If you’re planning to sell your business, you’ve likely heard the term “earn-out”, and potentially broken into a cold sweat. While earn-outs can bridge valuation gaps and help close deals, they also represent one of the most contentious and high risk components of a business sale.
An earn-out is essentially a contingent payment structure where a portion of your sale price is tied to future business performance and key metrics after closing. The buyer pays you an initial amount at closing, with additional payments contingent on the business hitting specific performance targets over the next 1 to 3 years. In theory, this aligns everyone’s interests – but in practice, it can become a minefield without proper planning and protection.
In this article, we’ll explore four critical tips for successfully navigating earn-outs. These strategies can help you maximize your chances of receiving those contingent payments while protecting yourself from common landmines that leave many sellers frustrated and with less overall proceeds from the sale.
1. Focus on the Right Performance Metrics
The performance metrics that trigger your earn-out payments can make the difference between collecting those future checks or walking away with nothing. Too many sellers accept metrics that are overly complex or outside their control.
What to Watch For:
- EBITDA-based metrics can be manipulated through accounting practices or spending decisions made by the new owner
- Revenue targets may be achievable but don’t account for profitability pressures
- Metrics dependent on new product launches or initiatives may be vulnerable to delays outside your control (think of the geopolitical turmoil in early 2025)
- Targets that require resources the buyer isn’t contractually obligated to provide (can they intentionally miss a target to save money?)
Why It Matters:
The wrong metrics can set you up for post-closing issues from the beginning. Once the deal closes, the buyer’s priorities may shift, market/political conditions may change, or the integration process may disrupt operations – all potentially impacting your ability to hit targets that seemed reasonable during negotiations.
Pro Tip: Push for metrics based on top-line revenue or gross profit rather than bottom-line EBITDA whenever possible. These measures are less susceptible to manipulation through discretionary spending decisions. If EBITDA must be used, negotiate for clear definitions and limitations on what adjustments the buyer can make, especially when it comes to allocation of overhead costs or other new costs that get layered in by the buyer.
Read more about evaluating the health of your key relationships and partners here: https://southcoastfp.com/evaluating-the-health-of-your-key-relationships-and-partners/
2. Maintain Operational Control Post-Closing
Your ability to hit earn-out targets largely depends on how much control you retain over business operations after the sale. Without proper protections, a buyer could inadvertently (or intentionally – yes it does happen) make changes that undermine your ability to achieve your targets.
What to Include in Your Agreement:
- Clearly defined authority over key operational decisions affecting the earn-out metrics
- Protection from having business resources diverted to other divisions or initiatives
- Assurances that your key team members won’t be reassigned or let go (identify them early in the deal process!)
- Guarantees about marketing budgets, product pricing changes, and other critical decisions that affect relationships with customers
- Ability to deny or veto significant changes to business strategy or operations during the earn-out period
Why It Matters:
Without operational control protections, you’re essentially betting your earn-out on the buyer’s goodwill and business capability. Even well-intentioned buyers may make decisions that seem reasonable from their perspective but destroy your chances of hitting performance targets. This is particularly important for buyers without deep industry experience in your field who are more of a financial versus strategic buyer.
Read more about the different types of buyers for your business here: https://southcoastfp.com/the-6-types-of-buyers-you-need-to-know-before-selling-your-business/
Pro Tip: Consider negotiating for a separate business unit or accounting structure that separates and protects your operations from the larger organization during the earn-out period. At minimum, clearly articulate levels of working capital, marketing, and sales budgets in the terms.
3. Protect Against “Material Changes” That Impact Performance
Even with the right metrics and operational control, external factors (again, think of early 2025 and the major economic and government impacts) or buyer decisions can significantly impact your ability to achieve earn-out targets. Smart sellers negotiate specific protections against these scenarios.
What to Include in Your Agreement:
- Adjustments to targets if the buyer changes business strategy, enters new markets, or exits existing ones
- Provisions for recalculating targets if there are supply chain disruptions, regulatory changes (tariffs) or political turmoil, or industry shifts
- Accelerated payment of a reasonable portion of the earn-out if the buyer sells the business during your earn-out period
- Clear dispute resolution mechanisms with neutral third-party arbitrators, ideally in your state
- Protection against changes in accounting methods, customer contract structures, or revenue recognition policies
Read more about protecting yourself from unpredictable supply chains here: https://southcoastfp.com/protect-yourself-from-unpredictable-supply-chain/
Why It Matters:
The business environment is continually changing, and what seemed like reasonable targets during negotiations can quickly become impossible due to factors outside your control. Without material change protections, you’re exposed to significant risk with little recourse.
Pro Tip: Include an “acceleration clause” that triggers immediate payment of some or all of your earn-out if the buyer makes any changes that materially impact your ability to achieve targets. This gives the buyer flexibility to make business changes if needed but ensures you don’t bear the financial consequences.
4. Structure the Earn-Out for Partial Wins
Many earn-outs are structured as “all-or-nothing” propositions – you either hit your targets and get paid, or you miss them and get nothing. This binary approach significantly increases your risk of getting less from the deal. Instead, push for a structure that rewards partial achievement, or achievement split between multiple metrics.
How to Structure It:
- Create tiered or sliding-scale payments that increase as performance improves (think how you would structure a performance based bonus plan for your team)
- Negotiate separate and independent targets for each earn-out year rather than cumulative targets
- Include catch-up provisions that allow overperformance in later periods to make up for shortfalls in earlier periods
- Consider multiple metric options (i.e., revenue OR profit targets) where achieving either one triggers some payment
- Establish quarterly or semi-annual measurement periods with partial payments rather than waiting for annual results
Why It Matters:
A well-structured earn-out acknowledges that business performance rarely follows a perfectly predictable path. By building in flexibility, you increase your chances of receiving at least some of the contingent payment while still giving the buyer the performance-based structure they desire.
Pro Tip: Calculate the net present value of your earn-out under various performance scenarios and negotiate for a higher upfront payment if the earn-out structure places too much of the total sale value at risk, especially if the earn out is 3 years or more in length. Remember that the value of a dollar today is worth more than a contingent dollar tomorrow – especially when that contingent dollar depends on a number of factors that you may not control.
Final Thoughts
Earn-outs can be valuable tools for closing valuation gaps and getting deals across the finish line, but they come with significant risks. By focusing on the right metrics, maintaining operational control, protecting against material changes, and structuring for partial achievements, you can significantly improve your odds of collecting on the full value of your business sale.
The key is approaching earn-out negotiations with both optimism and professional skepticism. Be optimistic about what your business can achieve under new ownership, but skeptical enough to secure protections against the many ways earn-outs can (and often do) go sideways.
Most importantly, remember that the best time to negotiate these protections is well before the deal closes. Once you’ve signed the purchase agreement, your leverage diminishes dramatically. Working with experienced advisors who have navigated these structures before can help you identify potential pitfalls and create an earn-out structure that truly aligns interests rather than creating future conflicts.
Read more about the Role of a CPA in a Business Sale here: https://southcoastfp.com/the-role-of-a-cpa-in-the-business-sale/
Ready to sell your business and structure an earn-out that protects your interests and maximizes your total cash collected? Reach out to our team to discuss how we can help you maximize the value of your business sale while minimizing the risks of contingent payment structures.
