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:

1. 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.
2. 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.

If you would like further information about selling a business, please contact Shakespeare Partners on 9321 2111.