Earn-out: Overview, definition and example
What is an earn-out?
An earn-out is a provision in a business sale agreement where part of the purchase price is dependent on the business achieving certain financial targets or performance goals after the sale. Instead of paying the full amount upfront, the buyer agrees to pay additional amounts over time, based on the company’s future performance. This allows both parties to share the risk and reward based on how well the business performs post-transaction.
Why is an earn-out important?
Earn-outs are important because they help bridge the gap between the seller’s expectations and the buyer’s valuation of the business. They provide a way to align the interests of both parties and reduce the risk for the buyer. For the seller, it’s an opportunity to earn more money if the business performs well. For the buyer, it helps mitigate the risk of paying too much for a company that doesn’t meet its projected targets.
Understanding earn-out through an example
Imagine a company is being sold for $10 million, with $8 million paid upfront. The remaining $2 million is structured as an earn-out, dependent on the company achieving $5 million in sales over the next two years. If the company hits the target, the seller will receive the additional $2 million. If the company does not meet the target, the seller may receive less or nothing at all.
For example, if the company only achieves $4 million in sales instead of $5 million, the earn-out payment could be reduced to $1 million or another agreed-upon amount.
Example of an earn-out clause
Here’s how an earn-out clause might look in a business sale agreement:
“The Seller shall receive an additional payment of up to $2 million, contingent upon the Company achieving $5 million in sales revenue within two years of the Closing Date. The payment shall be based on the Company’s audited financials and paid within 30 days of finalizing the audit for the relevant period.”
Conclusion
An earn-out is a common mechanism in business transactions that allows for part of the purchase price to be paid based on the future performance of the company. It helps balance the risk between the buyer and seller, ensuring that the seller is rewarded for the continued success of the business post-sale. Understanding how earn-outs work is crucial for both buyers and sellers when negotiating business sales or acquisitions.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.