Earn-outs are a growing topic of conversation in the world of business sales. Since 2020, the use of earn-out agreements has increased, mainly due to restrictions on business operations during the global pandemic and the economic uncertainty that ensued. Unknown factors made it unclear how much of a business’ earning potential would return. Five years down the line, the business sales market continues to operate in this way – with high risk aversion.
At Uscita, 50% of business sales in the last 24 months featured earn-outs compared to 33% between 2020 and 2022. Political changes like Trump tariffs have created an unstable and unpredictable business climate. In some sectors, such as manufacturing, market conditions have changed overnight. Given such high uncertainty, earn-outs provide a level of security to those looking to buy a business. Earn-outs give buyers time to assess market stability and build confidence in their business purchase.
If you are considering entering into an earn-out agreement when selling your business, this article explains everything you need to know to make your decision. Based on 20 years’ experience selling businesses, we explain what an earn-out is, when to use them, and how to measure success. We also share the benefits and common pitfalls of earn-outs, to help you avoid becoming unstuck.
What is an earn-out?
An earn-out is a share purchase agreement used in business sales to defer a percentage of the final payment, e.g. the buyer pays 75% now and 25% in two years. This type of agreement is useful when the vendor and buyer can’t come to an agreement on what the business is worth when compared to the risks it presents. Earn-outs help to balance a buyer’s estimation with the vendor’s expectations. Normally, the value of the final offer is based on measures of financial and non-financial performance.
When are earn-outs used in business sales?
Earn-outs tend to feature in sales where there is an element of uncertainty, such as:
- In volatile or unpredictable sectors, e.g. science and technology and healthcare
- Where growth potential is high, but hard to quantify at the time of the deal, e.g. a software start-up
- Where the parties have differing opinions about what future success looks like, e.g. the next big contract which will significantly change the profitability of the business
- When a buyer is the right choice, but doesn’t have access to funds to cover the full purchase price.
We see earn-outs most often in larger business sales, but they are also becoming increasingly common in SME business sales, especially in the post-Covid era of market instability.
The benefits of earn-outs
Earn-outs have benefits for both sides of the deal. From a buyer perspective it reduces the risk of overpaying. From a vendor point of view, it can help you achieve the best price when selling, and allow you to profit from a new owner coming in, and still have an opportunity to benefit from business performance. That said, you may have to agree to stay on in the business in some capacity, sometimes for as long as three years.
How to measure the value of an earn-out
The value of an earn-out will be linked to KPIs agreed during the negotiation process. Vendors – be wary of agreeing to measures that may jeopardise your earn-out potential and ultimately impact final business value. Both vendor and buyer need to agree on performance measures that align their expectations and achieve balance of control. This is when having a broker or business exit consultant on your side during negotiations is invaluable.
Earn-out performance measures are usually linked to financial and/or non-financial targets. Here are some of the most common…
Financial targets
- Turnover/revenue
- EBITDA
- Earnings before interest and tax (EBIT)
- Profit before tax (PBT)
- Gross margin
- Gross margin %
Non-financial targets
- Volume of sales
- New customer contracts
- Contract length/stability
- Customer satisfaction ratings
- Employees retained
What are the risks of earn-outs?
As a business owner you believe in the continuing potential of your business to be successful, but this always comes with a degree of bias. A buyer carries a degree of cynicism. They don’t want to pay for a business that begins to fail as soon as the vendor has left, so they will build earn-out terms into their offer to buy.
If you cannot agree on an acceptable sale price with your buyer, an earn-out might help to bridge the gap. Working with an intermediary can help both parties reach a realistic business valuation and avoid the need for an earn-out, therefore reducing the risk of a sale which fails to satisfy either side.
Avoid unnecessary risk in your business sale. Book a free, no-obligation discovery call to find out how we can help.
What can go wrong with an earn-out agreement?
There are several risks associated with earn-outs, which all parties need to be aware of.
- Unrealistic performance targets: when earn-out measures cannot be met, or missed by the smallest margin, the vendor risks not getting the final settlement payment they had planned for. Be wary of dishonest buyers pushing for unachievable targets.
- The agreement favours one party: when the Share Purchase Agreement is drafted without due care and attention, it could be biased towards one side of the deal, rather than encouraging you to work together in the best interests of the business. The agreement should have reasonable terms that don’t favour the intentions of either side.
- Disputes and disagreements: relationships may break down over time, causing the vendor to leave their role in the business and miss out on the chance to influence business performance.
- The new owner decides to invest during the earn-out period: all forms of investment, whether it’s spent on machinery or expanding their team, will significantly impact profits. Whether you target turnover or profits is a crucial decision. This is why it is important to include protections for the vendor in the agreement.
- The new owner changes the accountancy practices: this could influence how the owner calculates profits, and in turn reduce the value of any profit based earn-out.
- Business performance declines: if a major client contract were to fall through or market conditions change, profits can dip and impact the value of an earn-out based on profit.
Need help negotiating an earn-out?
Earn-outs are not right for every business sale. Our advice is to seek reliable advice from someone you trust and ensure the agreement so there’s no room for ambiguity. A robust agreement aligns with both parties’ expectations and includes protections for all. At Uscita, we support you through the business exit process from valuation and marketing, through negotiation and due diligence, until the sale proceeds land in your bank account.
Where earn-outs are part of a business sale, our work doesn’t stop when the deal gets over the line. Part of our role as your broker is to monitor earn-out payments, to ensure you achieve the value you deserve. In some cases, our involvement will continue years after a business has changed hands. Interested to learn more? Contact us here.
