How to Determine if You Should or Should Not do an Earn-out

Erik Sullivan

Sellers Seller Articles Seller FAQ

An earn-out is a common deal structure we see requested when selling MidStreet businesses. Accepting one can play a big role in how much money you walk away with.

So, when does it make sense to accept an earn-out, and when should it be avoided?

Earn-outs are commonly viewed as a negative for the seller, but in reality, they can be a helpful tool for both buyers and sellers to bridge valuation gaps and accomplish everyone’s goals.

To help you figure out if an earn-out fits your sale, we will go over what an earn-out is, what it is based on, when it is used, the risks, the contingencies you can set, when it makes sense to do one, and when it should be avoided.

Let’s hop in.

What is an Earn-out and What is it Based on?

In the context of a business sale, an earn-out is an agreement where a portion of your compensation is dependent on the future performance of the business. 

Earn-outs are best when they “cut-both-ways,” meaning if the business reaches certain performance metrics, the seller is actually compensated more based on the agreement.

Earn-outs can be measured by any variable like employee retention, customer retention, or gross profit, but revenue and net profit are the most common. For example, your buyer may request an earn-out that requires that 90% of the staff be retained by a certain date or that sales stay above 90% of the previous year, or both. 

The key is, provisions of an earn-out are all negotiable based on the risks that a buyer wishes to mitigate, or the benefits that an owner wishes to receive.

When are Earn-outs Used?

Earnouts are generally proposed for one main reason: The seller and the buyer have differing opinions on the value of the business. 

Other reasons can include:

  • Your buyer wants you involved post-sale to ensure their success 
  • There is a part of your business that makes the buyer uneasy
  • You feel there is guaranteed growth potential that you would like to be compensated for

As a seller, it’s generally your preference to get all of your money at closing - as a company that represents sellers exclusively, we get that. 

However, sometimes an earnout can be a good solution, especially when they cut both ways.

Here’s an example of an earnout that benefits the buyer if the business performance drops, and the seller if they beat expectations.

Simplified example of an earn-out in a business sale

In this example, the business is being purchased for $850,000 cash, with an additional amount being paid as a seller note. The amount of the note will be determined based on the company’s revenue in the next calendar year after closing. 

The buyer in this instance was concerned that with current margins, they would not be able to afford the debt service on their loan if revenues fell below $1,750,000. The seller was confident the business was primed to have its best year ever and wanted to ensure they were paid for that performance. 

This structure protects both parties. If the business performs how the seller believes it will, the seller will benefit. If not, the buyer is protected.

What Are the Risks of an Earn-out?

It’s always a gamble accepting an earn-out as a portion of your sale proceeds. However, there are two main cases where you may consider doing an earn-out: 

  • You do not have a lot of interested buyers to choose from
  • You want a higher sales price than what the buyer is willing to pay

The main risk of an earn-out is the lack of control you have. You are putting the business into someone else’s hands and basing a portion of your compensation on the company’s future performance. 

That’s why you should include contingencies. By having contingencies in place, you can make sure the buyer continues to operate the business the same way you have so you achieve your earn-out. 

Additionally, you should consider what your earn-out is based on. If your earn-out is based on net profit, that can be easily skewed through accounting tricks to misrepresent the actual numbers. 

What Contingencies Can You Set on an Earn-out?

If you are considering doing an earn-out, there are a few ways you can protect yourself and your chance of receiving all of the proceeds from your sale. Some examples of clauses set on earn-outs are: 

Employee retention - The buyer cannot negatively change compensation or employee benefits during the course of their earn-out. 

Customer retention - The buyer cannot stop serving your important customers without reasonable cause.  

Misc. Contingencies - Every situation is different and depends on your specific business - a contingency can be anything you feel is critical to the business’s operational success.

Contingencies are meant to prevent the buyer from making changes that jeopardize the performance of the company and cause you to lose your earn-out. If you do go through with an earn-out, it should be one based on a metric you feel confident in with clauses that protect it. 

Does it Make Sense to Do an Earn-out?

Depending on your situation, there may be reasons an earn-out does or doesn’t make sense. 

When it might make sense: A strategic buyer who knows the industry purchases your business and will run it themselves, allow your dedicated management team to run it, or put an expert in place to run it. 

When it probably doesn’t make sense: An individual buyer who has never run a company before and does not have experience in your industry purchases your company. 

Some reasons you may feel comfortable doing an earn-out include:  

  • You (the previous owner) are planning to stay in the company for the duration of the earn-out
  • There has been a large investment in the company that has not yet translated into financial performance 
  • You can’t find another buyer for your business and you want to get it sold
  • You like the buyer, but you have a difference in valuation expectations
  • You feel very confident in the future performance of the business regardless of who the owner is

You should avoid doing an earn-out if: 

  • You are concerned about the future performance of your industry 
  • You are not planning to train the buyer for a long duration
  • You have a lot of competition amongst buyers to purchase your business 
  • You are just not comfortable with the idea of an earn-out 
  • The buyer does not have experience in your industry

Determine if an Earn-Out is Right For The Sale of Your Business

Deciding whether to do an earn-out should be evaluated on a case-by-case basis. You will need to determine what goals the earn-out would be measured by, what contingencies you would set to protect it, and how risky it would be.

A merger and acquisition (M&A) advisor will be able to advise you on the best strategy for your sale and let you know if an earn-out is necessary. Learn more about earn-outs by reading “The Top 5 Questions About an Earn-Out in a Business Sale.” 

Knowing how to navigate selling your business on your own can be difficult. To get help selling your company, give us a call today at MidStreet Mergers & Acquisitions.

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