Business Sales and Acquisitions often hinge on one tricky question: what is a business truly worth? For many SME owners, selling a company you’ve poured your heart and soul into means balancing your belief in its future potential against a buyer’s focus on current numbers and inherent risk.

This valuation gap can stall or even derail a promising deal. Incorporating earnout clauses in SME transactions is one way to bridge that divide. An earnout is a contractual agreement where the seller receives additional payments in the future, but only if the business achieves agreed performance targets after completion.

What is an Earnout in Business Sales and Acquisitions

At its core, an earnout is a financial bridge built on future success. Instead of the buyer paying the entire purchase price upfront, a portion of it is held back and paid out over time, contingent on the business hitting pre-agreed financial or operational milestones. These payments are earned based on post-acquisition performance. The metrics used are typically tied to tangible results like revenue, gross profit, or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation).

This structure fundamentally differs from a straightforward cash sale. In a traditional deal, the seller receives their money and walks away, transferring all future risk and reward to the buyer. An earnout, on the other hand, fosters a shared interest in the business’s continued prosperity. If the business succeeds as the seller expects, the seller receives a higher total price. If it doesn’t, the buyer is protected from overpaying. This alignment of interests manages the buyer’s risk, while also giving the seller a stake in achieving the company’s potential value.

How Earnouts Work in SME Transactions

In the context of an SME transaction, an earnout agreement is a meticulously crafted component of the sale and purchase agreement. The structure usually defines a specific period, often one to three years, during which performance is measured. The targets must be clear, objective, and quantifiable. For instance, an agreement might stipulate that the seller will receive an additional $200,000 if the business achieves an annual revenue of $2 million within the first 24 months post-sale.

The choice of metrics is critical. While revenue is a key metric, a savvy buyer might push for profit-based targets like EBITDA to ensure growth is sustainable and not driven by high-cost sales. The calculation can be a simple lump sum for hitting a single target or a tiered structure with increasing payouts for exceeding different performance levels.

These crucial details are hammered out during the negotiation phase of an M&A transaction, a stage where both parties outline the terms that will govern their relationship. Success is not just in the negotiation, but in how these terms are managed during the post-closure integration, as the new owner’s operational decisions will directly impact the seller’s ability to achieve their earnout.

Why Buyers and Sellers Use Earnouts

Distinct motivations from both sides of the table drive the decision to incorporate an earnout. For a buyer, the primary benefit is risk mitigation. They may be hesitant to pay a premium based on a seller’s optimistic projections. An earnout allows them to validate those projections with actual results before paying the full price. This approach is consistent with the principle that successful companies often use acquisitions for growth with less cost and risk. By tying a portion of the payment to performance, the buyer ensures they are paying for proven value, not just potential.

For a seller, the motivation is often the opposite: maximising value. If you are confident in your business’s future growth, perhaps a new product is about to launch or a large contract is in the pipeline, an earnout allows you to be compensated for that future success. It can unlock a deal that might otherwise fail due to a valuation disagreement. This mechanism gives sellers a tangible way to prove their business’s worth and achieve a higher overall sale price than would be possible with a simple upfront payment. A common misconception is that earnouts are inherently unfair, but a well-structured agreement can create a win-win opportunity, aligning both parties toward a common goal of sustainable growth.

Risks for Sellers and How to Protect Against Them

While earnouts offer significant upside, they are not without considerable risks. Once you hand over the keys, you lose control. A new owner might run the business differently, making decisions that inadvertently (or intentionally) suppress the metrics your payout depends on. For example, a buyer could reduce marketing spend or shift resources to other divisions, causing revenue to dip just below the earnout threshold. Payment delays or disputes over calculations are common headaches here.

Protecting yourself requires a meticulously drafted agreement. Here are some essential strategies:

• Ensure performance metrics are defined with absolute precision. Specify how revenue, profit, or other KPIs will be calculated according to established accounting standards, leaving no room for ambiguity.
• Include Protective Covenants: Negotiate for clauses in the sale agreement that require the buyer to operate the business in a manner consistent with past practices for the duration of the earnout period. This could include maintaining certain budget levels for key departments like sales and marketing.
• Establish a Dispute Resolution Mechanism: Agree on a clear process for resolving disagreements. This often involves appointing a neutral third-party expert, such as an independent accountant, to make a binding decision, avoiding costly and lengthy litigation.

Lessons learned from past disputes often highlight the danger of vague language. Courts tend to favour the explicit terms of the contract, so what is written down is paramount. Taking the time to model different scenarios and stress-test the earnout language before signing can save immense frustration later on.

Legal and Tax Considerations

The legal framework of an earnout is the foundation upon which its success is built. A robust Sale and Purchase Agreement (SPA) is non-negotiable. This document must clearly articulate every detail of the earnout, from the metrics and measurement periods to payment schedules and operational covenants. Early in the process, a Non-Disclosure Agreement (NDA) is essential to protect sensitive information as you begin discussions. Your due diligence shouldn’t focus on the business itself, but on assessing the buyer’s capability and commitment to running the company in a way that makes the earnout achievable.

The tax implications are equally critical and can be complex. Earnout payments may be treated differently from the initial lump sum. Depending on the structure and jurisdiction, they could be classified as capital gains or, in some cases, as ordinary income, which is typically taxed at a higher rate. It is vital to seek specialist tax advice to structure the deal optimally. For instance, the distinction between an asset purchase versus a share purchase has significant tax consequences for both parties. Engaging experienced legal and financial advisors from the outset is a necessity to ensure compliance and protect your financial interests.

When to Use an Earnout vs. Avoid One

An earnout is a strategic tool, not a universal solution. Knowing when to deploy it is as important as knowing how to structure it. An earnout is highly beneficial in situations where a clear valuation gap exists between a confident seller and a cautious buyer. It is also ideal for businesses with uncertain but high-growth potential, such as a tech company launching a new software platform or a business expanding into a new market. The structure works particularly well when the seller remains involved in the business post-acquisition, as their incentives are directly aligned with the buyer’s to drive performance.

However, there are circumstances where an earnout is a poor fit and could lead to conflict. Suppose the buyer plans a deep integration of the business into their existing operations. In that case, it can become nearly impossible to isolate the specific performance metrics needed to calculate the earnout fairly. Similarly, in industries where performance is volatile or difficult to attribute to specific actions, setting clear, objective targets can be problematic.

Role of an M&A Consultant in Negotiating Earnouts

Navigating the complexities of an earnout negotiation is where the expertise of an M&A consultant becomes invaluable. An experienced advisor, like the team at Oasis Partners, brings a wealth of knowledge from facilitating hundreds of transactions. They understand the market standards, common pitfalls, and creative solutions that can turn a contentious negotiation into a successful agreement. Their role is to ensure the earnout terms are fair but also realistic and achievable.

A consultant acts as a crucial intermediary, bridging the gap between buyer and seller expectations with objective, data-driven advice. They help define metrics that are robust and difficult to manipulate, incorporating specific conditions that protect the seller’s interests while remaining commercially reasonable for the buyer.

For example, an advisor might suggest an “acceleration clause” that triggers an immediate full earnout payment if the buyer sells the business again before the earnout period ends. With over 35 years of founder-led insight, Oasis Partners provides the strategic guidance needed to structure these complex arrangements, ensuring your journey from growth to exit is a successful one.

If you are considering selling your business and want to explore how an earnout could help you achieve its maximum value, contact Oasis Partners today for a confidential discussion.