Earn-Outs in M&A: A Comprehensive Guide for Entrepreneurs
As an entrepreneur considering a merger or acquisition, one key issue you may encounter is bridging the valuation gap between your company’s perceived worth and what a prospective buyer is willing to pay. Earn-outs provide a mechanism to reconcile these differences by tying a portion of the purchase price to the target company’s future performance. While earn-outs can move deals forward and offer substantial upside for sellers, they also introduce complexity, potential disputes, and significant negotiation challenges. Understanding earn-outs, their advantages and disadvantages, and how to structure them effectively is essential if you want to achieve a favorable outcome when selling your business or acquiring another entity.
What Is an Earn-Out?
An earn-out is a contractual provision often included in private M&A deals. Instead of receiving the entire purchase price at closing, the seller agrees that part of the consideration will only be paid if the target company attains certain performance benchmarks post-closing. These benchmarks can include financial metrics like EBITDA or revenue, or operational milestones such as achieving a set number of new customers or obtaining regulatory approvals. If the targets are met during predefined periods, the buyer makes additional payments to the seller. If not, the buyer either pays nothing further or pays a reduced amount. Earn-outs help when the buyer and seller cannot agree on the target’s current valuation. Perhaps the target company is young and has significant growth potential but lacks a proven track record, or maybe the company’s earnings have recently dropped due to temporary market conditions. In such scenarios, the seller might believe the business is worth more than what the buyer is offering based solely on historical performance. By structuring part of the price as contingent on future success, the deal can move forward while leaving the ultimate valuation partly dependent on outcomes that will unfold after the transaction closes. Earn-outs, however, are not always the right fit. If the buyer intends to integrate the acquired business immediately or significantly alter its operations, measuring standalone performance might be difficult. Similarly, if the seller wants a clean exit without ongoing dependence on the company’s future operations, earn-outs can be less appealing.
Advantages of an Earn-Out
For Sellers
For founders and stockholders of a target company, an earn-out can unlock a higher total purchase price than what the buyer would pay upfront. Without an earn-out, the buyer might heavily discount the price due to uncertainty about future profitability. With an earn-out, the seller secures immediate base consideration plus the potential for more if growth projections come true. This structure is particularly helpful if the seller believes strongly in the company’s trajectory and wants to participate in the upside. Additionally, if the target company’s integration with the buyer’s existing business can generate synergies, these post-closing improvements may help the seller meet earn-out targets more easily, potentially yielding higher overall payouts. This upside-sharing mechanism can benefit sellers in distressed situations, providing immediate liquidity and preserving potential value without forcing a lower outright sale price.
For Buyers
From the buyer’s standpoint, earn-outs can prevent overpayment by aligning the final purchase price with actual future performance rather than historical data or uncertain projections. By tying a portion of the consideration to future results, the buyer pays a premium only if the business achieves the projected growth or profitability. This reduces the buyer’s upfront capital requirements—helpful if credit markets are tight or if the buyer prefers to fund part of the purchase from future earnings of the acquired company. Risk-sharing is another advantage: if the target underperforms, the buyer pays less. Earn-outs also motivate key sellers who remain involved post-closing to drive success. In competitive auction scenarios, proposing an attractive earn-out can help a buyer stand out by offering a potentially higher total price without committing all cash immediately.
Disadvantages of an Earn-Out
General Disadvantages
Earn-outs frequently lead to disputes. After closing, the parties may disagree on how to measure the target’s performance, particularly if financial metrics are involved. Complexity arises because myriad external factors beyond the target’s intrinsic performance—like market downturns or strategic shifts by the buyer—can influence whether targets are met. Negotiations become more intricate and time-consuming. Accounting complexities and frequent involvement of financial professionals are often needed. Monitoring and measuring performance over the earn-out period increases administrative burdens and potential distractions from running the business. Moreover, earn-out payments can have adverse tax and accounting implications. Misestimating the fair value of earn-out obligations can create volatility in the buyer’s financial statements. From a tax perspective, earn-outs may be taxed as compensation at higher rates rather than as capital gains, depending on the structure. This can diminish the seller’s expected after-tax proceeds. Additionally, if the earn-out structure inadvertently accelerates gain recognition for tax purposes, the seller may pay taxes earlier than anticipated.
Seller-Specific Disadvantages
For sellers hoping for a clean break, an earn-out prolongs their involvement and financial dependence on the company’s success. Even if the seller departs operationally, the seller’s payout depends on how the buyer stewards the business. If the buyer mismanages or deprioritizes the acquired company’s growth objectives, the seller may never realize the contingent payments. The buyer may also offset indemnification claims against the earn-out, reducing the seller’s eventual payout. This leaves the seller vulnerable and potentially creates tension as the seller monitors the buyer’s post-closing decisions.
Buyer-Specific Disadvantages
For buyers, earn-outs can impose restrictions on post-closing operations. To ensure targets are achievable, the seller often pushes for covenants limiting major strategic changes. If the seller remains involved in management, the buyer’s ability to integrate or redirect the business may be curtailed. Additionally, a seller managing for short-term earn-out milestones could implement cost-cutting or short-sighted strategies that hit near-term targets at the expense of long-term value creation. In sum, earn-outs add another layer of negotiation complexity and can impede full strategic freedom.
Structuring an Earn-Out
Every earn-out should be carefully customized to the business and the parties’ strategic objectives. Key structuring elements include defining targets, setting the earn-out period, deciding on payout structures, establishing dispute resolution mechanisms, and determining post-closing operational covenants. The goal is to minimize ambiguity and the likelihood of future disputes.
Choosing Earn-Out Targets
Targets can be financial (revenue, net income, EBITDA), non-financial (customer acquisition numbers, regulatory approvals), or a combination. Financial targets are common but tend to be more susceptible to accounting interpretations and manipulation. Non-financial targets can be simpler and more objective, focusing on measurable milestones like obtaining a patent approval or reaching a user base threshold. The chosen targets should align with the target company’s business nature, be clearly defined, objective, and realistically achievable given the market context and the buyer’s planned operation of the business. If the seller believes the buyer’s approach might reduce the target company’s ability to meet earn-out targets, the parties should consider adjusting terms or adopting simpler milestones. For instance, if the seller will continue running the company, they may push for revenue-based or operational milestones that are harder for the buyer to manipulate but easier for the seller to achieve by focusing on top-line growth.
Earn-Out Period and Payment Structure
Most earn-outs last one to three years, though this can vary. Sellers may want shorter periods to reduce uncertainty and credit risk. Buyers might prefer shorter periods to limit ongoing constraints or might accept a longer timeline if they believe short-term manipulation is likely. Earn-out payments can be structured as a single payout at the end of the earn-out period or multiple payments at regular intervals. The amount can be a flat sum per period, a formula based on how much the target surpasses a threshold, or a percentage of performance. Some agreements allow for catch-up provisions if targets are missed one year but exceeded the next. Conversely, buyers might seek provisions that prevent sellers from benefiting disproportionately if early performance is strong but later declines. Additionally, parties may negotiate buyout or acceleration options. A buyout option lets the buyer pay a lump sum to end the earn-out early, useful if the buyer wants to sell the company mid-way. Acceleration clauses can trigger immediate payment if certain events occur, like a breach of operational covenants by the buyer, ensuring the seller is not unfairly deprived of upside if circumstances change drastically.
Mechanics and Dispute Resolution
To minimize conflicts, the agreement should detail how performance is measured and who prepares the calculations. Usually, the buyer’s accountants prepare these calculations because the buyer controls the post-closing books and records. The agreement should specify the accounting principles, the degree to which GAAP is applied consistently with past practices, and whether certain items (like extraordinary expenses or integration costs) are included or excluded. The seller should have rights to review and challenge calculations within a set time frame. If disputes arise, an independent accountant or another neutral third party can resolve them. The agreement should define the scope of their authority, timelines, and how costs are shared. Clarity and specificity are crucial to avoid protracted disputes and litigation over accounting interpretations.
Post-Closing Operational Covenants
The seller may seek protections to prevent the buyer from taking actions that harm the target’s ability to meet earn-out targets. Such covenants might include requiring the buyer to run the business consistent with historical operations, maintain minimum working capital, or refrain from asset divestitures that undermine the business. The buyer generally resists such constraints, preferring full operational freedom. As a compromise, the buyer might agree to a “fair dealing” covenant, promising not to act in bad faith to thwart earn-out achievement, rather than actively working to maximize it. Additionally, if the buyer plans to sell the target company during the earn-out period, the parties must clarify what happens to the earn-out. Sellers often seek acceleration of earn-out payments upon a sale to avoid relying on an unknown third party. If no acceleration is agreed, the new buyer might assume the earn-out obligations. Such scenarios should be explicitly addressed upfront.
Continued Involvement of Sellers
In cases where the seller remains involved post-closing—perhaps as a manager or advisor—tying earn-out payments to continued employment can further complicate tax treatment. While the buyer may want the seller to remain motivated and engaged, linking earn-outs to employment might risk recharacterizing them as compensation rather than capital gains. The parties must balance the desire to incentivize the seller against the potential unfavorable tax implications. If the seller’s involvement is integral to meeting targets, they must ensure that targets are fair and attainable and that they retain sufficient operational latitude to achieve them. Conversely, buyers may rely on the seller’s involvement and thus be open to granting certain leeway or guaranteed minimum payouts if the seller devotes full efforts to the business.
Security for Earn-Out Payments
To protect the seller against non-payment risk, the buyer may place the anticipated earn-out amounts in escrow or offer a parent company guaranty. Alternatively, granting the seller a security interest in the target’s assets or shares can provide additional reassurance. Buyers may be reluctant to provide such security because it limits their flexibility and could complicate future financing. The seller should also verify that no lender covenants restrict earn-out payments. If such restrictions exist, the buyer must secure waivers or otherwise ensure that no external impediments prevent payment when due.
Accounting Treatment
Under current accounting standards, buyers must record the estimated fair value of potential earn-out payments at the acquisition date and then revalue them periodically. If the initial estimate differs from what is eventually paid, the difference affects the buyer’s income statement, potentially creating earnings volatility. Inaccurate forecasting of earn-out probabilities leads to goodwill adjustments and impairment charges. To reduce these complexities, buyers sometimes prefer shorter earn-out periods or avoid earn-outs altogether. Clarity in definition, predictable targets, and straightforward calculations help reduce valuation uncertainties and reporting issues.
Tax Treatment
Tax considerations loom large for entrepreneurs, as the characterization and timing of income from earn-outs can significantly impact after-tax proceeds. If earn-out payments are classified as deferred purchase price, they may qualify for capital gains treatment, subject to favorable long-term capital gains rates. Conversely, if the earn-out resembles compensation—especially if contingent on the seller’s ongoing services or tied to a non-compete covenant—then ordinary income tax rates and employment taxes may apply. Another tax complexity involves interest, either actual or imputed. Without explicit interest provisions, the tax law imputes interest on deferred payments, subjecting a portion of each payment to ordinary income tax rates. The timing of gain recognition is also crucial. Under the installment method, gain recognition is deferred until payments are received, but special basis recovery rules for uncapped earn-outs or those lacking fixed terms can create traps. For instance, if the potential earn-out is large but uncertain, these rules might force the seller to back-load basis recovery and prematurely accelerate gain. Careful structuring can mitigate these pitfalls. Consulting with tax professionals to design an earn-out that maximizes the seller’s after-tax proceeds and aligns with buyer objectives is essential.
Securities Law Considerations
In certain deal structures, the right to receive earn-out payments might be considered a security under US securities laws. If that happens, the parties may need to register the earn-out under the Securities Act or rely on an exemption, increasing the burden and complexity of compliance. Entrepreneurs and their counsel should structure earn-outs in a manner that avoids securities law complications altogether. Factors that ensure the earn-out is not treated as a security include ensuring it represents deferred consideration integral to the transaction, is not represented by a certificate or instrument, confers no shareholder-like rights, and is non-transferable. Adhering to these guidelines helps sidestep the complexities of securities regulations.
Avoiding Pitfalls
Many earn-out disputes and tax or accounting surprises can be avoided by thorough upfront planning. Entrepreneurs should anticipate scenarios that might arise: What if the buyer makes acquisitions that inflate or deflate the target’s performance metrics? What if a significant downturn hits the industry? What if there are extraordinary costs post-closing? By addressing these hypotheticals in the purchase agreement—specifying how to handle extraordinary items, shared expenses, or integration impacts—the parties reduce the likelihood of acrimonious disputes. Sellers should also consider negotiating liquidated damages for breaches of operational covenants, removing the need to prove hypothetical alternate outcomes. Even if the buyer fails to meet its obligations, the seller then recovers a predetermined amount rather than engaging in complex litigation.
Conclusion
Earn-outs are a powerful but complex tool in M&A transactions, especially for entrepreneurs seeking to justify their valuation ambitions and secure upside potential. They foster risk-sharing, can unlock higher eventual payouts for sellers, and protect buyers from overpaying if expectations are not met. Yet earn-outs also create fertile ground for post-closing disputes, impose stringent requirements for financial clarity, and may limit operational freedom. The interplay between operational decisions, complex accounting methods, tax treatments, and even securities laws underscores the importance of meticulous planning and drafting. By working closely with experienced legal and financial advisors, entrepreneurs can craft earn-outs that are precisely calibrated to their business context. The key is to define targets objectively, set appropriate periods and payment structures, implement robust dispute resolution procedures, and anticipate how future business changes might affect performance. With foresight, negotiation skill, and careful drafting, entrepreneurs can use earn-outs to achieve equitable, value-maximizing results in their M&A transactions.
