Business Exits: A Tear Down of Earn Outs — Part Two

When you are selling a business for one price and the buyer is offering a lower price, an earn out is a way of meeting in the middle. This is the second post looking at earn outs in detail.

Earn outs usually depend on the target hitting agreed KPIs after settlement. They arise in two classic situations:

(a) The “private information setting” where one party has information that the other doesn’t. This is usually manifested by the seller being confident that KPIs can be met if the target is run the way it has been running it. The buyer may not share that confidence, or even have the information on which that confidence is based.

(b) The “non-convergent priors setting” where the parties simply don’t agree on the deal value and are not able to overcome their differences.

In either case, an earn out is a payment or series of payments based on verifiable information obtained after settlement so that the problems of private information or non-convergent priors over valuation are overcome.

Operational Control

Earn outs usually require that sellers or their managers continue on in the business and run it to the best of their ability so that:

(a) The sellers get their earn out, and

(b) The buyer gets to have the business run well after settlement.

The earn out is a good idea on the face of it, because it appears to align the interests of the seller and the buyer.

Here’s the problem. Sellers are only committed to achieving the KPIs that unlock their earn out within the earn out period. If their KPI is based on achieving a certain EBITDA, for example, then sellers are often committed to achieving that EBITDA at the expense of investing in the future profitability of the business past the earn out period. The buyer, however, could be incentivised to forgo short term earnings for long term investment in the business. This non-alignment of interests is the breeding ground of the moral hazard of earn outs.

The other issue is that the sellers may act altruistically in the management of the target for the earn out period, but the buyer frustrates their efforts, doesn’t put in sufficient marketing, or otherwise hampers perfectly achievable KPIs. Some of the issues I have seen arise are when:

(a) The buyer sold the product line that the earn out depended on

(b) The target was integrated into the buyer’s organisation to the extent that the KPIs couldn’t be measured any more

(c) The target was not integrated into the buyer’s organisation as envisaged in the original earn out, depriving the target of anticipated economies of scale and other synergies

(d) The buyer bought more businesses that were similar to the target, rebranded them all and integrated them into one entity so the original KPIs couldn’t be measured.

How Does the Seller Control the Earn Out After Settlement?

So how does the seller control the post-settlement conduct of the business so that the KPIs are achieved? That is, how does the seller get around the old adage, “the money you see at settlement is the only money you are ever going to see”?

One way is to include a covenant that after settlement the buyer has to run the business “in the ordinary course of business defined by reference to past practice prior to settlement.” This definition is negotiated, but it usually ends up as “past practice with a few agreed differences.” I even did an agreement once where the buyer agreed to run the business to maximise the seller’s earn out. That took a bit of negotiating and it was a big ask, but I usually still ask for it anyway just to see the reaction. If the seller refuses to countenance it at all, and I am acting for the seller, then I usually take this as a reason to rethink the whole earn out scenario because it introduces a sense of doubt about the buyer’s bona fides in relation to the earn out.

Another way of dealing with the issue is to have covenants that give the seller some authority or rights about major decisions that come up during the earn out period. When acting for the seller, I often look at a standard shareholders’ agreement and go through the decisions that require a special resolution of the shareholders and/or the board of directors — and put some of these into the covenants. Things to put in might be some or all of the following:

(a) Ceasing all or a substantial part of the business

(b) Merging or combining the target with other businesses

(c) Loans to directors or shareholders

(d) Winding up the company whilst solvent

(e) Mergers or sale of the assets

(f) Acquisitions of new businesses

(g) Returns of capital

(h) Appointment or removal of a CEO, COO, CFO or other senior managers

(i) Sales or dealings with the assets other than in the ordinary course of business, or other transactions other than in the ordinary course of business

(j) The creation of the business plan or budget or increase in the budget or substantial changes to the business plan

(k) Material alterations to the business.

Other covenants the seller may want include:

(a) Requiring adequate funding of the target post settlement — especially in the areas of marketing (and R&D if the target is reliant on this)

(b) Requiring separate books and records be kept for the target for the earn out period

(c) The seller having a seat on the board of the buyer.

It’s all a matter of negotiation, so make sure you have someone good on your side.

How Does the Seller Control the Earn Out After Settlement?

The obvious one here is for the seller to retain as much control as possible, since it has already paid most of the money. The thing to remember for the seller is that it hasn’t paid all the money, so it still owes a duty of sorts to the seller. That duty is mostly contractual (with some overlay of legislation such as the CCA in Australia), so it is not the same as duties to shareholders/oppression of minorities, but has some of that flavour. Of course, if you overcome the valuation issue by selling the shares in the company, but retaining 20% or so of those shares to secure the seller’s earn out, oppression remedies then become available.

In essence, the buyer has to deal in good faith and be fair. The biggest complaint I hear from disgruntled sellers is that the buyer deliberately drove the business into the ground for a one year earn out period, then resurrected it in year two after the earn out has expired. Mind you, I once heard of a seller whose 15% earn out amounted to more than his 85% settlement amount, so it all depends on the facts and the people involved.

Another issue for the buyer is that if the seller’s managers are running the business post settlement, they might run it to maximise their earn out without regard to other aspects of the business. The worst one here for a buyer is an earn out based on revenue where the seller’s managers write business at cost or even at a loss — simply to maximise the revenue that the earn out is based on. You would think that buyers couldn’t be that dumb, but they are.

There is also the tendency for seller’s managers to try to run the business as a separate unit for as long as possible so that their KPIs are easily recognisable, thus resisting the integration of the target into the acquirer’s organisation. This deprives the buyer of synergies and often frustrates the reason for buying the target in the first place.


Negotiations over price can take forever and often the parties too readily seize the opportunity of overcoming the valuation question by agreeing an earn out. There is a lot of value in an earn out, but also a few traps. My advice? Get some good advice…