Earn-Outs in Business Acquisition Finance: How Lenders Treat Deferred Payments

Key takeaways

• An earn-out bridges a gap between the vendor's view of future earnings and the price the buyer and lender will fund today.
• Lenders size the senior loan on the fixed price, then test cover as if every earn-out tranche will be paid in full.
• Success creates a cash squeeze: the year the target is hit is the year a large payment falls due, often before the extra profit has arrived as cash.
• The metric must be defined far more tightly than ordinary accounting terms, or the earn-out becomes a dispute.
• Earn-outs carry tax consequences for both parties, including special look-through rules for some arrangements - take tax advice before signing.

How does an earn-out work?

An earn-out splits the price into a fixed amount paid at settlement and a contingent amount paid later if the business performs. For illustration: a vendor believes the business is worth $2,000,000 because of growth they expect over the next two years. The buyer, and the buyer's lender, will only fund a price based on current earnings, about $1,400,000. They agree $1,400,000 at settlement plus up to $600,000 over two years, payable in two $300,000 tranches if EBITDA reaches agreed targets.

The government's guide to valuing a business notes that, for a buyer, the biggest value is usually future profit. An earn-out lets each side keep its own view of that future: the vendor is paid for growth if it happens, and the buyer does not pay for growth that never arrives.

Common features (indicative; every deal differs):

• A measurement period of one to three years after settlement.
• A metric such as revenue, gross profit or EBITDA, measured for each period.
• Either all-or-nothing tranches or a sliding scale between a floor and a cap.
• A cap on the total, so the buyer knows the maximum price.

Why does an earn-out reduce the upfront debt?

Because the lender funds the fixed price, not the possible total. Continuing the example, and assuming the senior lender will fund half the upfront price:

The earn-out structure needs $300,000 less debt and $300,000 less equity on day one. It also shifts risk to the vendor: if the growth does not come, $600,000 is never paid. That is why lenders often prefer an earn-out to the buyer simply paying the higher price - the leverage on day one is lower and the extra price is only paid if earnings support it. Our guide to business acquisition finance covers how the senior loan itself is usually structured.

How do lenders treat an earn-out?

Credit teams treat the earn-out as a contingent liability - a debt that may arise - and usually assume the worst case for cash flow, which is that every tranche is paid. Expect the lender to:

• Test cover including the earn-out in each year a tranche could fall due.
• Require subordination. The vendor's right to the earn-out ranks behind the senior loan, and payments are allowed only if there is no default and covenants are still met after the payment.
• Ask how it will be funded: from surplus cash, from fresh equity, or from a pre-agreed additional facility.
• Read the definition of the metric, because a loose definition is a litigation risk sitting next to its loan.
• Look at acceleration clauses, which can make the whole earn-out payable on a resale, a change of control or a default - exactly when cash is tightest.

Some lenders will only accept an earn-out payable from free cash flow after senior debt service, or will require a cash reserve to be built before a tranche can be paid.

Worked example: what happens to cover when the target is hit?

Continuing the illustration, with an example rate (not an offer): the senior loan is $700,000 at 9.0% over five years, costing $14,531 a month or $174,370 a year. Current EBITDA is $500,000. The first tranche of $300,000 is due if year-one EBITDA reaches $560,000; the second if year-two EBITDA reaches $620,000. Tax and capital spending are assumed at $100,000 a year.

Senior cover is strong throughout - 2.87 times on today's earnings. But in year one, the good outcome leaves the business $14,370 short of the earn-out, and that assumes the extra profit has already been collected as cash; if customers pay on 60-day terms, the gap is wider. Including the earn-out, year-one debt service cover is $560,000 / $474,370, or 1.18 times. Fixes include paying each tranche in instalments, holding back part of the buyer's equity as a reserve, or agreeing an earn-out facility with the lender up front. Model your own figures in the ICR and DSCR calculator, and see our guide to cash flow forecasts lenders accept for presenting the years ahead.

How should the earn-out metric be drafted?

Ordinary accounting words are not precise enough. business.gov.au's key financial terms define net profit as gross profit minus all business expenses - a fine definition for a business owner, and an invitation to argue in an earn-out, because the buyer now decides what the expenses are.

Whatever the metric, the contract should set out the accounting policies to be used, which costs are excluded (the buyer's head office charges, integration and acquisition costs, new expansion spending), who prepares the earn-out accounts and when, the vendor's right to see the books, how one-off items are treated, and what happens if the business is sold or merged during the period.

Why do earn-outs end in disputes?

After settlement the buyer controls the business and the vendor's money depends on it. Vendors suspect costs are being loaded or sales deferred; buyers suspect the vendor oversold the growth. Common sources of trouble:

• A metric that depends on accounting choices the contract does not fix.
• The buyer changing pricing, staff or product range in a way that lowers the measured result.
• No agreed process for preparing and checking the earn-out accounts.
• The vendor staying on as an employee and disagreeing with how the business is run.

Practical protections: conduct-of-business undertakings for the measurement period, an independent accountant as expert to decide disputes over the calculation, fixed timetables, and a cap. Lenders favour expert determination, because a court fight over an earn-out can freeze cash and distract management for months. The written sale contract, which the government's guide to buying an existing business says should state the final cost and payment method, is where all of this belongs.

What are the tax issues with an earn-out?

This is general information, not tax advice. Earn-outs create tax questions for both sides: when the vendor makes a capital gain, how the buyer's cost base is worked out, and what happens if an earn-out is never paid. Australian tax law has special look-through rules for some earn-outs linked to the business's future performance, which broadly let the parties deal with the tax as payments are made rather than valuing the right at settlement. Conditions apply, and not every earn-out qualifies.

The deferred amounts can also interact with the vendor's eligibility for the small business CGT concessions. Because the tax treatment affects what each side actually receives, it often affects the price too. Both parties should have their accountant review the earn-out clause before it is signed.

What should a buyer check before agreeing to an earn-out?

An earn-out can look as if it costs you money only when things go well. In practice it is a promise to pay a large sum at a time you do not choose. Before you sign, work through these questions with your accountant and your lender:

• Can the business pay the maximum tranche from its own cash in the year it falls due, after senior debt service, tax and capital spending? If not, what fills the gap?
• Can the target be reached without spending you have not budgeted, such as new staff or marketing the vendor wants you to fund?
• Is there a catch-up if year one is missed but the two-year total is met, and does the contract say so?
• If the vendor stays on as an employee, what happens to the earn-out if they resign or are dismissed?
• What happens if you merge the business with another one you own, so its results can no longer be measured separately?

How do different lenders treat earn-outs?

Put the full earn-out terms in front of lenders at the start, including the maximum total and how each tranche will be paid. When the structure is clear, post one business acquisition finance request on ADS and 200+ verified lenders and brokers can ask about it.

Frequently asked questions

Will a lender fund the earn-out payments?

Sometimes. Many lenders fund the fixed price at settlement and expect earn-out tranches to come from surplus cash or fresh equity. Some will agree an additional facility up front for the tranches, subject to the targets being met and covenants holding. Raise it before you sign, not when the first tranche falls due.

How long does an earn-out usually run?

As an indicative guide, many run one to three years after settlement. Longer periods increase dispute risk and keep the vendor tied to a business they no longer control. The period also interacts with the tax rules for earn-outs, so the length should be settled with your accountant.

Can the vendor take security for an earn-out?

They can ask, and some do take a second-ranking security interest. Senior lenders usually require any vendor security to sit behind theirs under a priority deed, with payments blocked while the senior loan is in default or covenants are breached.

What happens to an earn-out if I sell the business early?

It depends on the contract. Many earn-outs accelerate on a sale or change of control, making the maximum or a calculated amount payable immediately. Lenders read these clauses closely because they can create a large payment at the same time as the senior loan must be repaid.

Is an earn-out better than vendor finance?

They solve different problems. Vendor finance defers a fixed amount the buyer owes regardless. An earn-out defers an amount the buyer owes only if targets are met. Earn-outs suit disagreements about future growth; vendor finance suits a gap between the price and what a lender will fund.

Related reading

• Business Acquisition Finance
• Cash Flow Forecasts Lenders Accept
• Directors' Guarantees: What You Sign

Sources

• Value your business: future profit as the main source of value — business.gov.au
• Key financial terms: net profit and gross profit — business.gov.au
• Buy an existing business: the written sale contract — business.gov.au
• Small business CGT concessions: eligibility overview — Australian Taxation Office