In an M&A deal, an earn-out is an agreement between the buyer and the seller in which the seller agrees to receive additional payments—usually a percentage of the company’s revenue or profits—based on the target company achieving certain financial milestones. Typically, earn-outs are used when the buyer and seller are unable to agree on a price for the business. By including an earn-out provision, they can bridge the gap between their two valuations and close the deal.
Earn-outs are also a way to share risk between the buyer and seller. For example, the buyer pays $40 million upfront for the business. An earn-out entitles the seller to an additional $10 million if the business hits $XX million in sales or EBITDA within two years of closing. If everything goes according to plan, both parties come out ahead. But if the business doesn’t perform as well as expected, the buyer can feel confident that they did not overpay, while the seller still has a chance to earn a higher price.
In today’s market, where many deals are being scrutinized for recession risk or economic uncertainty, earn-outs are becoming increasingly popular as a way to close deals. Buyers and sellers can agree on a lower purchase price upfront while still providing some upside potential for the seller.
Some studies have indicated averages between 17%-26% of middle market deals having some sort of earn-out or component for contingent compensation.
How Earn-Outs Work
There are two main types of earn-outs: absolute and relative. Absolute earn-outs are based on hard numbers, such as revenue or profit targets. For example, the seller might receive an additional $1 million in annual revenue reaching $X million within two years of closing. Relative earn-outs are based on softer measures, such as market share or customer satisfaction levels or retention.
Absolute earn-outs are generally easier to measure and negotiate than relative ones because there is no subjectivity involved—it is simply a matter of whether or not the company meets its targets. However, relative earn-outs can provide more motivation for the seller due to them being based on growth measures rather than static numbers.
No matter what type of earn-out is used, ensuring that there are clear benchmarks in place is key so that everyone knows what needs to be done in order to receive the additional payments. Without well-defined benchmarks, there’s a risk that disagreements could arise down the road about whether or not those benchmarks were actually met.
Earn-outs are a common tool used in M&A deals to close gaps between buyers’ and sellers’ valuation opinions and share risk between both parties.