The earn-out is one of the most commonly used and least understood mechanisms in corporate transactions. We analyse when it is a useful tool and when it becomes a source of conflict.
The earn-out is a portion of the purchase price that is conditional upon the company meeting certain targets after closing. It is a frequent tool in the middle-market — an estimated 20% to 30% of transactions include some earn-out component — but its design and execution are fraught with pitfalls that can turn what should be an interest-alignment mechanism into a source of disputes.
The earn-out exists to solve a specific problem: the difference between what the seller believes the company is worth and what the buyer is willing to pay. When this difference cannot be bridged through price negotiation, the earn-out proposes a solution: “If you are right and the company achieves these results, you will receive more. If I am right and it doesn’t, I will pay a price in line with reality.”
In theory, it is an elegant mechanism. In practice, it works well only under certain circumstances:
When the valuation gap stems from genuine uncertainty. If the buyer and seller have different views on the company’s growth potential, and that difference is based on objective factors whose outcome will be known within a reasonable timeframe, the earn-out is the appropriate tool.
When the seller remains in management. The earn-out works best when the seller stays connected to the company and has the ability to influence the achievement of the targets. If the seller leaves on closing day, they are trusting the buyer to manage the company in a way that allows them to collect the earn-out, which is naive.
When the targets are clear and measurable. Revenue, EBITDA, gross margin: objective and auditable financial metrics form the basis of a viable earn-out. Qualitative or subjective targets are a recipe for conflict.
When the timeframe is reasonable. An earn-out of one to two years is manageable. A five-year earn-out is a source of sustained tension that erodes the relationship.
This is the seller’s most common fear, and it is not unfounded. The buyer who controls management can make decisions that, while rational for the company in the long term, damage short-term results and, therefore, the seller’s earn-out.
Examples: increasing marketing spend (reduces short-term EBITDA), hiring additional staff (increases costs), renegotiating prices downward with an important client (reduces revenue now to secure it long-term), transferring costs from another group company to the target.
Which EBITDA? Accounting, adjusted, normalised? Under what normalisation criteria? Who defines them? An earn-out based on an ambiguous definition of EBITDA is a lawsuit waiting to happen.
If the buyer integrates the target with another company in its portfolio, merges business lines, or transfers clients, measuring the earn-out becomes impossible or arbitrary.
The earn-out creates a structural conflict of interest between buyer and seller during the earn-out period. The seller wants to maximise earn-out metrics; the buyer wants to maximise the long-term value of the company. These objectives do not always coincide, and the resulting tension poisons the relationship.
Every earn-out metric must be defined with precision in the contract, including applicable accounting standards, permitted and excluded adjustments, and the identity of who prepares the calculations and who audits them.
The seller should negotiate clauses that protect them from buyer actions that could artificially affect the earn-out: obligation to manage the business consistently with historical practice, prohibition of transferring clients, assets, or costs between the target and other group companies without consent, obligation to maintain a minimum level of operational investment, and the seller’s right to audit earn-out calculations.
The contract must provide a clear procedure for resolving disagreements over the earn-out calculation, typically the appointment of an independent auditor whose determination is binding on both parties.
The shorter the earn-out period, the lower the risk of conflict. If the earn-out can be structured over twelve months instead of twenty-four, all the better.
An earn-out representing a small percentage of the total price — say 10% or 15% — is more tolerable than one representing 30% or more. The seller should negotiate for the majority of the price to be fixed, with the earn-out as a supplement rather than an essential component.
Before accepting an earn-out, the seller should consider alternatives that serve similar functions with less risk:
Fixed price with escrow. Instead of conditioning part of the price on future results, retain an amount in escrow for a set period. It is simpler, cleaner, and generates fewer conflicts.
Vendor loan. The seller lends the buyer part of the price, which the buyer repays in agreed instalments. The seller earns interest and has a real guarantee over the shares.
Retained participation. The seller maintains a minority stake in the company and participates in future value increases. This aligns interests more naturally than an earn-out, though it introduces governance complexities.
At Blue Mountain, we use earn-outs sparingly and only when there is a genuine reason for doing so. Not as a tool to pay less for a company, but as a mechanism to bridge legitimate valuation differences.
When we include an earn-out in a deal, we strive for fairness: reasonable targets, clear definitions, protection clauses for the seller, and a short timeframe. Because a poorly designed earn-out benefits no one: neither the seller, who lives in uncertainty; nor the buyer, who inherits a latent conflict.
The goal of a business acquisition is to build a productive relationship between buyer and seller. The earn-out, used well, can contribute to that goal. Used poorly, it destroys it.
By Blue Mountain Capital
By Blue Mountain Capital
By Blue Mountain Capital
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