Earn-outs: what it means when the buyer holds back part of your price

An earn-out means part of your price arrives later, and only if the business performs.

Most explanations of this treat it as a way to bridge a gap between what you want and what the buyer will pay. That is what it does. It is not what it means.

A buyer who offers you an earn-out is telling you, in a document their lawyer drafted, that they are not confident the business performs once you leave. So they are asking you to carry that risk instead of them. The proportion of your price they hold back, and for how long, is a measurement of how much of the business they think is you, priced by someone with their own money at stake.

It is the most honest number you will ever be shown about your own company.

What is the meaning of earnout?

The ATO describes the arrangement this way:

So there is money at settlement, and then there is a right to more money if things go well. The right itself is the thing the tax rules care about.

Who pays an earnout?

The buyer, in the ordinary version. But there is a second version most owners have never heard of, and the ATO sets both out:

Read the second one again. In a reverse earn-out you can be required to give money back if the business misses its targets after you have gone.

The ATO also notes that some arrangements combine both, so the same contract can hold money back from you and require you to repay some of what you did receive.

Which version you are being offered is the first thing to establish, before any discussion about the size of the number.

What is an example of an earnout?

The ATO uses this one, and the shape is typical of a smaller business sale:

In the ATO's example the revenue lands at $700,000, then $800,000, then $700,000, so the buyer makes further payments of $100,000, $150,000 and $100,000.

Notice what that structure does to the seller's position. Whether they receive the second and third payments depends on how the business trades in years they no longer control, run by people they no longer manage.

How an earn-out is taxed

This is your accountant's territory and the rules turn on whether your arrangement qualifies as what the law calls a look-through earnout right. The ATO sets out eight conditions that must all be met, and one of them puts a hard limit on the timeframe:

Where the look-through treatment applies, the ATO states that a valuation of the earnout right itself is not required, and that the CGT consequences for the seller are not reported and assessed until the financial benefits are received or provided. Where it does not apply, a different and older set of rules operates instead.

Two things in the ATO's guidance deserve your attention before you sign anything, because they are the parts that catch people:

• Future payments under an earn-out may affect your eligibility for some of the small business CGT concessions, and may also affect the time you have to satisfy the eligibility requirements.
• If you have made superannuation contributions to access a concession, the ATO states you cannot withdraw those contributions if the concession is no longer available to you.

Put plainly, the earn-out can reach backwards and disturb the tax position you thought was settled at sale, and one of the moves you might make to secure a concession cannot be undone. Take the actual terms to your accountant before signing, not after. our guide to tax when you sell a business covers how the timing of payments interacts with the concessions.

What the earn-out is telling you

Set the tax aside for a moment and look at the commercial signal.

A buyer prices what transfers. Plant, premises, contracts and a trained team all transfer. Your judgement about which jobs to quote, the relationship with the customer who calls you directly, the ability to tell in ten seconds that a quote is wrong: none of that transfers, and the buyer knows it.

When they cannot see how the business runs without you, they have two options. Pay less, or pay the same but only if it works. The earn-out is the second option, and from their side it is a reasonable request rather than a hard-nosed one.

Which is why the size and length of the earn-out is worth reading as information. A small holdback over twelve months is a buyer managing normal uncertainty. Half the price over five years is a buyer telling you they think they are buying your presence rather than your business.

What to do if you are offered one

Three things, before the negotiation about the number starts.

• Establish which version it is: standard, reverse, or both. A repayment obligation is a different risk from a delayed payment.
• Take the terms to your accountant to check against the look-through conditions, especially the five year limit and the effect on any concession you were counting on.
• Ask the buyer what specifically would have to be true for the holdback not to be needed. Their answer is your work list, and it will be about who makes decisions when you are not there.

The last one is the useful part. An earn-out is a problem you can only solve before it is offered. Once the buyer is at the table, the structure of the business is already what it is, and the only variable left is how much of your own money you are willing to leave on the outcome.

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