Business Exits: How Earn Outs Work in Detail - Part Two

Selling a Business
This is the second part of the article I've written before. You can also read the first part of the series

Rarely does the buyer of a business agree with the seller on valuation. So when you are offered a lower price, an earn out is one way of meeting the buyer in the middle. Earn outs, however, are a minefield, so the more you know about them, the better off you are. This is the second part of our detailed look at the mechanics of earn outs.

The way you as the seller get more money from the buyer after settlement is by agreement that if the business hits agreed KPIs after you sell, then you get more money. Now, there are usually only two situations where the buyer and seller don't agree on price:

  • The first is the private information setting where one party knows things about the business that the other part does not. This usually happens when the seller is confident that KPIs can be hit if the business keeps running the way the seller has been running it. The buyer, on the other hand, may not share this confidence or have the information on which this confidence is based.
  • The second is the non-convergent priors setting where both parties just don't agree on how much should be paid and they haven't been able to resolve their differences.

In either of these two situations, an earn out is often the solution. The earn out is a series of payments based on verifiable information and made after settlement. It solves the problems of the private information setting and the non-convergent priors setting and provides a way forward to agree how much should be paid for the business.

Who has Operational Control?

When an earn out is agreed, it usually requires the seller or its managers continue on in the business and run it so that the seller gets it's earn out and the buyer has the business run well after it buys it. So you would think that the interests of the buyer and the seller are aligned - the business has to do well so that the seller gets its extra money.

That, however, is not always the case. There are two common situations where it gets tricky:

  • The first is where the seller or the seller's managers are only committed to achieving the KPIs that trigger their earn out during the earn out period. So, for example, if the earn out is based on hitting an agreed EBITDA, then the seller or its managers might focus solely on that EBITDA figure at the expense of investing in the future profitability of the business. The buyer, on the other hand, doesn't want capex, marketing or R&D to be strangled just so the EBITDA can be achieved - this puts the future of the business past the earn out period at risk. This is where the interests of the parties are not aligned - and it could lead to significant arguments.
  • The second is when the seller or its managers actually acts in good faith in the management of the company for the earn out period, but the buyer makes it impossible to achieve the KPIs because it doesn't do enough marketing, doesn't provide enough resources or otherwise prevents the KPIs being achieved. 

This second scenario arises quite often because it is a natural result of the type of things that buyers typically want to do with the businesses they have just bought:

  • The buyer does a roll up of similar businesses and integrates them all into one entity so that the KPIs can't be measured any more.
  • The buyer sells the entire product line upon which the KPIs depend.
  • The buyer integrates the business into its own business so much so that the KPIs can't even be measured any more.
  • The buyer doesn't integrate the business into its own business as was originally envisaged when the earn out was agreed, so the business never gets the benefits of the anticipated synergies.

How Do You as a Seller Control the Earn Out After You Sell the Business?

Now that you know a few of the issues in your proposed earn out, what can you do about ensuring that you hit the KPIs and still be on speaking terms with the buyer? This is tricky, and leads to that old saying in M&A: the money you see at settlement is the only money you are ever going to see.

The best way to do it is in the sale and purchase agreement. If you have a good lawyer, you can get them to include a clause that requires the buyer to run the business in the ordinary course of business defined by reference to past practice prior to settlement. OK, so this might be the subject of a bit of argy bargy, but in essence you should be happy with something like, past practice with a few agreed differences.  

If you are feeling lucky, you could try asking for a clause where the buyer agrees to run the business to maximise the seller's earn out. Asking for this sort of clause really goes to the heart of the good faith of the buyer if they agree to it, then everything may work for both of you. If they refuse point blank, they may have wildly different plans for the business and these plans may not include you to any great extent.

Another way of doing it is to have covenants that give you as the seller some rights in relation to major decisions concerning the company during the earn out period. For example, you could ask for rights in relation to:

  • Ceasing all or a substantial part of the business
  • Merging or combining the target with other businesses
  • Loans to directors or shareholders
  • Winding up the company whilst solvent
  • Mergers or sale of the assets
  • Acquisitions of new businesses
  • Returns of capital
  • Appointment or removal of a CEO, COO, CFO or other senior managers
  • Sales or dealings with the assets other than in the ordinary course of business, or other transactions other than in the ordinary course of business
  • The creation of the business plan or budget or increase in the budget or substantial changes to the business plan
  • Material alterations to the business

Obviously the more you ask, the more you are impinging on the buyer's ability to deal with the business as it likes, but it's all a matter of negotiation.

How Does the Buyer Control the Earn Out after it has Bought the Business?

The buyer will clearly want to control the business as much as possible after paying good money for it. This, of course, is balance by the buyer's desire to have your management team run the thing profitably for it. Since the seller hasn't paid all the money, you should make clear that the buyer has a duty of sorts to you as the seller. That duty arises in the sale and purchase agreement, and may be heightened if you have reserved (say) 20% of the shares until the agreed buy out period is ended, whereupon you sign them over. In this case, you also have the added protection of a legal action for oppression of minorities.

What you have to look out for is the buyer who drives the business into the ground for the majority of the earn out period, then brings it to life as soon as you are out of the picture. The buyer, of course, is wary of the seller's management running the business after settlement to maximise their earn out with little or no regard to the rest of the business. This can happen when the earn out is based on increased turnover. This encourages management to pursue any and all business, even at a loss, just so that their earn out is maximised. Buyers also have to watch out for the seller's management trying to keep the business as a separate unit for as long as possible so that their KPIs can be easily ascertained - at the expense of integrating the business into the buyer's business. This deprives the buyer of the synergies it originally expected when it bought the business.


Sometimes negotiations can seem like trench warfare and take so long that one side or the other gives in to a lop-sided earn out. There is a lot of value in an earn out in helping to reach an agreement, but also a few traps for both sides. The best advice is this: get some good advice!

Ben Killerby


Corporate Advisor and Legal Counsel for Saxon Klein, a corporate advisory firm in Melbourne.