How does an earn-out work?
SHORT ANSWER
The buyer pays part of the price at closing. The rest is paid over one to three years if the business reaches set targets, such as revenue or profit.
Example: a buyer offers $5 million, with $4 million at closing and $1 million paid over two years if revenue stays above $8 million a year. If revenue falls short, some or all of the $1 million isn't paid.
What are the risks for the seller?
SHORT ANSWER
After closing, you no longer control the business that has to hit the target. The buyer's decisions on staff, pricing or spending can affect whether you get paid.
How can sellers protect themselves?
- Choose the right measure.Revenue is harder to manipulate than profit.
- Define it exactly.Spell out how the target is calculated.
- Keep some control.Agree on what the buyer can and can't change during the earn-out.
- Plan for a resale.Decide what happens if the buyer sells the business during the earn-out.
- Get audit rights so you can check the numbers.
- Check the tax.Earn-outs can be taxed in different ways. Ask your CPA before the letter of intent fixes the structure.
A simple rule: value the earn-out as if it may never be paid. If the cash at closing works for you on its own, the earn-out is a bonus.