An earn out is a provision in a business acquisition agreement that makes a portion of the purchase price conditional on the company achieving performance goals after the sale. This structure is used when a buyer and seller disagree on the company’s value. It allows the deal to proceed by tying part of the final price to future results, bridging valuation gaps and managing risk for both parties.
How Earn Out Payments Work
An earn out functions by deferring a part of the total purchase price, paid only if the business meets pre-agreed targets after the acquisition. At the closing of the deal, the buyer pays the seller an initial amount. The remaining portion, the earn out, is held back and paid later if the company performs as expected over a defined period.
This mechanism is similar to a performance bonus for achieving set objectives. The process is contractually defined in the Share Purchase Agreement (SPA), which outlines the specific metrics, timeline, and payment details. For instance, a portion of the price might be tied to hitting a revenue target within two years post-acquisition. If targets are met, the seller receives the payment; if not, the buyer is protected from overpaying.
This structure incentivizes the seller, who may remain involved, to ensure a smooth transition and continued success. The payment is made in cash, although it can be delivered as shares in the acquiring company. This arrangement aligns the interests of both parties toward the long-term health of the business.
Key Components of an Earn Out Agreement
The effectiveness of an earn out agreement hinges on the clarity of its core components. These elements are meticulously negotiated to define the conditions for contingent payments and anticipate potential conflicts.
Performance Metrics
Performance metrics are the foundation of an earn out and are used to measure post-acquisition success. Commonly, these are financial metrics like revenue, gross profit, or Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). Non-financial metrics can also be used when strategic goals are a priority, such as customer retention rates, a new product launch, or securing a patent. The choice of metrics depends on the nature of the business and the drivers of its value.
Payment Structure
The payment structure dictates how and when the seller receives money if targets are met. One approach is a tiered structure, where the seller receives different amounts for achieving various levels of performance. For example, a seller might get one amount for hitting 80% of a revenue target and a larger amount for 100%. Another structure involves a multiplier with profit-based metrics like EBITDA, where payment is multiplied by a predetermined factor. Payments can also be a percentage of revenue or profit earned during the earn out period.
Earn Out Period
The earn out period is the timeframe for measuring performance against targets, and it ranges from one to three years. This duration is intended to demonstrate the company’s performance trajectory under new ownership. A shorter period may not accurately reflect potential, while a longer one can create uncertainty and disputes. The length is negotiated based on the industry, business cycle, and the buyer’s goals.
Operational Control and Covenants
A contested aspect of an earn out is the seller’s control over operations post-sale. The seller needs assurance the buyer will not run the business in a way that undermines performance. The agreement should define the seller’s role, authority, and budget control. Covenants, or promises, outline how the business will be operated. These may include commitments from the buyer to maintain working capital, not divert resources, and keep employees on board. These clauses help prevent the buyer from making decisions that could suppress the metrics the earn out is based on.
Advantages of Using an Earn Out
The primary benefit of an earn out is its ability to bridge valuation gaps between a buyer and a seller. Sellers often have an optimistic view of their business’s future growth, while buyers tend to be more cautious. An earn out allows a deal to move forward by making a portion of the price contingent on that future growth materializing.
For the buyer, this structure mitigates the risk of overpaying. If the business underperforms after the sale, the total purchase price is automatically adjusted downward. It also incentivizes the seller to remain committed to the company’s success and facilitate a smooth integration.
From the seller’s perspective, an earn out provides the opportunity to achieve a higher overall sale price than what a buyer might offer upfront. If the seller is confident in the company’s trajectory, they can benefit financially by proving its value over time.
Potential Risks and Disadvantages
Earn outs carry significant risks. For the seller, the most substantial risk is not receiving the full payment. Business performance can be affected by market downturns or other unforeseen events. The seller also risks losing operational control, allowing the buyer to make decisions that negatively impact the ability to hit targets.
Another concern for sellers is the potential for buyers to manipulate financial results to avoid payment. This can involve strategic accounting or operational changes that suppress revenue or profit during the earn out period. Such situations often lead to costly disputes, requiring legal action to resolve disagreements over the calculation of metrics.
For the buyer, the primary disadvantage is potential post-acquisition conflict. The seller, focused on hitting short-term targets, might make decisions that are not in the best long-term interest of the company. This can create friction between the former owner and the new management team.
When an Earn Out Makes the Most Sense
An earn out is well-suited for transactions where uncertainty is a major factor. They are effective when a business has a high but unproven growth trajectory, such as a tech or healthcare company with a new product in the pipeline. In these cases, future value is speculative, and an earn out allows the seller to be compensated if that potential is realized.
This payment model is also logical when the company’s value is heavily dependent on the seller’s continued involvement. If customer relationships or intellectual capital reside with the owner, an earn out ensures they remain motivated to transition those assets successfully. It serves as a mechanism to retain and incentivize talent through a critical post-acquisition period.