The earn-out without getting trapped

An earn-out clause says that part of the price will be paid later, only if the business hits agreed results after the sale. It can bridge a price gap between you and the buyer. For it to work in your favor, it has to be short, measurable, protected against the buyer's own decisions and drafted with precision.

When an earn-out really helps

An earn-out settles a disagreement about the future: you believe the business is worth more, the buyer wants to see it before paying. It's useful in three situations:

• You believe in growth the numbers don't show yet. A new contract, a new product line, a market that's just starting. The buyer won't pay for a promise; you don't want to give it away.
• Part of the revenue is still tied to you. The buyer worries that clients will leave with you. The earn-out shares that risk.
• Both sides are close, but not aligned. Rather than splitting the difference, you tie the gap to a verifiable result.

It becomes a trap when it hides a low offer: a high headline price, a large part of which will probably never be paid. A useful habit: value every offer as if the contingent part were worth zero, then ask yourself whether you'd still sign.

Three rules for a fair earn-out

Short

Every extra month is a month where the results depend more on the buyer's decisions than on the work you did. One or two years give enough time to confirm clients stay, without tying you to choices you no longer control. Beyond that, negotiate partial payments each year rather than a single payment at the end.

Measurable

Pick one simple metric an accountant can verify without debate. Revenue, or gross margin from a specific client group, is often safer for you than net profit or EBITDA. Why? Because the buyer controls the expenses: parent-company management fees, new salaries, integration costs. Each one reduces profit, and so your payment, without clients changing anything.

Also write down the accounting rules: the same methods as before the sale, a list of excluded expenses, the calculation date, and access to the numbers for your accountant.

Fair

An all-or-nothing payment is dangerous: missing the target by a dollar and losing the whole amount breeds conflict. Prefer a sliding scale: part of the payment from a threshold, the full payment at target, with a cap if the buyer asks for one.

Also plan for the buyer changing the rules of the game. If the business is resold, merged into another, or your role is ended without cause, the payment should be accelerated, in whole or in part.

The most common traps

1. The metric the buyer controls. Net profit loaded with new charges can make your payment disappear.
2. The business that vanishes into another. If your sales are blended with the buyer's, they can no longer be measured. Require that the business stay separately measurable for the period.
3. Being judged on what you no longer control. If you no longer have decision-making power, the target should reflect that.
4. No information. Without regular financial statements, you find out the result at the end. Require quarterly reports.
5. Disagreement with no referee. Name an independent accountant from the start to settle calculation disputes.

An example in Estrie

A made-up case, but a plausible one. A maker of roof trusses and prefabricated wall panels in Coaticook does $7 million in sales with 45 employees. The founder is 62. He has just signed a supply agreement with a group of residential builders that could grow sales significantly. The buyer doesn't want to pay for an agreement that's only a few months old.

Their first offer: $5 million cash, plus up to $2 million contingent over three years, calculated on the EBITDA of the buyer's entire group. In other words, $2 million that hinges on management fees, hiring and acquisitions at a group the founder doesn't control.

With his advisors, and because a second buyer was still interested, the founder counters:

• $5.3 million cash;
• up to $900,000 contingent, over 18 months only;
• measured on sales invoiced to the builders' group, a single client group that's easy to isolate;
• paid on a sliding scale: nothing below 70% of target, then a growing share up to 100%;
• accelerated if the business is resold or folded into another.

The buyer agrees, because the metric targets exactly the risk that worried them. The founder agrees, because he can check the result himself from the invoices. The numbers are fictional, and the percentages aren't a norm. The principle is real: a good earn-out measures the specific risk, not the whole business.

What to propose instead of saying no

When a buyer puts a large earn-out on the table, refusing outright often ends the conversation. Counter with structure instead: a shorter period, a narrower metric, a sliding scale, or swap part of the earn-out for vendor financing, which is a debt the buyer owes regardless of results. In a competitive sale process, a second offer with less contingent money is your strongest argument.

The checklist before you accept

Before accepting an earn-out clause, ask your lawyer and accountant these questions:

1. What is the single metric, and can the buyer reduce it through their decisions?
2. How long does it run, and are there partial payments?
3. Is it a sliding scale or all-or-nothing?
4. Which accounting rules apply, and which expenses are excluded?
5. What happens on a resale, a merger, or the end of my role?
6. What information do I receive, and how often?
7. Who decides if we disagree on the calculation?

The tax point to settle before signing

How an earn-out is taxed depends on how it's drafted: share or asset sale, how the amount is calculated, when it becomes payable. One trap in particular: if the payment depends on you staying on as an employee, it may be treated as pay rather than as part of the price, and taxed differently. That's one more reason to keep your transition agreement separate from the price. Have your tax advisor confirm the treatment before you sign, not after.

This week

Ask your accountant for your sales and gross margin by client, or by client group, over the last three years. If a buyer ever proposes an earn-out, that's the base that lets you counter with a narrow metric and a history nobody can dispute. If your systems can't produce those numbers easily, that's a project to start now.

The best protection: needing less of it

An earn-out covers a risk. The more your business depends on you, the more the buyer will ask for. That's why the work in the earlier steps, like the Transition Document, directly shrinks this part of the price. To see how it combines with vendor financing and other tools, read how to structure a win-win deal, or go back to step 8: sell at the right price.

Do it with a pro

An earn-out clause takes ten minutes to read, but a loosely defined calculation can be disputed for years. With us and our regional partner, the metric, the term and the protections are negotiated from the letter of intent onward, with your lawyers and tax advisors, before the buyer imposes their version. Start with our free audit.

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