Earn-Out: a Worked Example

An earn-out is what a sale agreement does with a price the two sides cannot agree. The seller has priced in the growth it expects; the buyer will not pay for growth it has not seen. So part of the price is left open, to be set later by a formula applied to the business's results in one or more years after completion, usually revenue or EBITDA, often with a floor below which nothing is paid and a cap above which nothing more is owed.

The lender to the buyer did not sign the sale agreement but carries its consequences. When the earn-out falls due, the buyer must find the cash, from operating cash, from a drawing on its facilities or from its owners. The amount can be large against a year's cash flow, and the claim arises because the business has done well, which is not when a lender expects to be asked for headroom.

A lender reads four parts of the clause. The measure: an EBITDA earn-out has its own definition, which seldom matches the facility's on accounting policies, charges from the buyer's group or businesses bought in the meantime, so the bank may test one EBITDA while the seller is paid on another. The period decides when the cash goes, in one sum or in instalments. The formula, often a multiple of the amount by which the measure beats a floor, decides how much. And the conduct terms decide what the buyer must keep doing to the business meanwhile, and who settles a disputed figure, commonly an independent accountant.

The accounts record it before anyone knows the answer. Under IFRS 3, adopted in New Zealand as NZ IFRS 3 and in Australia as AASB 3, and applied by UK listed groups in their consolidated accounts, the buyer counts the earn-out's fair value at the acquisition date as part of the price. One payable in cash is a financial liability, revalued at every balance sheet date, and movements caused by what happens after completion, such as a target being hit, go to profit or loss. Reduced-disclosure (Tier 2) reporters in both countries measure it the same way. Payments the seller loses automatically by leaving employment are pay for future services, an expense, not price. UK companies on FRS 102 include an earn-out in the cost of the acquisition when payment is probable and can be measured reliably, and treat later revisions as adjustments to that cost; the edition in force for periods from 2026 also excludes from that cost amounts that pay former owners for future services.

An IT services group, constructed for this page like every figure in it, buys a smaller firm for US$12m at completion plus an earn-out on the firm's EBITDA in its second year: three times the excess over US$2.0m, capped at US$6m. The founder of the acquired firm stays on to run it. At the end of year 2 the group's net debt is US$20m, after the completion payment, and the rest of the group earns EBITDA of US$8m. The earn-out will be paid from the revolving facility.

Leverage moves little across the outcomes, because the payment grows with the earnings that carry it. What moves is cash: in the best case US$6m leaves in a single quarter, against a revolver the bank sized for working capital. The lender's first question is whether the facility has the headroom on the payment date, and the second is whether the payment is permitted under the agreement at all.

The third question is what the target rewards. Each dollar of year-2 EBITDA above the floor is worth three dollars to the founder, who controls the spending:

The group has paid US$1.5m more for earnings that were borrowed from the following year, and its lender sees year-3 EBITDA fall just as the revolver carries the payment. A lender reading the year-2 accounts looks at what was spent, not only at what was earned.

A vendor loan and an earn-out both leave the seller waiting, but they put different questions to the bank. The vendor loan's amount is settled on the day of completion and falls due in good years and bad. The earn-out's amount is settled by the results, so it is smallest when the business is weakest. Against a vendor loan the bank subordinates and blocks payments in a bad year. Against an earn-out, its concern is the timing and size of a payment in a good year, and the quality of the earnings that triggered it.

Facility agreements also differ in how they count an unpaid earn-out. Some include it in financial indebtedness from completion; others only once it is due and unpaid, or not at all. A lender reading the leverage covenant checks which, and reads the earn-out among the debt-like items either way. On the earnings side, a fair-value charge and an earn-out treated as pay are both expenses that a borrower's adjusted EBITDA may add back, which is where an add-back cap earns its place.

DEFINED IN ONE PARAGRAPH → · PRO FORMA EBITDA → · THE NET DEBT DEFINITION →

It decides the conditions on payment. A lender commonly allows an earn-out to be paid only if no default is continuing and, often, only if a leverage test is met with the payment counted. A borrower who expects to pay from the revolver asks for the headroom to be kept for it. The bank may also ask for the seller's claim to be subordinated, so that a dispute over the figure cannot become a rival demand on the business in a bad year.

It decides how the earnings are read. A credit paper on an acquisitive borrower separates EBITDA earned from EBITDA that triggered a payment, and reads the year after a measurement period as closely as the period itself. And a founder still owed an earn-out is both a manager and a creditor, two roles that can pull in different directions.

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