Understanding Earn Outs
Understand contingent sale proceeds, payout calculations and the operating and collection risks behind a potential later payment.
Overview
An earn out makes part of the sale price conditional on future results. It can bridge a valuation gap, but the owner takes the risk that agreed goals are missed. An earn out can pay nothing.
Evaluate closing cash separately from potential later proceeds. Test whether closing cash meets your needs if the earn out pays zero, and compare lower, middle and maximum payouts and their timing.
Three takeaways
- Define success precisely. Revenue may be easier to observe but reward low-margin sales; EBITDA is sensitive to cost allocation and spending. A contract or regulatory milestone may fit some businesses.
- Attach a worked calculation. Agree accounting policies, permitted adjustments, revenue timing, shared overhead, integration costs and how the acquired business is tracked.
- Negotiate control and payment mechanics. Buyer decisions, employment changes, a resale, offsets and the payer’s ability to pay affect the outcome.
Considerations
- Set measurement dates, deadlines and a cap. Clarify sliding scales versus all-or-nothing thresholds; for multiple years, decide annual versus cumulative testing and recovery of earlier shortfalls.
- Discuss pricing, staffing, investment and integration authority, including shared services and transferred customers. Write operating commitments clearly.
- Agree reporting, supporting-record access, objection deadlines and dispute authority, timing and costs. Accounting disagreements and operating-commitment breaches may need different resolution processes.
Outcomes depend on the business, market conditions and negotiated documents. Consult your legal and tax advisers about your circumstances.
A payout illustration, not a forecast
Assume $20 million at closing and up to $4 million later. For one specified 12-month period, the earn out pays $2 for each $1 of contract-defined EBITDA above $5 million, capped at $4 million. EBITDA means earnings before interest, taxes, depreciation and amortization.
- Period EBITDA of $5 million or less: $0 earn out; $20 million total paid.
- Period EBITDA of $6 million: $2 million earn out; $22 million total paid.
- Period EBITDA of $7 million or more: $4 million earn out; $24 million total paid.
Read the example’s limits
Illustrative arithmetic only. Total paid combines closing cash and the later payment, assuming it is earned and collected. Figures exclude taxes, fees, offsets and other price adjustments. This is not a forecast or an estimate of the earn out’s present value.
Employment, a later sale and collection
Clarify resignation, retirement or termination provisions. Ask whether a resale or restructuring accelerates payment, transfers the obligation or changes the calculation. Do not assume these outcomes.
Have tax advisers assess any link to continued employment: payments tied to services may be compensation, with treatment depending on facts and documents.
Identify the entity owing payment and its ability to pay. Ask counsel about guarantees or credit support, indemnity offsets and treatment of disputed and undisputed amounts.
For information only. This material is not an offer or solicitation, or legal, tax or investment advice. Structures and terms depend on the business, counterparties and definitive documentation.