Buying a business
How an earn-out works when you buy a business from a retiring owner
An earn-out lets you pay part of the price for a business later, if agreed targets are met. Here is how it works with a retiring seller, and how a lender sees it.
An earn-out means part of the price for a business is paid later, and only if the business hits agreed targets. When you buy a business from a retiring owner, an earn-out can cut the cash you need on day one. It also gives the seller a reason to help with the handover. But a lender will look closely at how it is written. This guide explains how an earn-out works, how it sits beside a loan, and what to agree before you sign.
Section 01
What is an earn-out?
An earn-out splits the price into two parts. You pay the first part when the sale completes. You pay the second part later, if the business performs as agreed.
Here is a simple example. The price is £600,000. You pay £300,000 on day one. The other £300,000 is paid over two years, but only if profit stays above an agreed level.
Is that the same as a vendor loan?
No. With a vendor loan, the seller lends you a fixed sum. You owe it whatever happens. With an earn-out, the amount depends on results. If the business falls short, you pay less. If it does well, you pay the full amount. Our guide to buying a business with little money down covers vendor loans in more detail.
Earn-outs suit a sale where the two sides disagree on value. The seller believes the profits will hold. You are not sure yet. The earn-out lets the results decide.
Section 02
Why an earn-out suits a retiring seller, and where it goes wrong
A retiring owner often holds the customer relationships. Staff and suppliers trust them. If they leave on day one, some of that value can leave with them.
An earn-out gives the seller a reason to stay involved for a while. They can introduce you to customers. They can help you keep key staff. They want the targets to be met, because part of their price depends on it.
So where does it go wrong?
It goes wrong when the terms are vague. Pin down these four points in the sale agreement.
The target
Agree exactly what is measured. Sales are harder to argue about than profit. Profit moves with choices you make after the sale, such as hiring staff or buying equipment.
The period
Two years is common in a small deal. A retiring owner rarely wants to be tied in for much longer than that.
The cap
Set a maximum amount. You need to know the most you could owe. So does your lender.
Who decides what
You will run the business. The seller may worry that you will hold profit down to pay less. Agree the rules on spending and accounting before you sign.
There is also a tax point, and it mostly affects the seller. HMRC's guidance sets out when an earn-out counts as part of the sale price and when it looks like pay. An earn-out that depends on the seller staying employed can look like pay. So can one with personal performance targets. Pay is taxed differently from sale proceeds. The seller's accountant will want to check the terms, and that can shape what the seller agrees to.
Section 03
How does a lender look at an earn-out?
Most buyers fund the day-one payment with their own money and a loan. The loan is repaid from the profits of the business. So is the earn-out. Two sets of payments come out of the same cash, and a lender will want to see that both fit.
A lender will usually ask three questions.
Can the business afford both?
The lender will test the cash flow with the loan payments and the full earn-out included. Plan on paying the full amount. If the deal only works when the business misses its targets, it does not work.
Who gets paid first?
The lender will expect its loan to rank ahead of the seller. In practice, the earn-out is often only payable while the loan payments are up to date. The lawyers write this into an agreement between the lender and the seller. Raise it with the seller early. It is a common sticking point late in a deal.
What happens in a bad year?
A well-written earn-out falls when profit falls. That protects the loan. An earn-out with fixed payments whatever the results is really a vendor loan, and the lender will treat it as one.
Does an earn-out help or hurt your application?
It can help. It shows the seller believes in the numbers. It can also reduce the amount you need to borrow. But an uncapped or loosely worded earn-out does the opposite, because the lender cannot see what the business will owe.
Section 04
What to have ready before you agree the deal
Agree the outline with the seller, then test it with lenders before anything is signed. An acquisition finance broker can put the structure to a range of lenders and tell you what they will accept. Have these ready.
- Three years of accounts for the business. The lender sizes the loan against the profit the business reliably makes.
- The earn-out terms in writing. Set out the target, the period, the cap and the payment dates.
- A cash flow forecast. Show the loan payments and the full earn-out together, month by month.
- Your own contribution. Lenders still expect you to put money in. An earn-out does not replace it.
- A handover plan. Say how long the seller stays, and what they will do in that time.
Are you part of the management team buying from your own boss? The options are slightly different. Read our guide to management buyout finance without a deposit.
This guide is general information, not financial advice. Applications are subject to status, affordability and lender criteria.
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