Module IV· ExitIntermediate
Question
What are 'earn-outs', and how do you treat them in the exit model?
Answer
What
Earn-outs are contractually agreed additional payments to the seller that depend on the target's future performance. Common in middle-market family buyouts — 35–50% of family deals include earn-out components.
Mechanics
Earn-out triggers are typically EBITDA thresholds (e.g. Year 1 above $30m → $5m payout). The total cap is typically 15–25% of the purchase price. For the sponsor it reduces closing cash and shares performance risk with the seller.
Deep diveShow more details
Example structure
| Earn-out component | Trigger | Amount |
|---|---|---|
| Year 1 EBITDA > $30m | – | $5m |
| Year 2 EBITDA > $35m | – | $8m |
| Year 3 EBITDA > $40m | – | $12m |
| Total cap | – | $25m |
Modeling treatment
| Phase | Earn-out |
|---|---|
| Closing day | as contingent consideration on the balance sheet (IFRS 3) |
| Quarterly | probability-weighted value |
| On trigger | cash payout, hits the P&L |
| On non-trigger | reverse the accrual, P&L-positive |
Common pitfalls
- An earn-out on an "EBITDA" trigger without a clear definition: seller and buyer argue over add-backs.
- An earn-out period that is too long: the seller then keeps influence over operations.
Pitch tip
Question: "Would you accept an earn-out in the pitch?"
Answer: "Yes, if clearly defined — a specific EBITDA definition, no 'reasonable adjustments' language. An earn-out reduces closing cash and shares performance risk with the seller. Win-win on family deals"