Should you ever accept one? Yes, sometimes, with your eyes open. Treat the earn-out as possible money, not promised money, and make sure the cash at closing is a number you would be happy with on its own.
What is an earn-out when you sell a business?
SHORT ANSWER
An earn-out means part of the purchase price is paid after closing, and only if the business hits agreed targets. Those targets can be revenue, gross profit, EBITDA or a key customer renewing. The rest of the price is paid at closing, as usual.
Here is a simple example. A buyer offers $5 million: $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 that $1 million is never paid.
Why do buyers offer earn-outs?
SHORT ANSWER
Buyers use earn-outs to bridge a gap on price. You think the business is worth more because of where it is going. The buyer will pay for that future, but only if it actually arrives, so part of the price waits until the results are in.
Earn-outs are common when the buyer and seller disagree on what the business is worth, or when future results are uncertain. Used well, an earn-out can be the thing that gets a deal done.
What are the risks of accepting an earn-out?
SHORT ANSWER
The biggest risk is control. Once you sell, you usually don't run the business anymore. The buyer can change pricing, staff, costs or strategy, and every one of those decisions can move the number your earn-out depends on, whether or not you agree with it.
Simon Fallows, our President, says he has seen more owners get burned on earn-outs than anywhere else in a sale. An earn-out is not free money. It's conditional money.
How do you judge whether an earn-out is fair?
SHORT ANSWER
Look at three things: the metric, the size and the length. A good earn-out uses a target the buyer can't easily move, ties up only a small slice of the price, and runs for a short period. The longer it runs, the more can change outside your control.
| Factor | Lower risk for you | Higher risk for you |
|---|---|---|
| The metric | Revenue, which is harder to manipulate | Profit, which is exposed to the buyer's overhead allocations and accounting choices |
| The size | A small slice of the price, which works as a sweetener | Half the price, which means you still carry the risk you were trying to sell |
| The length | Shorter terms; one to three years is common | Longer terms, where more can change outside your control |
How can you protect an earn-out in writing?
SHORT ANSWER
If you accept an earn-out, protect it in writing. The protections that matter most are a clear definition of the metric, reporting and audit rights, limits on what the buyer can change, and an agreement on what happens if the buyer sells or merges the business.
- Define the metric exactly, including how the target is calculated.
- Get reporting and audit rights so you can check the numbers.
- Agree on what the buyer can and can't change during the earn-out.
- Decide what happens if the buyer sells or merges the business.
Check the tax side too. Earn-outs can be taxed in different ways, and the Canada Revenue Agency allows a special reporting method for some share sales only when certain conditions are met, including that the earn-out ends within about five years (CRA, IT-426R). Ask your accountant before the letter of intent fixes the structure.
Is an earn-out your only option?
SHORT ANSWER
No. In a vendor take-back, you finance part of the price yourself and are paid on a schedule, rather than only if the business hits a target. That is a different kind of risk, and sometimes a better one, so compare both before you agree to either.
What this means for you
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. Before you agree to one, ask yourself:
- Would I be happy with the cash at closing if the earn-out never paid out?
- Is the target revenue or profit, and how easily could the buyer move it?
- What share of the price is tied to the earn-out, and for how long?
- Are the definition, audit rights and limits on the buyer in writing?
- Has my accountant reviewed the tax treatment?
You don't need to be planning a sale to benefit from this. Knowing what your business is worth today makes any future offer easier to judge.
