When Should You Consider an Earn-Out as Part of Your Transaction?

Earn-outs provide the seller of a business with the opportunity to benefit financially from that business after it has been sold, based on the future successful performance of the business. Simply put, an earn-out is a tool that is used by the seller of a business to share in the future earnings of that business, in circumstances where the seller is confident in the growth potential of that business.

Earn-outs take the form of contractual provisions stipulating that a seller is to receive future compensation following the sale, provided that the business achieves certain financial objectives. They are typically used as part of a merger or acquisition deal, for the purpose of resolving different expectations of a seller and buyer in relation to a business, such as bridging gaps in the valuation of the business or mitigating uncertainties as to the future performance of the business.

The main situation where a seller should consider including an earn-out in the sale of their business is where the business is growing, and the seller has full confidence that they want to capture additional value from that business in the future. Confidence in a business’s growth potential post-sale is the main situation where earn-outs are used, because otherwise sellers will want to get as much money as possible from the sale itself, rather than from the potential future success of the business.

In other words, earn-outs are most commonly used where there is ongoing growth in the business being sold, and the seller wants to participate in the future upside of that growth. Specifically, if a seller is selling a business that is growing, and they are confident that there is going to be more realisable income from the business in the future, then this is the ideal situation for using an earn-out in the transaction. In such a situation, the buyer will not want to pay in advance for this realisable income in case it does not actually come, which is where the earn-out will come into play.

Overall, when an earn-out is used in these circumstances, the seller and the buyer are trying to bridge the gap between concern about the viability of sustainable revenue on the one hand, and the opportunity or the upside on the other. The gap to be bridged is usually in the form of a disagreement between the seller and the buyer as to the current value of the business.

Another situation in which earn-outs can be used is for shared profits and shared risk going forwards. In these circumstances, the seller agrees with the buyer to share in any future profits from the business following the sale. In addition, the seller agrees with the buyer to share in any risks where there are uncertainties about the future performance of the business, such as in an industry or market with high volatility or rapid changes. 

However, such a scenario is arguably not the best use of an earn-out. This is because in these circumstances, a seller will need to have confidence in the buyer’s management to operate the company in a way that will preserve and recognise any future profits.

To elaborate on this point, once the business has been sold, the seller is essentially on the outside looking in. Having sold the business, they now have no further say in how that business is run by the buyer. Therefore, if the buyer does not run the business in an ideal way after the sale, then the seller has no recourse, because they have effectively lost control of that business to the buyer, even with the presence of an earn-out provision.

Another possible situation where earn-outs can be used is in incentivising shareholders who are integral to the business to stay with the business during the transition period. This will ensure that such key shareholders stay involved following the sale, in order to transition the revenue and assist with maintaining the continuity and stability of the business after the sale.

Lastly, in a situation where the buyer might be concerned with the successful integration of the acquired business into their existing operations, an earn-out could help to ensure a smooth transition in this respect following the sale. This would involve tying the earn-out to specific performance metrics or milestones achieved by the business following the sale.

Overall, careful consideration needs to be given to including earn-outs in a transaction. Such arrangements are not to be dealt with lightly, because the future value that earn-outs were intended to achieve is often not actually attained.

Therefore, on the one hand, a seller needs to be both satisfied with the upfront payment for the sale and confident in the future growth potential of the business. In particular, a seller needs to be confident that the business will hit the milestones stipulated by the earn-out provision. On the other hand, a seller also needs to understand that earn-outs are not within their full control following the sale of the business. In short, earn-outs involve a delicate balance between those two factors.

Another point to make is that the use of earn-outs is not market-driven, but rather opportunity-driven, in the sense of the seller being confident about the future growth of the business. This means that no matter what the state of the particular industry or market in general, the ideal circumstances for using earn-outs remain fairly consistent. In any event, it is important to ensure that the earn-out arrangement aligns with the interests of both the seller and the buyer, as well as being fair and enforceable.

Lastly, it should be noted that while earn-outs can be useful tools, they can also lead to disputes between the seller and the buyer down the track, particularly in relation to any complexities and potential conflicts connected with the earn-out. As a result, in addition to having clear and well-defined dispute resolution mechanisms, it is imperative that an earn-out arrangement provides absolute clarity as to what the performance metrics are going to be for the business post-sale. For example, the seller needs to make sure that there are safeguards in place to prevent the buyer from changing their operations or the way they track revenue.