An Earn-Out is a financial arrangement in a business purchase transaction where the seller receives additional payments after the sale, based on the future performance of the business. It is commonly used in mergers and acquisitions (M&A) to bridge valuation gaps between the buyer and seller.
How an Earn-Out Works
• The buyer pays an initial purchase price at closing.
• The seller receives additional payments (earn-out) if the business meets specific financial targets post-sale.
• Earn-out payments are usually based on metrics like revenue, EBITDA, net profit, or customer retention.
• These payments are made over a set period, typically 1 to 5 years.
Why Use an Earn-Out?
• Bridges valuation gaps: If the buyer and seller disagree on the company’s worth, an earn-out allows the seller to prove future success.
• Reduces buyer risk: The buyer avoids overpaying upfront for uncertain future performance.
• Gives sellers upside potential: If the business performs well post-sale, the seller benefits financially.
Example of an Earn-Out
• A company is sold for $10 million upfront, with an additional $5 million tied to an earn-out.
• The agreement states that if revenue grows by 20% in the next two years, the seller receives the extra $5 million.
• If revenue grows by only 10%, the seller might receive a reduced earn-out.
Key Considerations
Performance Metrics – Define clear and measurable financial goals.
Time Frame – Typically 1-5 years post-sale.
Dispute Resolution – Include a process for handling disagreements on financial results.
Control Issues – The seller may have limited influence over business decisions after the sale, which could impact earn-out payments.
Payment Structure – Payments can be structured as lump sums, installments, or a percentage of future earnings.