Is It Really an Earn-Out — or Is It Deferred Consideration?
Why business sellers need to look beyond the label and understand who is really carrying the risk.
Earn-outs are becoming an increasingly common feature in business sale transactions.
From a buyer’s perspective, the argument is usually straightforward:
“We need an earn-out to protect ourselves and make sure the business transitions successfully.”
There can be very good commercial reasons for that.
But there is another side to the equation that business owners need to understand.
If part of your purchase price is being paid months or years after settlement, you are
also providing a form of vendor finance — regardless of whether the agreement calls it
an earn-out, deferred consideration or something else.
And the larger the amount deferred, the greater the financial risk being carried by the seller.
Why Buyers Want Earn-Outs
Most buyers don't ask for an earn-out without a reason.
An earn-out is commonly used where the buyer believes there are risks surrounding the future maintainability of the business.
Two of the most common risks we see are:
Key-person dependency
The business remains heavily dependent on the owner or another key employee. Important
customer relationships, technical knowledge, sales capability or operational knowledge may
reside with one or two people.
The buyer is effectively asking:
“What happens to this business when the owner leaves?”
Customer concentration
A significant percentage of revenue may come from one or several major customers,
particularly where those relationships are not protected by long-term contracts or formal
supply agreements.
If a customer representing 20%, 30% or even 50% of revenue leaves shortly after settlement,
the value of the business can change dramatically.
In circumstances like these, the buyer understandably wants protection.
There are generally two ways they can achieve it:
1. Reduce the purchase price upfront; or
2. Make part of the purchase price conditional upon future performance or
continuity.
Increasingly, we are seeing buyers favour the second option.
But Who Is Protecting the Seller?
This is where negotiations can become interesting.
A buyer may regard the earn-out entirely as a mechanism designed to protect them.
But consider the transaction from the seller's perspective.
Imagine a business is sold for $4 million.
The buyer pays $2.5 million at settlement and the remaining $1.5 million is payable over the
following three years, subject to agreed conditions.
The seller has transferred ownership and control of the business but is still waiting to receive
a substantial portion of the agreed consideration.
Economically, the seller has significant capital tied up in a business they no longer own or
control.
That creates an entirely different category of risk.
An Earn-Out Can Also Become Vendor Finance
The terminology used in the Business Sale Agreement is important, but sellers should also
consider the commercial substance of the arrangement.
There is a significant difference between:
A genuine performance earn-out
Additional consideration becomes payable only if the business achieves future revenue,
EBITDA or other performance targets.
And:
Deferred consideration linked primarily to continuity
A portion of an agreed purchase price is paid later, provided specified customers, employees
or other elements of the business remain in place.
The second structure can begin to look much more like deferred consideration.
And from the seller's perspective, deferred consideration has characteristics of vendor
finance.
The seller is effectively allowing the buyer to pay part of the purchase price over time.
That raises an important question:
If the buyer requires protection against business continuity risk, shouldn't the seller also
seek appropriate protection against the buyer's credit and payment risk?
Why Buyers Can Resist Providing Security
This is often where buyer and seller perspectives diverge.
The buyer may say:
"The earn-out exists for our protection. Why would we provide security for it?"
But these are two separate risks.
The earn-out conditions protect the buyer against identified business risks.
Security for deferred payments protects the seller against payment and credit risk once
those conditions have been satisfied.
One does not necessarily eliminate the need for the other.
Depending on the transaction, sellers and their legal advisers may therefore consider
protections such as guarantees, security interests, escrow arrangements, bank guarantees or
other appropriately negotiated mechanisms.
The appropriate structure will depend on the transaction and should be determined with
qualified legal advice.
The Bigger the Earn-Out, the Bigger the Seller's Exposure
A relatively small earn-out may represent an acceptable commercial compromise.
But as the percentage of the purchase price deferred increases, the transaction begins to
change materially for the seller.
If 30%, 40% or even 50% of the purchase price remains outstanding after settlement, the
seller needs to consider more than whether the earn-out targets are achievable.
They should also ask:
Who controls the business after settlement?
Can the buyer make decisions that affect whether the earn-out is achieved?
What happens if a major customer leaves for reasons outside the seller's control?
What happens if the buyer changes pricing, staffing, marketing or strategy?
What happens if the buyer's financial position deteriorates?
If the earn-out becomes payable, what security exists to ensure it is actually paid?
These issues can be every bit as important as negotiating the headline sale price.
The Best Earn-Out Is Often the One You Don't Need
There is an even more important lesson for business owners considering selling.
Many of the reasons buyers demand earn-outs can be addressed before the business goes to market.
If your business has excessive owner dependency, customer concentration, undocumented
systems or key relationships that exist primarily because of you, these issues will almost certainly be identified during due diligence.
A sophisticated buyer will price that risk.
They may reduce their offer.
They may require an earn-out.
They may require you to remain in the business longer than you intended.
Or they may walk away altogether.
This is why preparing a business for sale should ideally begin years rather than months
before the transaction.
Turn Buyer Risk Into Seller Value
At MBS Advisory, we work with business owners before they sell to identify and address the
factors that can reduce business value or lead to unfavourable deal structures.
That can include reducing owner dependency, diversifying customer concentration,
strengthening contracts and recurring revenue, documenting systems and processes,
developing management capability and improving the overall transferability of the business.
The objective isn't simply to increase the theoretical valuation of the business.
It's to create a business that a buyer sees as lower risk, easier to transition and therefore
more valuable.
And when buyer risk decreases, the seller is generally in a much stronger position to
negotiate more money at settlement and less consideration subject to future conditions.
Thinking About Selling in the Next 1–5 Years?
Don't wait until a buyer identifies these risks during due diligence.
MBS Advisory can assess your business through the same lens a sophisticated buyer will
use and identify the areas that could affect your valuation, deal structure and eventual
sale outcome.
Book a confidential consultation with MBS Advisory and start preparing your business
for a cleaner, stronger and more valuable exit.
This article provides general information only and does not constitute legal, financial or taxation advice. Business owners considering an earn-out or deferred consideration arrangement should obtain appropriate professional advice.
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