What is an “Earn-Out”?

When selling a business, there are several ways in which the purchase price can be structured. The most common include:

• cash on completion;
• deferred consideration; and
• an earn-out.

Cash on completion is the simplest structure, with the buyer paying the agreed price in full at completion. However, more complex structures – particularly deferred consideration and earn-outs – are often used in practice and are sometimes confused.

Deferred consideration arises where part of the purchase price is fixed and agreed at completion, but is payable at a later date. This can allow the buyer to spread the cost of the acquisition and preserve cash flow. For the seller, it may help secure a higher overall price.

However, deferred consideration carries an element of risk: if the buyer is unable to pay the deferred amount when it falls due, the seller may not receive the full purchase price. As a result, sellers will often seek security for these future payments.

Earn-outs, by contrast, operate differently. Rather than fixing the full purchase price at completion, an earn-out links part of the consideration to the future performance of the business. Typically, the seller receives an initial payment on completion, followed by additional payments over an agreed period, depending on how the business performs post-completion.

The performance targets used to calculate earn-out payments vary, but commonly include:

• EBITDA (earnings before interest, tax, depreciation and amortisation);
• gross profit; or
• turnover.

Earn-outs are frequently used where:

• the buyer and seller cannot agree on the value of the business; or
• the buyer needs to reduce the upfront cash payable on completion.

From a seller’s perspective, an earn-out can be attractive as it provides the opportunity to benefit from the continued success of the business after the sale. It can effectively bridge a valuation gap and ensure that payment reflects the business’s actual performance.

However, earn-outs also present risks. A key concern is the level of control the seller retains during the earn-out period. If the seller no longer has meaningful involvement in the business, there is a risk that the buyer’s decisions could adversely affect performance and therefore reduce the earn-out payments.

To mitigate this risk, it is essential to agree appropriate protections within the sale documentation. These may include:

• obligations on the buyer to operate the business in the ordinary course;
• restrictions on actions that could artificially reduce profits;
• clear and objective accounting policies; and
• information and access rights for the seller during the earn-out period.

Careful structuring and drafting are critical to ensuring that an earn-out works as intended and minimises the risk of disputes.

Thinking about selling your business?

BHW’s Corporate and Commercial Team can guide you through the process of selling your business and help you achieve the best possible outcome. Contact the team on 0116 289 7000 or email info@bhwsolicitors.com.