Earn-Out Agreements When Buying a Business in Australia: How They Work and When to Use Them
An earn-out agreement is a deal structure where part of the purchase price for a business is deferred and paid only if the business hits agreed performance targets after settlement. The buyer pays less upfront; the seller earns more if the numbers hold up. In theory, it's elegant. In practice, it's one of the most misunderstood and poorly structured components of a small business deal.
I've seen earn-outs used well — where they bridged a genuine valuation gap and got a deal done that otherwise wouldn't have happened. And I've seen them used badly, which usually means six months of post-settlement tension, arguments about accounting treatment, and a seller who feels ripped off even when the targets are missed fair and square.
This is Module 6 of the Playbook. Understanding when earn-outs make sense — and when they don't — is part of structuring a deal you can actually live with.
What Is an Earn-Out Arrangement?
An earn-out arrangement is a clause in a business sale agreement where a portion of the total purchase price is contingent on the business achieving specified performance metrics during a defined period after settlement.
A simple example: you buy a landscaping business for a headline price of $800,000. You pay $600,000 at settlement. The remaining $200,000 is an earn-out — payable over 24 months if the business hits $350,000 in annual revenue. If revenue drops, the earn-out reduces proportionally. If revenue grows, the seller receives the full amount.
The earn-out targets can be set against almost any financial metric — revenue, net profit, EBITDA, customer retention rates, or contract renewals. In small business deals, revenue tends to be simpler and less prone to disputes than profit (more on that shortly).
Why Earn-Outs Exist: The Valuation Gap Problem
The fundamental reason earn-outs get used is that buyers and sellers often disagree about what a business is currently worth — particularly when the seller is making claims about future performance.
A cleaning business owner might say: "This business made $220,000 last year, but I've just signed three new commercial contracts that will push it to $340,000 annually. That's what you should be valuing it on."
The buyer's response, reasonably enough: "I'll believe it when I see it."
An earn-out resolves this standoff. You pay a price based on the current demonstrated earnings — valuing the business on what it has actually delivered. If the seller's projections prove accurate, they get paid for that future performance over time. If they don't, the buyer doesn't overpay for promises.
This is particularly common in service businesses — trades, cleaning, landscaping, pest control — where revenue is lumpy, owner-dependent, or based on a handful of key contracts. A plumbing business that's just landed a large body corporate contract looks very different in six months than it did when you signed the sale agreement.
How Earn-Out Payments Are Calculated
There are three main approaches you'll see in Australian small business deals:
Revenue-based earn-outs — the most common in SME transactions. The earn-out payment is calculated as a percentage of revenue above a floor threshold, or as a fixed amount if total revenue exceeds a specified figure. Revenue is harder to manipulate than profit and less susceptible to accounting disputes.
EBITDA or profit-based earn-outs — more common in larger deals. More accurate as a measure of business performance, but creates incentive problems: a seller who is still running the business during the earn-out period has strong motivation to suppress costs, delay investments, and generally optimise for the earn-out metric rather than the long-term health of the business. Watch for this.
Milestone-based earn-outs — tied to specific events: contract renewals, staff retention, licences maintained, or customer numbers above a threshold. Useful when the business value is genuinely dependent on a specific factor rather than overall financial performance.
A broker I spoke with last year described a plumbing business deal that nearly fell over because the seller insisted on a profit-based earn-out — and then, during the earn-out period, cut his own drawings to zero (technically an expense reduction), inflating the reported profit figure while the new owner watched the operational cash flow tell a very different story. The lesson: be precise about your definitions upfront.
The ATO's Position on Earn-Out Arrangements
This is important and many buyers overlook it when structuring a deal.
The Australian Tax Office has specific rules about how earn-out payments are treated for capital gains tax purposes. Under the look-through earnout rules (which have applied since July 2017), earnout payments received by the seller are treated as part of the capital gain from the original sale, rather than as income. This means:
- The seller's CGT is recalculated as each earn-out payment is received
- The buyer can generally treat each payment as additional cost base for the asset
- Both parties may need to amend earlier tax returns as payments are made
The timing implications for both sides are real, and the structure of the earn-out agreement can significantly affect each party's tax position. Get a tax adviser involved before you finalise the terms — not after.
How Long Should an Earn-Out Period Be?
Most small business earn-outs in Australia run for 12 to 24 months. That's long enough to capture meaningful performance data and short enough to give both parties clarity.
Shorter than 12 months tends to be too arbitrary — a single bad quarter can distort the picture unfairly. Longer than 24 months starts to feel punitive for the seller and creates alignment problems. If the seller is involved in operating the business during the earn-out (common in trades), they're essentially working on commission for two years while you own the asset. That arrangement only works if the relationship is genuinely collaborative.
For businesses with annual contracts (commercial cleaning, pest control, some HVAC maintenance businesses), 12 months is often the right period — it captures at least one full contract renewal cycle. For businesses with shorter revenue cycles, quarterly milestones within a 12-month window give more useful data.
When Earn-Outs Make Sense for a Buyer
Used properly, an earn-out is a legitimate risk mitigation tool. It makes sense when:
- The seller's forecast is materially above trailing performance. If last year's revenue was $400K and the seller is projecting $600K, paying today for that projection is a gamble. An earn-out converts the gamble into a performance obligation.
- Revenue is concentrated in a small number of customers. If two clients represent 60% of income, an earn-out that's contingent on retaining those clients protects you against losing the value you paid for.
- The seller is staying on. If the seller is transitioning out over 12-24 months and the business genuinely depends on their relationships, an earn-out aligns their incentives with yours during that period.
Earn-outs make less sense — or become more complicated — when the seller is leaving the business entirely on settlement day. Without their involvement, the earn-out metrics may swing around based on factors completely outside their control, which creates legitimate grievances on both sides. This is worth thinking about before you propose the structure.
Want the full framework for structuring a business acquisition deal? Grab the free Letter of Intent template — it covers earn-out clause structures along with all the other key LOI terms.
The Clauses That Protect You as a Buyer
If you're going to include an earn-out in a deal, the drafting matters enormously. The vague earn-outs are the ones that end up in disputes.
Define your metrics precisely. Revenue based on what? Gross invoiced revenue, cash received, or recognised revenue? Does it include or exclude GST? What happens with refunds or disputes? The definition needs to be tight.
Specify accounting standards. If the earn-out is profit-based, specify what accounting method applies and who prepares the earn-out accounts. Ideally both parties agree on the accountant upfront. The seller shouldn't be doing their own earn-out calculations.
Cap deductions during the earn-out period. If the seller remains operationally involved, include provisions limiting their ability to cut costs in ways that artificially inflate profit metrics — staff reductions, deferred maintenance, that kind of thing.
Establish dispute resolution. Include a mechanism for resolving earn-out disputes — typically an independent accountant arbitrator — rather than leaving both parties to lawyers if the numbers are contested.
Include anti-interference clauses. If you're the buyer and you're now controlling the business, the seller will be concerned that you'll make decisions that deliberately suppress the earn-out metrics. A mutual non-interference clause protects both sides.
A good letter of intent should flag that an earn-out is proposed and sketch the key parameters, even if the detailed mechanics get worked out later in the sale agreement. Don't leave earn-out structure entirely to the formal contract stage — if the parties are materially misaligned on the concept, you want to know that early.
When Earn-Outs Go Wrong
The earn-out disputes I've seen generally fall into three categories.
First: the metrics were ambiguous. Both parties had a different mental model of what the earn-out was measuring and nobody nailed it down in writing. This is entirely avoidable.
Second: the seller remained involved but the buyer made operational changes that affected performance. New software, staff changes, pricing adjustments — all legitimate business decisions that happen to affect the earn-out. If you haven't addressed this scenario in the documentation, you'll have a problem.
Third: the earn-out was used as a negotiating tactic by the seller rather than as a genuine deal structure. Some sellers propose an earn-out not because they believe in their own projections, but because they want to headline a higher purchase price and assume the earn-out will never fully pay out. This is fine if you understand it for what it is — essentially a way of closing a deal at a price both parties can live with — but don't structure the earn-out expecting to pay the full amount if you've priced the deal assuming you won't.
Earn-Outs in Trades and Blue-Collar Businesses
Blue-collar service businesses — cleaning, plumbing, landscaping, pest control — lend themselves to earn-outs for specific reasons.
Revenue in these businesses is often more predictable than in, say, a retail business, but it's also frequently tied to the owner's personal relationships with customers or suppliers. A commercial cleaning business might have $800K in annual contracts — but those contracts have three-month termination clauses and were won largely because the owner has a 15-year relationship with the facilities managers who signed them.
An earn-out that's contingent on contract retention during the transition period is a legitimate way to price that risk. It says to the seller: if your relationships transfer, you get paid for them. If they don't, the buyer doesn't pay for something that evaporated.
Pair this with a proper due diligence checklist that documents customer concentration and contract terms before you sign anything. The earn-out protects you at the deal structure level; the due diligence tells you whether the earn-out metrics are even worth proposing.
The Simpler Alternative
Before you reach for an earn-out, it's worth asking whether the same risk can be managed through a simpler mechanism.
Vendor finance — where the seller leaves part of the purchase price as a loan — achieves a similar cash flow outcome for both parties with less complexity. The seller gets paid out over time; the buyer preserves cash and aligns the seller's ongoing interest in the business's performance without needing a formal earn-out structure.
A price adjustment mechanism at settlement — where the final price is adjusted based on actual financials at settlement rather than projections — can also resolve a valuation disagreement that might otherwise require an earn-out.
Earn-outs are useful. They're not always the right tool. If you can finance a business acquisition cleanly and the valuation gap is modest, a simpler structure is usually better for both parties.
Frequently Asked Questions
How much of the purchase price is typically an earn-out in a small business deal? In Australian SME transactions, earn-outs usually represent 15-30% of the total purchase price. Higher than that and the seller starts to feel like they're being asked to carry too much of the deal risk.
Does the seller need to stay involved in the business during the earn-out period? Not necessarily, but the earn-out mechanics need to account for whichever arrangement you've agreed on. If the seller leaves at settlement, the earn-out targets need to be achievable without their involvement — otherwise you'll have a dispute when performance dips.
Are earn-out payments tax-deductible for the buyer? This depends on how the payments are structured and the nature of the asset purchased. In many cases earn-out payments form part of the cost base of the asset, rather than being immediately deductible. Get tax advice before you finalise the deal structure.
What happens if we can't agree on whether the earn-out targets were met? Your sale agreement should include a specific dispute resolution mechanism — typically both parties agreeing to appoint an independent chartered accountant whose determination is binding. Without this clause, you end up in litigation over accounting definitions, which is expensive and slow.
Can an earn-out clause be renegotiated after settlement? It can if both parties agree. But the power dynamics after settlement are different from before it, and renegotiating earn-out terms is rarely straightforward. Get it right in the first document.
For more on structuring deals that actually work — including how to combine vendor finance, bank lending, and earn-outs into a workable structure — this is all covered in Module 6 of the Playbook.
And if you want the practical detail on how Australian business acquisitions get funded before you even get to earn-out territory, sign up for The Leveraged Worker newsletter — I write about deals in progress, mistakes made, and what I'd do differently.