What is an Earn-out?
Understanding Earn-Outs in M&A Transactions
In the world of mergers and acquisitions (M&A), one of the most powerful tools used to bridge a valuation gap between buyers and sellers is the earn-out. Today, I’m going to walk you through what an earn-out is, when to use it, and how to structure one so that both parties benefit.
What Is an Earn-Out?
An earn-out is a contingent payment made to the seller of a business based on the future performance of that business. It’s typically used in M&A deals when the buyer and seller disagree on the value of the company—often due to uncertain future projections or market risks.
Instead of walking away from a deal, the buyer might agree to pay a portion of the purchase price up front and the rest later—if the business meets specific financial targets, such as revenue or profit goals.
Why Use an Earn-Out?
The most common use of an earn-out is to overcome a valuation gap. For example, if a seller is asking for $2 million and the buyer is only willing to pay $1.5 million, an earn-out can bridge that $500,000 difference.
An earn-out can:
Provide downside protection for buyers if the business underperforms.
Offer upside potential to sellers if the business continues to grow.
Align incentives between both parties.
When structured properly, it can be a win-win. But it's important to note: According to KPMG, only 15% of earn-outs are fully paid. That statistic makes sellers understandably cautious.
How to Structure a Fair Earn-Out
To make an earn-out successful, start with simplicity. Here's how we advise structuring it:
1. Start with a Straightforward Offer
Even if the seller’s asking price seems high, begin with a clean all-cash offer. If that’s rejected, then consider using an earn-out to close the gap creatively.
2. Use a Realistic Example
Let’s say:
The seller wants $2 million.
You’re only comfortable offering $1.5 million.
A $500,000 earn-out can be tied to performance over the next 2–3 years.
You can structure the earn-out so that the additional $500,000 is paid if the business meets specific metrics.
3. Choose the Right Metric
Sellers often worry that buyers will manipulate profit numbers to avoid paying the earn-out. So picking the right performance metric is key.
Common metrics include:
Revenue: This is straightforward and hard to manipulate. For example, if a business does $5 million in annual revenue, the earn-out might pay out if it stays at or above that level.
Gross Profit: This is a more balanced metric. If raw materials spike or operating costs rise post-sale, it ensures the business is still generating sufficient returns.
A typical payout structure might be:
$500,000 earn-out
Paid over 3 years
1/3 of the amount released each year if performance goals are met
Strategic Advantages for Sellers
Earn-outs aren’t just for buyers. Sellers can use them to negotiate a higher total purchase price—especially if they’re confident in their business's future performance.
For example:
The buyer offers $1.5 million upfront.
You negotiate an additional $750,000 as an earn-out.
If the business performs, you walk away with $2.25 million—more than your original asking price.
Earn-outs can be a smart move if:
The buyer is well-positioned to grow the company post-sale.
You’re confident in the company's trajectory.
The terms are clearly defined and achievable.
Final Thoughts: Proceed with Caution
Earn-outs can be a powerful way to bridge valuation differences and align incentives, but choose your buyer carefully. The success of an earn-out depends on the buyer’s ability to run and grow your business effectively.
If you're considering an earn-out as part of your M&A deal, it’s critical to structure it thoughtfully—and partner with a buyer who has both the intent and capability to follow through.