January 6, 2025
What Are “Contingent Payments” in M&A, and How Do They Work?
When selling your small business, structuring the deal to align with both parties’ interests is critical. One mechanism often used to bridge valuation gaps or address buyer concerns is contingent payments. These payments can help maximize your business’s sale price while sharing the risks and rewards with the buyer. However, they also introduce complexity and require careful planning.
In this article, you will learn how to:
Understand what contingent payments are and their role in M&A.
Evaluate the advantages and challenges of contingent payments.
Structure and negotiate terms that protect your interests.
Avoid common pitfalls when including contingent payments in your deal.
What Are Contingent Payments?
Contingent payments are provisions in a purchase agreement that tie a portion of the sale price to the future performance of the business. Instead of receiving the entire payment at closing, the seller receives a portion upfront and the remainder—if earned—after specific financial or operational milestones are met.
Quick Tip: Contingent payments are often structured as “earn-outs” or performance-based bonuses, allowing buyers to mitigate risks and sellers to capture additional value if the business performs well post-sale.
Why Are Contingent Payments Used in M&A?
Buyer’s Perspective:
Buyers use contingent payments to:
Mitigate risk: Reduce upfront financial exposure by linking part of the price to the business’s future performance.
Bridge valuation gaps: Accommodate a seller’s high valuation expectations without overpaying upfront.
Align incentives: Motivate the seller to support the transition and contribute to post-sale success.
Seller’s Perspective:
Sellers may agree to contingent payments to:
Maximize value: Capture additional proceeds if the business performs as expected or better.
Demonstrate confidence: Show belief in the business’s potential to alleviate buyer concerns.
Facilitate deal closure: Resolve disputes over valuation without lowering the upfront price excessively.
Types of Contingent Payments
Type | Description | Common Metrics | |||
|---|---|---|---|---|---|
Earn-Outs | Payment linked to achieving specific financial targets (e.g., revenue, EBITDA). | Revenue growth, EBITDA margins. | |||
Performance Bonuses | Additional payments for hitting operational goals (e.g., customer retention). | Customer churn, project success. | |||
Milestone Payments | Payments triggered by specific events (e.g., FDA approval, product launch). | Regulatory approvals, milestones. |
Quick Tip: Earn-outs are the most common form of contingent payment in small business sales due to their focus on measurable financial metrics.
How Are Contingent Payments Structured?
Key Components
Performance Metrics: Define clear, measurable targets, such as revenue, EBITDA, or operational milestones.
Measurement Period: Specify the timeframe over which performance will be evaluated (e.g., 1–3 years post-sale).
Payment Formula: Detail how the contingent payment will be calculated based on the metrics achieved.
Caps and Floors: Set limits on maximum and minimum payouts to manage expectations.
Reporting Requirements: Establish how and when performance data will be shared with the seller.
Metric | Target | Payment Formula | Maximum Payout | ||||
|---|---|---|---|---|---|---|---|
Revenue Growth | $5M in Year 1 | $100K per $1M above $4M threshold | $500K | ||||
EBITDA Margin | 20% by Year 2 | Additional $200K if margin exceeds 20% | $200K | ||||
Product Launch | Launch by Q4 | $150K upon successful launch before deadline | $150K |
Pros and Cons of Contingent Payments
Advantages
Pro | Explanation | ||
|---|---|---|---|
Bridging Valuation Gaps | Helps reconcile differing opinions on the business’s current and future value. | ||
Upside Potential for Sellers | Allows sellers to benefit from the business’s future growth. | ||
Risk Mitigation for Buyers | Reduces buyer’s risk by tying payments to actual performance. |
Challenges
Con | Explanation | ||
|---|---|---|---|
Uncertainty of Payment | Sellers may not receive full payment if targets aren’t met. | ||
Complexity in Agreements | Requires detailed negotiation and careful drafting of terms. | ||
Potential for Disputes | Ambiguities in metrics or disagreements over performance can lead to conflicts. |
Quick Tip: Always treat contingent payments as a bonus rather than a guaranteed payout.
Negotiating Contingent Payment Terms
Tips for Sellers:
Set Realistic Targets: Base targets on historical performance and achievable growth.
Secure Transparency: Insist on regular reporting and access to financial data.
Incorporate Safeguards: Include audit rights and clear dispute resolution processes.
Tips for Buyers:
Define Hard Metrics: Use specific, measurable, and unambiguous performance criteria.
Cap Payouts: Limit potential liabilities with maximum payment thresholds.
Balance Incentives: Ensure targets encourage long-term success rather than short-term gains.
Protecting Your Interests as a Seller
Key Considerations:
Financial Reporting: Specify frequency and format of performance updates.
Audit Rights: Reserve the right to review the buyer’s financial records if discrepancies arise.
Operational Covenants: Negotiate terms to prevent buyers from taking actions that could undermine performance metrics (e.g., cutting marketing budgets).
Legal Protections: Work with an experienced M&A attorney to draft enforceable terms.
Common Pitfalls and How to Avoid Them
Pitfall | Solution | ||
|---|---|---|---|
Ambiguous Performance Metrics | Use clear, objective, and measurable targets. | ||
Unrealistic Expectations | Base targets on data-driven forecasts and industry benchmarks. | ||
Disputes Over Financial Reporting | Include detailed reporting requirements and audit provisions. | ||
Overly Complex Structures | Keep formulas and conditions as simple as possible to reduce room for error. |
Summary
Understand Contingent Payments: These can bridge valuation gaps and offer upside potential but come with inherent risks.
Structure Carefully: Use clear metrics, achievable targets, and fair formulas to avoid disputes.
Negotiate Wisely: Balance incentives and safeguards to protect your financial interests.
Stay Involved: Monitor performance and maintain communication with the buyer post-sale.
Next Steps
Still unsure if contingent payments are the right choice for your business sale? Every deal is unique. Our team at OffDeal specializes in helping small business owners navigate complex deal structures to maximize value while minimizing risks.
Schedule a free confidential consultation to:
Learn how contingent payments could affect your total proceeds.
Understand best practices for structuring fair and enforceable terms.
Get expert advice tailored to your business’s specific needs.
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.
