Understanding Earn-Outs: Should You Consider One When Selling Your Business?
Selling a home service business, whether it’s an HVAC company, plumbing service, landscaping business, or roofing firm, can be a rewarding yet complex process. One of the biggest decisions owners face during negotiations is how they will be paid. While some business sales are all-cash transactions, many include alternative financing options, such as an earn-out.
An earn-out is an arrangement in which part of the sale price is paid upfront, while the remaining portion is tied to the business’s future performance. This structure can be beneficial in certain situations, but it also comes with risks. Understanding how earn-outs work, when they make sense, and how to structure them properly can help business owners decide whether this option is right for them.
What Is an Earn-Out?
An earn-out is a payment agreement where the seller receives a portion of the business’s sale price over time, based on the company meeting specific financial or performance targets. These targets typically include revenue, profit margins, or customer retention metrics. If the business meets these goals, the seller gets additional payments. If not, the seller may receive a reduced amount or, in some cases, nothing beyond the initial payment.
For example, if a business is sold for $1 million, a buyer might pay $700,000 upfront, with the remaining $300,000 to be paid over three years based on the company maintaining certain revenue levels. If the business hits the agreed-upon targets, the seller gets the full amount. If it falls short, the seller may receive only a portion of the remaining balance.
Earn-outs are more common in sales where the buyer perceives some risk, perhaps the business relies on a few key customers, operates in a fluctuating market, or has had recent financial inconsistencies. They are often used when the buyer and seller have differing views on the business’s value or when the buyer needs additional reassurance that the business will continue performing well after the sale.
When Does an Earn-Out Make Sense?
Earn-outs can be useful in certain situations, especially when there’s a gap between the seller’s asking price and what the buyer is willing to pay upfront. If a seller believes the business is worth more based on its future potential, an earn-out can help bridge the gap by allowing the seller to prove its worth over time.
They can also be beneficial when a business has strong recent growth that isn’t yet reflected in its long-term financial history. For example, if a home service business has secured new contracts, expanded into a new service area, or implemented new revenue streams, but these improvements haven’t fully materialized in financial statements, an earn-out can help justify a higher sale price.
Buyers sometimes prefer earn-outs when they have concerns about customer retention. If a business has key accounts that drive a significant portion of revenue, the buyer may want to ensure those customers remain after the sale before paying the full amount. An earn-out linked to customer retention can provide reassurance that the business’s value will hold steady.
For sellers who are confident in their business’s continued success, an earn-out can provide an opportunity to receive a higher overall sale price. However, it requires trust in the buyer’s ability to run the business effectively, as future payments depend on the company’s performance under new ownership.
Risks and Challenges of Earn-Outs
While earn-outs can help close a deal, they also come with risks. One of the biggest concerns is that sellers have limited control over the business once the sale is complete. If the new owner mismanages operations, fails to invest in marketing, or makes poor strategic decisions, the business could underperform, reducing or eliminating the seller’s remaining payments.
Disputes over financial performance can also arise. If the seller believes the business is performing well but the buyer manipulates expenses or changes accounting methods to lower reported profits, it can lead to conflicts. To minimize these risks, it’s essential to define clear and objective performance metrics in the earn-out agreement. Using revenue-based targets rather than profit-based targets can help, as revenue is harder to manipulate.
Sellers must also consider the financial stability of the buyer. If the buyer struggles to maintain the business or runs into financial trouble, they may be unable to make future payments. Conducting due diligence on the buyer’s financial health and requiring some form of security, such as a personal guarantee or escrowed funds, can help protect the seller.
Another challenge is that earn-outs can extend the seller’s involvement in the business. If the agreement includes a requirement for the seller to stay on as a consultant or provide ongoing support, it can delay a full exit from the company. While some sellers are comfortable with a gradual transition, others prefer a clean break.
How to Structure a Fair Earn-Out Agreement
A well-structured earn-out agreement should be clear, fair, and legally enforceable. Both parties should fully understand the terms and agree on realistic performance targets that reflect the business’s potential.
The first step is defining the performance metrics that will determine earn-out payments. Revenue-based targets are typically the safest for sellers, as they are straightforward and less likely to be influenced by accounting adjustments. If profit-based metrics are used, the agreement should specify how expenses will be calculated to prevent disputes.
The length of the earn-out period should also be considered. While earn-outs commonly last between one and three years, shorter agreements reduce risk for the seller. The longer the earn-out period, the more uncertainty there is about how the business will perform.
To protect the seller, some agreements include minimum guaranteed payments, ensuring that the seller receives a portion of the earn-out regardless of performance. Structuring payments in a way that rewards growth while providing a safety net can help reduce risk.
Legal protections, such as requiring the buyer to maintain a certain level of investment in marketing and operations, can also be included. This prevents the buyer from cutting costs in ways that could artificially reduce business performance and impact earn-out payments.
Sellers should work with an experienced attorney and business broker when structuring an earn-out to ensure that the agreement is fair and enforceable. Clear legal language and financial oversight can help prevent misunderstandings and ensure that both parties uphold their commitments.
Final Thoughts
Earn-outs can be an effective way to close a business sale when there is a gap between the seller’s expectations and the buyer’s willingness to pay upfront. They provide an opportunity for sellers to receive a higher total sale price while giving buyers reassurance that the business will continue to perform well. However, they also come with risks, including limited control over business operations and potential disputes over financial performance.
If you’re considering an earn-out as part of your business sale, it’s essential to structure the agreement carefully, define clear performance targets, and include legal protections to minimize risk. Working with a business broker can help you navigate the process and ensure that the deal is structured in a way that benefits you while protecting your financial interests.
We specialize in helping home service business owners sell their companies successfully and negotiate favorable deal terms. If you’re thinking about selling and want to explore whether an earn-out is right for you, we can provide expert guidance to ensure you get the best possible outcome.
Contact us today for a free consultation, and let’s discuss how to structure your business sale for maximum success.