Earn-Outs When Selling a Small Business

An earn-out means part of your sale price depends on how the business does after you sell it. It can help close a deal when you and a buyer don't agree on value, but it also means some of your money is uncertain. Here's how it works and what to look for.

What an earn-out is

In an earn-out, the buyer pays part of the price at closing and agrees to pay more later if the business reaches certain targets. BDC describes it as a type of vendor financing where the amount is earned only if and when agreed conditions are met. Those conditions are usually financial, such as total profit or sales of a product, or operational, such as keeping the seller involved or holding on to staff.

For example, a buyer might pay most of the price on closing day, plus an extra amount at the end of each of the next two years if yearly sales stay above a set figure.

Why buyers propose one

• A gap in value. You expect next year to be strong; the buyer isn't so sure. An earn-out lets both views be tested by real results.
• Uncertainty. A new product, a large new customer or a recent change can be hard for a buyer to value at closing.
• Financing. Paying part of the price later can make the deal easier for the buyer and their lender to fund.
• Keeping you involved. When results depend on you, an earn-out encourages a smooth handover.

What a clear earn-out spells out

1. The target. Sales, gross profit or another measure. Sales are usually simpler to check than profit, which depends on how costs are counted.
2. How it's measured. Which accounting rules apply, who prepares the numbers and when you get to see them.
3. The period. How many years, and when each payment is due.
4. The payment. A fixed amount when a target is met, or a sliding amount based on results, and whether there's a cap.
5. How the business is run. What the buyer agrees not to do during the earn-out, such as merging it into another company or moving key customers elsewhere.
6. Disputes. How a disagreement about the numbers gets settled, for example by an independent accountant.

Risks for the seller

Once you sell, the buyer controls the business. Their decisions about pricing, staff, spending or how costs are recorded can affect whether a target is met, even if you did everything right. Payments can also be delayed or argued over. A good rule of thumb is to look at the cash you get on closing day and ask whether you would be comfortable if the earn-out paid nothing.

If you're also lending the buyer money through vendor take-back financing, think about how much of the total price is really at risk.

Before you agree

1. Have clean, consistent financial records so the starting numbers are clear. Our guide to add-backs and normalized earnings can help.
2. Prefer simple targets you can check yourself.
3. Make sure you'll have access to the numbers during the earn-out period.
4. Ask your accountant how the earn-out affects when and how the sale is taxed.
5. Have your lawyer review the earn-out terms in the letter of intent and again in the purchase agreement.

A note on advice

This guide is general information, not legal, tax or financial advice. Earn-out terms can change how much you are actually paid for your business, so please have your own lawyer and accountant review them before you sign.