit. Clear calculations, agreed accounting principles and sensible operating restrictions deal with most of it. Earn-outs are one of several ways a purchase price can be adjusted after the deal is signed. Completion accounts and locked box mechanisms are the others, and there is a separate page on purchase price adjustments that compares them.

Next steps

If an earn-out is on the table, agree the calculation mechanism and the financial targets in detail before heads of terms are signed, not after. Buyers should map their post-completion plans against the proposed restrictions, and sellers should list the protections they need. Then have a corporate solicitor draft the earn-out provisions in the share purchase agreement so that both sides know exactly when the money becomes payable.