January 3, 2025
A Small Business Owner’s Guide to Earn-outs
When selling your small business, arriving at the right deal structure can be as important as agreeing on the final purchase price. One mechanism frequently used to address a valuation gap and manage buyer’s risk is the earn-out. This strategy, called an earn-out, ties a portion of the purchase price to the future performance of your target business under new ownership. While this arrangement can potentially increase your total proceeds, it also introduces complexity and uncertainty.
In this article, you will learn how to:
Understand what earn-outs are and why they’re used
Evaluate the pros and cons of including an earn-out in your deal
Structure earn-out terms that are fair and enforceable
Navigate common challenges and maximize your outcome
What Is an Earn-out?
An earn-out is a provision in the purchase agreement (often documented in a share purchase agreement, depending on structure) that commits the buyer to pay the seller additional compensation over time if the acquired business meets certain financial targets or operational milestones. Instead of receiving the entire purchase price at closing, you get a portion upfront and the rest—if earned—after the business performs and hits agreed-upon benchmarks. These contingent earnout payments can significantly boost your overall payoff if the company achieves or exceeds the specified goals.
Quick Tip: An earn-out can also function as a deferred payment, letting the buyer and seller bridge differences in valuation while sharing the risk and potential upside.
Personal and Financial Considerations
Before committing to an earn-out agreement, think about:
Risk tolerance: Earn-outs link part of your payoff to the buyer’s ability to operate your acquired company successfully. Are you comfortable with this uncertainty and potential potential risks?
Patience and involvement: Earn-outs often mean longer-term financial ties. You may remain involved post-sale, either formally or informally, to help the new owner achieve specific targets. This might also involve collaboration with key employees.
Financial goals: If you’re counting on the full sale price for retirement or another investment, understand that the earn-out portion—and thus a significant portion of your proceeds—is not guaranteed.
Market Timing
Earn-outs are more common in deals where there’s disagreement over the company’s expected growth or future event milestones. If you’re confident that your company will grow substantially under new ownership, an earn-out might let you capture that upside. Conversely, if market conditions are uncertain, the buyer may insist on an earn-out to mitigate buyer’s risk.
Quick Tip: Consider earn-outs if you believe the buyer’s resources, expertise, or network will drive growth you couldn’t achieve on your own. This can justify tying a portion of your payout to future performance.
Why Include an Earn-out?
Pros
Bridging valuation gaps | If you and the buyer disagree on the company’s current worth, an earn-out can let them pay more—if you’re right about future growth. | ||
Upside potential | If the business outperforms expectations, you could end up with more money than if you had accepted a lower, all-cash price. | ||
Alignment of interests | Earn-outs incentivize you to provide a smooth transition and ongoing support, which can help protect your legacy and ensure the business thrives post-sale. |
Cons
Uncertainty of payment | You may never receive the full amount if targets aren’t met. | ||
Reduced control | Once you hand over the reins, you rely on the buyer’s decisions to achieve earn-out milestones. | ||
Complex legal agreements and monitoring | Negotiating and enforcing earn-out terms can be time-consuming and might create disputes down the line. |
Quick Tip: An earn-out isn’t a guaranteed payout. Treat it as a bonus, not a certainty, and make sure the upfront portion still meets your core financial needs.
Structuring an Earn-out
Key Earn-Out Components
When creating an earn-out, you must define several elements:
Performance metrics: Common metrics include revenue, gross profit, EBITDA, or even
adjusted EBITDA. Choose a clear, measurable earnout metric that can’t be easily manipulated.
Measurement period (relevant period): Determine over what timeframe (e.g., 1–3 years post-sale) you’ll measure performance.
Payment formula: Specify how much you’ll earn if the financial targets are met or exceeded. Will it be a percentage of revenue above a certain threshold or a multiple of incremental profits?
Defining Earn-Out Targets
Set realistic, attainable specific targets. If milestones are too ambitious, you risk never seeing the earnout payments. Use historical data, market analysis, and growth forecasts to establish fair, mutually agreeable benchmarks.
Quick Tip: Avoid overly complicated formulas. The simpler the earn-out calculation, the less room for disputes.
Protecting Your Interests
Ensuring Transparency: Since you won’t have control after the sale, you need assurances that the buyer won’t take actions to avoid paying the earnout amount. Consider:
Financial reporting requirements: Specify how often the buyer must provide financial statements and which accounting standards they’ll follow.
Audit rights: Reserve the right to review financial documents or request an independent audit if you suspect manipulation.
Operational covenants: In some cases, you can agree on certain operational decisions (e.g., minimum staffing levels, marketing budgets) to ensure the buyer maintains or attempts to grow the business rather than cutting costs to boost short-term earnings.
Dispute Resolution: Include a clear dispute resolution process —such as mediation or arbitration—to handle disagreements calmly, efficiently, and cost-effectively.
Quick Tip: Hiring an experienced M&A attorney is critical. They can help craft terms that balance simplicity with sufficient detail to protect your financial interests and address corporate governance concerns.
Negotiating the Terms
Buyer’s Perspective: From the buyer’s standpoint, earn-outs reduce their upfront risk. They might push for aggressive targets or limit your oversight. Expect the buyer to:
Seek tight deadlines and hard metrics to minimize long-term obligations.
Resist excessive reporting or operational restrictions that curb their freedom to run the acquired company.
Your Perspective: As the seller, you want terms that ensure fairness and transparency:
Moderate targets: Achievable milestones that reflect the business’s current trajectory.
Clear definitions: Metrics, accounting methods, and relevant period should be spelled out, leaving little room for interpretation.
Security measures: If possible, negotiate some form of security or escrow arrangement to ensure payments if targets are met.
Quick Tip: Be prepared to trade off some flexibility. For example, if you insist on strict operating conditions to protect your earnout payments, you may have to accept a smaller upfront payment or a shorter earn-out period.
Post-Sale Involvement and Monitoring
Your Role After Closing: Earn-outs often come with expectations that you’ll assist with the transition. This might mean consulting hours, introducing the buyer to key customers, or helping maintain supplier relationships—including continued coordination with key employees. Clarify your responsibilities in the agreement.
Ongoing Communication: While you may not have a formal management role, maintaining a good relationship with the buyer can foster transparency and goodwill. Regular check-ins can help identify issues early, allowing for timely course corrections to achieve targets.
Enforcement of Terms: If the business fails to hit financial targets or if you suspect the
buyer isn’t following the earnout agreement, refer back to the contract. Use any agreed dispute resolution methods before considering legal action.
Quick Tip: Document all interactions and keep a paper trail of communications, financial reports, and any adjustments to the earnout metric.
Summary
Know your goals: Decide if the potential upside of an earn-out justifies the uncertainty and long-term involvement.
Weigh the benefits and risks: Earn-outs can bridge a valuation gap and offer upside, but they’re not guaranteed and may require ongoing oversight.
Structure carefully: Choose clear, measurable metrics and reasonable targets. Keep formulas simple to reduce the risk of disputes.
Negotiate protections: Insist on transparency, audit rights, and fair operational conditions to safeguard your financial interests.
Plan for disputes: Include a clear dispute resolution process to address disagreements without costly litigation.
Stay engaged: Even after closing, maintain communication and follow through on your transition obligations to maximize the likelihood of meeting earnout payments.
Next Steps
Still unsure if an earn-out is right for you? Every sale is unique. Whether you’re exploring earn-outs for the first time or curious if this is the right mechanism for your target business, we’re here to help guide your approach.
Schedule a free confidential consultation to:
Understand how earn-outs could affect your total purchase price
Learn best practices for setting achievable financial targets and protecting your interests
Get expert advice on negotiating fair and enforceable earn-out terms
Preview potential buyers, for free
OffDeal leverages advanced technology and expertise to help small business owners achieve the same quality of M&A service previously reserved for large corporations. Our mission is to ensure every business owner has the opportunity to maximize their value when they're ready to sell.
