Selling a business? The pros and cons of earn-out clauses

Earn-out clauses for the sale of a business are increasingly common. We look at the positives and negatives that every business owner should consider.

Business transactions often include earn-out clauses where the vendors ‘earn’ part of the purchase price based on the performance of the business post the transaction. Typically, an earn-out will run for a period of one to three years post transaction date.

There are two main reasons to include an earn-out in a sale:

• To bridge a gap in the sale price expectations between the vendor and the purchaser. The earn out represents an ‘at risk’ form of consideration. If the business produces the result, the vendors are rewarded through a higher sale price.
• To incentivise the vendors who are continuing to work in the business and maintain the growth momentum of the business post sale.

Advantages of earn-outs include:

• The ultimate sale price has a performance component to it – both buyer and seller benefit.
• May assist in achieving a sale where a price impasse would otherwise prevent the sale.
• If the calculation of the earn-out is transparent and easily measurable, there should be no dispute between the parties.
• Creates equity where the business has lagging income, new business initiatives in play at the time of sale or a high growth rate.
• The incremental sale price can be effectively funded by the business out of realised growth.

The key to an effective earn-out is in their construction, both from a commercial and a legal perspective. Get them right and they can enhance the continuity and succession of a business.