The Role of Earn-Outs: What You Need to Know

Earn-outs are a common feature in M&A deals, particularly for digital agencies, as they help bridge valuation gaps between buyers and sellers. While they offer opportunities to maximize your payout, they also introduce complexities and risks that require careful planning. Often, earn-outs span multiple years, with payouts tied to specific (performance) milestones. Whether an earn-out works for you ultimately depends on personal preference – do you trust the buyer, and do you want to stay involved post-sale?

Want to jump right in? Here you go:

What is an Earn-Out?

An earn-out is a contractual agreement in which part of the sale price is deferred and paid out based on the business achieving specific performance metrics post-sale. These metrics often include revenue or gross margin growth, EBITDA, or client retention and are designed to align buyer and seller interests. Multi-year earn-outs, typically spanning two to three years, are common in agency sales. This structure allows the seller to benefit from the ongoing success of the agency but also introduces dependencies on the buyer’s operational decisions and external market conditions.

Pros and Cons of Earn-Out Agreements

Pros:

  • Opportunity to maximize the sale price.
  • Aligns buyer and seller interests by sharing risks and rewards.
  • Allows the seller to benefit from future growth of the agency.

Cons:

  • Usually requires the seller to remain involved post-sale.
  • Increased dependency on future buyer’s decisions, which may impact performance metrics (e.g., EBITDA) post-sale.
  • Disputes often arise around items impacting EBITDA, revenue, or gross margin calculations – thus precise definitions, particularly for adjusted metrics, are essential to avoid misunderstandings and unfair valuation.

Key Elements of an Earn-Out Agreement

Earn-out agreements typically include detailed performance metrics, a clear timeline (often two to three years), and a payout structure tied to achieving specific goals. These metrics must be straightforward and measurable, such as revenue or gross margin growth, EBITDA, or client retention, with explicit adjustments to account for factors outside the seller’s influence. Payment schedules are also crucial, ranging from lump sums to staged payouts or sometimes even percentages of profits. Ensuring protections against buyer-initiated changes, such as caps on discretionary expenses, can help safeguard payouts.

Common Risks and How to Mitigate Them

Earn-outs inherently carry risks for the seller, particularly when performance metrics are impacted by buyer decisions. Loss of control over operational factors such as staffing, marketing budgets, or strategic pivots can jeopardize earn-out payouts. Sellers should:

  • Negotiate protections that limit the buyer’s ability to make changes that impact earn-out metrics.
  • Introduce adjusted EBITDA, revenue, or gross margin clauses to exclude extraordinary or discretionary expenses.
  • Involve a neutral third-party auditor if disputes arise over performance results.

Strategic Tips for Negotiating Earn-Outs

Keep performance metrics simple and measurable to minimize ambiguity. When possible, tie earn-out metrics to areas you can directly influence, such as client retention, revenue, or gross margin growth. Work closely with legal advisors to ensure the agreement includes safeguards against changes in buyer behavior that could impact performance metrics.

Alternatives to Earn-Outs

If earn-outs seem too risky or complex, consider alternative structures. As the seller you can try negotiate a higher upfront payment to minimize reliance on post-sale performance. Another option is to remain a shareholder in the business rather than fully exiting. This approach allows the seller to stay actively involved in decision-making and reduces the risk of being pushed out. Retaining shares often creates stronger alignment between buyer and seller, as both parties remain invested in the business’s success.

Whether through earn-outs, retaining a shareholding position, or negotiating alternative structures, aligning buyer and seller interests is key to achieving a successful outcome. Need help? Get in touch and let’s have a chat!