What are Earn-Out Agreements?

When buying a business, there are many ways to structure the deal. One common method is through an earn-out agreement. But what exactly is an earn-out agreement, and how does it work? Let’s break it down in simple terms.

An earn-out agreement is a deal where the buyer agrees to pay the seller additional money in the future, but only if the business meets certain goals. These goals are usually based on the business’s performance after the sale, like hitting specific revenue or profit targets. 

Think of it as a way to share the risk between the buyer and the seller. The seller gets a chance to earn more money if the business does well, and the buyer doesn’t have to pay the full price upfront if the business doesn’t perform as expected.

Earn-out agreements are often used when the buyer and seller can’t agree on the value of the business. For example, the seller might believe the business is worth more because they expect it to grow, while the buyer might be unsure and want to pay less upfront. An earn-out agreement helps bridge that gap by tying part of the payment to the business’s future success, still with me? Here is a example: 

A Car Wash Example: How Earn-Out Agreements Work in Real Life

Let’s say you’re buying a car wash business. The seller claims the car wash makes $100,000 in profit each year and expects it to grow. 

However, you’re not entirely convinced. Maybe the car wash is in a busy area, but you’re worried about competition or rising costs. This is where an earn-out agreement can come in handy.

Instead of paying the full price upfront, you and the seller agree on a deal. You’ll pay  $300,000 now, with an additional $100,000 promised over the next two years—contingent on the car wash making $100,000 in profit each year. If the car wash earns less, the payment is reduced. If it performs better, the seller receives the full $100,000 in profit each year.

This way, the seller has an incentive to help you succeed during the transition. They might stay on for a few months to train you or share tips on running the business. At the same time, you’re protected because you’re not paying for future success that might not happen.

Pros and Cons of Earn-Out Agreements

Like any deal structure, earn-out agreements have their advantages and disadvantages. Here’s a quick look at the pros and cons:

Pros:

Reduced Risk for Buyers: You don’t have to pay the full price upfront. If the business doesn’t perform as expected, you pay less.

Incentive for Sellers: Sellers are motivated to help the business succeed during the transition, which can make the handover smoother.

Flexibility: Earn-outs can help bridge the gap when buyers and sellers disagree on the business’s value.

Cons:

Potential Disputes: If the business’s performance is unclear, buyers and sellers might argue over whether the earn-out goals were met.

Seller Dependency: If the seller stays involved, their departure after the earn-out period could hurt the business.

Complexity: Earn-out agreements can be tricky to set up and require clear terms to avoid misunderstandings.

Is an Earn-Out Agreement Right for You?

Earn-out agreements can be a great tool for buying a business, especially if you’re new to the process or unsure about the business’s future performance. They allow you to share the risk with the seller and give both sides a reason to work together during the transition.

However, it’s important to think carefully about the terms of the agreement. Make sure the goals are clear and realistic, and consider getting help from a lawyer or business advisor to avoid potential pitfalls. If done right, an earn-out agreement can be a win-win for both buyers and sellers.