Earn-outs: when part of the price depends on how the business performs

When a buyer and seller cannot agree on price, an earn-out can close the gap: part of the price is paid later, and only if the business reaches targets set in the contract. Our guide to financing a business purchase introduces earn-outs briefly. This guide is for the first real conversation about one. It is general information, so get advice from a solicitor and an accountant before you agree to anything.

How an earn-out differs from vendor finance

The ATO describes a common structure: an initial lump sum at settlement, plus a right to later payments that depend on how the business performs. If the targets are missed, the seller may receive less, or nothing.

With vendor finance, the seller lends part of a fixed price, and the buyer owes it whatever happens to the business. An earn-out shares the risk of future performance between the two sides. Some deals use both.

business.gov.au notes that the contract sets out the price and the method of payment. With an earn-out the final price is unknown at signing, so the contract must set out exactly how it will be worked out.

When an earn-out can help

• A disagreement about future profit. The seller expects growth and wants to be paid for it. The buyer will only pay for what the records show.
• A business in growth. New contracts or locations may not yet show in the figures.
• A business that depends on the seller's relationships. An earn-out tied to keeping key customers or referrers gives the seller a reason to make the handover work.

If a listing's asking price looks high against its published profit, you can raise an earn-out through the enquiry form.

When it may not fit

An earn-out can be hard to make work in a small business run day to day by its owner. Once the seller leaves, results depend mainly on the buyer's work. One new employee or a price change can move profit either way, and the cost of drafting and checking can outweigh the amount at stake. A lower price, a longer handover or vendor finance may be simpler.

Choosing the measure

• Revenue. Easiest to measure, but it can grow while profit falls, so it says less about value.
• Gross profit. Revenue less the direct cost of sales. It reflects margins but not overheads such as wages and rent.
• Net profit. Closer to what the business is worth, but the measure the buyer's decisions move most, through wages, management fees, interest and depreciation.
• Customer retention. Whether named customers are still trading with the business at the end of the period. Useful where the value sits in a few relationships.

If profit is the measure, define it as carefully as the profit used to set the price (see our guide to add-backs and normalised profit).

The accounting rules

Two accountants can produce different figures from the same records. The contract should name the accounting policies (often the ones used in the accounts the price was based on), say how items such as the buyer's own wage, interest, sale costs and charges from the buyer's other businesses are treated, say when revenue counts, and say who prepares the calculation and by when.

The period, the target and the payment

• The period. How long the measure runs after settlement, and whether there is one measurement or several. The length also matters for tax (see below).
• The target. The figure that triggers a payment, and which past figures it was set from.
• All-or-nothing or sliding. An all-or-nothing target creates a cliff: a result just short pays nothing, which invites disputes. A sliding scale pays part of the amount between a lower and an upper figure.
• A cap. The most the earn-out can pay, whatever the result. A seller may ask for a minimum in return.

Control after settlement

The buyer runs the business after settlement, so the seller's payment depends on decisions the seller no longer makes. Agree in advance how these will be treated:

• Pricing. Discounts or price rises that shift revenue or margins.
• Staff. Hiring, cutting hours or replacing key people.
• Marketing. Cutting or increasing spending.
• Merging with another business. Combining operations or moving customers, which makes results hard to separate.

The buyer wants freedom. The seller wants the business run in the ordinary way, not steered to miss the target. If the seller stays on, set out their role, pay (separate from the earn-out), how long it lasts and what happens to the earn-out if it ends early.

Information and disputes

Give the seller regular reports, the full calculation at the end and access for their accountant to check the records. Set a period to object, and name an independent accountant, or a way to appoint one, to decide disputes, saying whether the decision is binding and who pays.

Security and later events

An earn-out is a promise to pay later, so the seller carries the risk that the buyer cannot pay. Our vendor finance guide explains security interests, the PPSR and personal guarantees. Ask your solicitor how they apply to an amount not known when the contract is signed. Also agree what happens if:

• The business is sold again. Whether the earn-out is paid out early, at what amount, or passes to the new owner.
• The buyer defaults or closes the business. What counts as default and what the seller can then do.

business.gov.au suggests having a lawyer draw up the sale contract so that it covers all aspects of the sale.

Tax

The ATO has specific capital gains tax rules for "look-through earnout rights". They apply only where every condition is met, including that:

• the right was created on or after 24 April 2015, under an arrangement disposing of an asset that was an active asset of the seller just before the sale
• the future payments are not reasonably ascertainable when the right is created
• all payments are to be made within five years after the end of the income year of the sale
• the payments depend on the economic performance of the asset or business, and their value reasonably relates to it
• the parties deal with each other at arm's length.

Where the rules apply, gains or losses on the earn-out right itself are disregarded. Payments the seller receives increase the capital proceeds from the sale, and payments the buyer makes increase the buyer's cost base. The ATO notes this may mean amending an earlier year, that the period for amendments is extended, and that payments may affect eligibility for some small business CGT concessions. Where the conditions are not met, the ATO treats the earn-out rights as separate CGT assets.

Because the terms affect whether the rules apply, both sides should ask an accountant to review them before signing. Our guide to the legal and tax steps in a business sale covers the wider tax picture.

An illustration

Illustration only. These numbers are invented and rounded, and are not a guide to prices or usual terms.

A seller asks $600,000. The buyer offers $500,000 on the past figures. They agree $500,000 at settlement, plus an earn-out of up to $100,000 on gross profit for the first 12 months after settlement: nothing below $350,000, the full $100,000 at $400,000 or more, and a proportional amount in between.

If gross profit is $380,000, the result is $30,000 into the $50,000 band, so the seller receives $60,000 and the total price is $560,000. At $340,000 the seller receives nothing. At $450,000 the cap holds the payment at $100,000.

Terms to agree

• What is paid at settlement, and what is the most the earn-out can add?
• What is measured, under which accounting rules, and over what period?
• What is the target, and is payment all-or-nothing or sliding?
• Which decisions need the seller's agreement, and what role does the seller have?
• What information does the seller receive, and who decides disputes?
• What security supports the earn-out?
• What happens if the buyer sells, merges or closes the business, or defaults?
• Have both sides had tax advice on the look-through rules?