What do you imagine will happen, when you think about selling your small business?
If you’re like most owners, visions of cold, hard cash hitting your bank account dance in your head.
But here’s the reality: Most buyers won’t want to hand you the entire sale price in cash on closing day. Instead, they’ll aim to structure their purchase to include an earn out.
This might not be necessary, depending on how your business is structured and what kinds of acquisition options are on the table. But if you do agree to an earn out, you want it to work in your favor.
Before we get into how to do that — what is an earn out? Let’s walk through the fundamentals.
An earn out definition
An earn out is a provision in your sale contract that ties part of your sale payout to your business’s future performance. (If you’d like a bit more detailed definition, there’s a good one here.)
Most people call this an earn out, while others write it as “earnout” or “earn-out.” In this article, we’ll use the most popular phrase. In any case, the meaning remains the same. These earn out payments are usually contingent on your business achieving certain financial targets after the sale.
An earn out example
What does an earn out look like? There are many ways to structure these payments. Here’s one example:
Say your business’s sale price is $1 million.
The buyer offers $500,000 on closing, and the other $500,000 in four quarterly payments over the course of the next year. In other words, four payments of $125,000 would arrive over the following year.
BUT: Those payments are only owed if you hit performance targets that are pre-determined. Say your agreement requires revenue to remain stable for you to get those payments. If revenue shrinks, the earn out payments will be reduced.
If revenue shrank 20%, the seller might receive four payments of just $100,000 apiece in the earn out, or whatever reduction was spelled out in their acquisition agreement. In that case, they’d realize $900,000 from the sale, instead of $1 million.
As this example illustrates, there’s one important, plain-English earn out definition sellers need to know: An earn out clause means the seller is at risk of not getting their full expected payout.
Why are earn outs common in business sales?
Buyers love earn outs because they’re scared that the minute the seller stops operating the business, sales will implode. Buyers often want to structure their purchase so they pay less if that happens.
From the seller’s point of view, though, earn out provisions introduce uncertainty. After all, you agreed to sell because you thought you were getting $X money for your business!
That’s why it’s important for sellers to structure earn out agreements carefully when you sell your business, so you have the best possible chance of being paid in full.
How to structure an earn out
What features of an earn out might benefit the seller? Here are some important points to consider in negotiating your earn out:
Get more cash up front
It’s in your best interest as the seller to have as little cash at risk in the earn out as possible. If the buyer proposes 50% of the sale price be paid in the earn out, you can push back by proposing a lower percentage.
If only 25% of the sale price is at risk in the earn out instead of 50%, that better protects you when you sell.
Don’t tie earn out payments to net income
Here’s the single most important thing to remember, when you negotiate an earn out: After you sell, you’ll often have no control over how your former business operates.
In their efforts to grow their new business unit, the buyer could hire many new sales reps or increase the ad budget or make any other choices that require spending money. Even if the business does well, net profits could shrink.
That’s why sellers should always tie earn out payments to revenue, rather than net profits, says Ryan Tansom, co-founder and partner at the Minnesota-based business firm Arkona, which helps businesses grow and maximize their sale profits.
You also need the right to verify the buyer’s revenue numbers. A good earn out will specify exactly how financials will be audited, ideally by an independent accounting firm, notes Tansom.
Don’t mistake an earn out for a service contract
If you’re planning to do any work for the buyer post-sale—you’ve agreed to train their new team, consult on strategy, or create marketing campaigns, say—that work isn’t part of the earn out. The earn out is purely about receiving fair compensation for the value of your business.
Too often, sellers accept a smaller sale price because they’ve signed a hefty service contract, Tansom says.
“Your service contract is not an earn out,” Tansom says. “Sellers have told me, ‘It’s great, I’m getting $300,000!’ and I say, ‘Yes…but you have a job.’” For sellers who wanted out of their business, this isn’t the ideal outcome.
Base the earn out on easily achievable goals
To lessen the risk, sellers should choose earn out targets that are reasonable and achievable, says entrepreneur Carrie Kerpen. The founder of New York-based social-media agency Likeable, Kerpen negotiated an 8-figure sale in 2021 to competitor 10Pearls, an agency based in Washington, D.C.
With initiatives in place that she felt sure would grow sales, Kerpen agreed to an earn out with modest revenue-growth targets, turning down an offer of higher payouts for bigger sales gains. Even though she ended up hitting those higher goals in the first year, she says she has no regrets.
“This made me feel safe,” she says.
Prioritize having control
Unlike many sellers, Kerpen was willing to stay on and work for the new owner of her business for multiple years. In an important move to secure her earn out payments, she negotiated to remain in charge of her business unit.
“I have complete control over the profit-and-loss,” she says. “That made me feel strongly that I could hit my earn out numbers.”
Without control, sellers have no assurances that they’ll be able to hit earn out targets, she notes.
List your requirements
The earn out doesn’t just describe targets your former business must achieve. It can also define actions the buyer must take.
If the buyer doesn’t hold up their end of the deal, you could be compensated for their failures–or even get your company back for free. That’s what happened to Sprout Pharmaceuticals co-founder Cindy Eckert, who sold to drug company Valeant for $1 billion. After Valeant jacked up the price of Sprout’s drug Addyi–known as ‘the female Viagra’–sales plummeted, as insurers stopped covering the medication.
Eckert and former Sprout shareholders sued over Valeant’s failure to meet the sales and marketing obligations outlined in Sprout’s earn out. To settle the suit, Valeant returned the company to Eckert and the shareholders in 2018, essentially free.
“Understand how everything can unfold, preplan all of it, and put it all in the earn out document,” Tansom says.
Make sure you’re paid enough
Realize that in a sale with an earn out, only one part of the price is guaranteed: the cash paid at closing. Tansom has seen companies go under shortly after making an acquisition, with the seller never seeing a single earn out payment.
Ideally, the up-front money captures the full value of the business you built. Earn out payments are a bonus.
If you wouldn’t be satisfied with the worst-case scenario, consider holding out for a better offer, Tansom says.
Tips for avoiding an earn out
Do you have to agree to an earn out provision in your sale contract? While a buyer might try to convince you otherwise, the answer is: no, you don’t.
There are various circumstances where you might negotiate to receive the full cash value at closing. For instance, if you have multiple potential buyers in a bidding war, you might choose one that offers a 100% payout on closing.
If the seller isn’t actively operating the business, and isn’t the “face of the brand,” an earn out might not be needed. After all, this setup means the seller’s absence shouldn’t impact revenue.
That was exactly the situation for Jodie Cook when she sold her 10-year-old social-media marketing agency in 2021. The UK-based entrepreneur sold JC Social Media to digital agency Low&Behold for an undisclosed sum.
Before the sale, Cook says, she had a goal of traveling frequently. She wanted to make sure everything ran smoothly, even if she wasn’t reachable. So she hired staff to cover all her responsibilities.
“I had the business set up to be self-sufficient because of the travel goal,” she says.
When it came time to sell, Cook was able to show that no revenue dip was likely, since she had no day-to-day role at JC. Her all-cash deal closed in June 2021.
“The moral of the story is, get yourself out of the business before the sale, if you want to avoid an earn out,” Cook says.
The upside of earn outs for sellers
Can earn outs benefit the seller? Surprisingly, yes, in some circumstances.
If there’s a new product ready to launch right after the sale closes, for instance, the seller could negotiate earn out targets that would add cash to the agreed-upon sale price. If revenue grows substantially in the months after the sale, the seller could benefit.
Before you nix an earn out, consider whether a carefully structured earn out might add to your payout. If you can exert enough control over how the post-sale period is handled, you might be able to increase your sale profits.
Whether you negotiate an earn out or avoid one, the bottom line is to make sure you get what your business is worth, says Tansom.
“Don’t sign an earn out unless you’re getting all the value you want out of the business,” he says.
We’re reporters, not financial advisors. If you need help with financial decisions, please hire a finance professional. The information contained in this piece is provided for informational purposes only, and should not be construed as financial advice.