An earn-out is a mechanism used during the sale of a business. It effectively bridges the gap between what a seller thinks their company is worth and what the buyer is willing to pay up front. In a startup environment, valuations are often based on future potential rather than historical data. This makes agreeing on a price difficult.
When an acquisition takes place, the buyer might offer a lower guaranteed cash amount at closing. To sweeten the deal, they include a provision for additional payments later. These payments are contingent on the company achieving specific financial goals over a set period.
This creates a scenario where the total price of the acquisition is not fixed until years after the papers are signed. It aligns the incentives of the founder with the new owners, ensuring everyone is working toward the same growth targets.
The Mechanics of the Deal
#Structure matters more than the headline price in these agreements. An earn-out usually lasts between one to three years following the close of the deal. During this time, the business must hit certain milestones to unlock the funds.
Common metrics used include:
- Revenue targets
- EBITDA thresholds
- Gross margin improvements
- Customer retention rates
If the startup hits 100% of the target, the founder gets the full earn-out payment. If they miss the target, they might get a partial payment or nothing at all depending on how the contract is written.
Founders need to understand that this money is not guaranteed. It is entirely at risk based on execution.
The Trade-off of Control
#One of the most significant shifts during an earn-out is the change in control. You go from being the final decision maker to being an employee or a division head within a larger organization. This transition is often jarring for entrepreneurs used to autonomy.
While you are responsible for hitting the financial targets to get your payout, you may no longer control the budget or hiring decisions required to hit those targets. The parent company might cut marketing spend or change strategic direction. This can directly impact your ability to achieve the goals set in the earn-out clause.
It is vital to negotiate how much operational control you retain during this period.
Cash vs. Contingent Payments
#When evaluating an offer, it is helpful to distinguish between cash at closing and contingent payments.
Cash at closing is the only definitive value in the deal. It is money in the bank. An earn-out is a promise of future money that relies on variables that may be outside your influence. A lower offer with all cash is sometimes mathematically superior to a higher offer that is heavily weighted toward an aggressive earn-out.
Critical Variables to Consider
#We must look at these agreements with a skeptical eye to understand the variables at play. There are questions you have to answer before signing.
Will the acquiring company integrate your product immediately or leave it standalone? If they integrate it, how do you attribute revenue to your specific unit?
Does the acquirer have a history of paying out earn-outs, or do they have a reputation for blocking the resources needed to achieve them?
How will your team react to the new ownership? If key employees leave, hitting your targets becomes exponentially harder.
By analyzing these unknowns, you can decide if the potential upside is worth the extended commitment and loss of control.