An earn-out transfers risk from the buyer to you. That is its function, and there is nothing improper about it: the buyer is paying for income that has not happened yet and would rather not pay in full for income that never does. The difficulty is that the risk transferred is not really performance risk. It is control risk. You carry the consequence of a target being missed, while the person who decides how the business is run is now somebody else.
This article is about the case the offer document does not dwell on: the targets are missed, and the money does not arrive.
Why targets get missed
Very rarely because the clients suddenly stopped valuing advice. Usually one of four things.
Attrition ran higher than assumed. Some proportion of clients do not follow the sale. Where the earn-out is measured on retained income, that attrition lands directly on your payment. This is covered in clients who will not move, and it is the single most common cause.
The integration got in the way. New systems, a new service proposition, a new fee schedule, a change of adviser. Each one is a moment at which a client reconsiders. The FCA's own review of consolidation notes that poorly managed integration risks poor consumer outcomes; from your side, poorly managed integration also risks your deferred consideration, and you are not the one managing it.
An adviser left and took relationships with them. Retention of the people is as material as retention of the clients, which is why keeping your advisers through a sale matters commercially and not just personally.
The measure moved. Not dishonestly, necessarily. Costs get allocated differently across a group, income gets recategorised, the definition of "recurring" turns out to be the buyer's definition rather than yours.
That last one is the reason to read the definitions clause harder than the number.
What the agreement usually says, and where it bites
Three features do most of the damage.
A cliff rather than a slope. If the earn-out pays in full at 100% of target and nothing at 95%, a rounding difference decides a large sum. A proportionate structure, where you receive the proportion achieved above some floor, converts a catastrophic outcome into a disappointing one. This is the single most valuable change most sellers can negotiate, and it is usually available because it also removes the buyer's exposure to a dispute.
Measures you cannot see. If the metric depends on management accounts you have no right to inspect, you have agreed to be paid an amount that somebody else calculates and you cannot check. An information right, with a stated frequency and a stated format, costs the buyer nothing if they intend to deal fairly.
Silence on interference. Without a protective clause, a buyer can make decisions that reduce your earn-out without breaching anything: repricing, restructuring, reassigning clients, moving advisers. Buyers do not generally do this deliberately, but they do make commercial decisions in which your earn-out is not a factor. A clause requiring the business to be run in the ordinary course during the earn-out period, and requiring your consent to specified changes, puts your interest on the table.
What to do before you sign
The most useful exercise takes an hour. Model the deal at zero earn-out. Assume the deferred element pays nothing at all, subtract the tax, and look at the remaining figure. Then ask a simple question: if this were the whole price, would I sell?
If yes, the earn-out is upside and the structure is survivable. If no, you are being asked to accept a price you would refuse, on the strength of a forecast you will not control. That is worth knowing before heads of terms rather than eighteen months later.
Then negotiate in this order, because this is the order of value:
- Move consideration from deferred to completion, even at a discount. Certain money now is worth more than uncertain money later, and a buyer who will not shift anything is telling you how confident they are.
- Replace the cliff with a slope.
- Get information rights.
- Get an ordinary-course covenant.
- Only then argue about the size of the target.
Most sellers do this list backwards, and spend their negotiating capital on the number.
If it has already gone wrong
Start with the arithmetic rather than the grievance. Obtain the calculation, check it against the definitions in the agreement rather than against your understanding of them, and identify precisely which input is lower than expected. A dispute about whether a particular block of income counts as recurring is a contractual question with an answer. A dispute about whether the buyer ran the business well is much harder to win.
Note also that the tax treatment of an earn-out does not simply follow the money: the position when deferred consideration is unascertainable is more involved than most sellers expect, and a payment that never arrives does not always undo a liability that already crystallised. How earn-outs are taxed covers the shape of it, and your accountant covers your facts.
The honest summary
An earn-out is a bet on a business you no longer control, placed by the person with the least ability to influence the outcome. Sometimes it is still the right deal, particularly where the alternative is a materially lower certain price. But it should be entered with the zero case modelled, the definitions read, and the protective clauses in place, rather than on the assumption that everyone will behave reasonably. They usually will. The structure needs to work in the case where they do not.
Putting numbers on the zero case
The exercise described above is worth doing properly rather than in your head, because the arithmetic is more uncomfortable than the intuition.
Take your recurring income and run it through this site's free IFA valuation calculator to establish the range the firm plausibly sits in. Take the middle of that range as the working figure rather than the top, since the top is the number a buyer offers before diligence and the middle is closer to what survives it.
Now split that figure the way the offer splits it. If the structure is, say, a majority at completion with the balance deferred against performance, write down three lines: the completion payment, the completion payment net of the tax due on the whole gain, and the completion payment net of tax with the deferred element assumed to pay nothing.
That third line is the number that matters, and for many sellers it is the first time the deal has been expressed in a way that is honest about risk. It is not a prediction. Deferred consideration frequently pays in full. It is the floor, and a floor you cannot live with means the structure is wrong regardless of how likely the good case is, because you are the party with no control over which case occurs.
The asymmetry worth naming
There is an imbalance in an earn-out that is rarely said out loud.
The buyer's downside is that they pay less for a business that performed worse, which is precisely the outcome the structure was designed to produce. Their risk is hedged by the mechanism itself.
Your downside is that you receive less for a business that performed worse under someone else's management, during a period in which your ability to influence it ranged from limited to none. Your risk is not hedged by anything except the drafting.
That asymmetry is not a reason to refuse every earn-out. It is the reason the protective clauses are not niceties: the ordinary-course covenant, the information rights, the slope instead of the cliff, and the treatment of clients in transit are the only things standing between you and an outcome decided entirely by someone else's decisions. A buyer negotiating in good faith will concede most of them, because a buyer who intends to run the business normally loses nothing by promising to.
If a buyer resists all four, that is the most useful piece of information you will get in the whole negotiation, and it arrives early enough to act on.
Read next: the questions to ask about an earn-out, deferred consideration, and the rest of the after the sale pillar.