When buying or selling a business, one common way to structure the deal is through an earn-out agreement. 

In an earn-out, a portion of the purchase price is contingent on the performance of the business after the sale. 

The performance metric used to calculate the earn-out can vary, with revenue, gross margin, and profit before tax being popular options. 

So which one is the best basis for an earn-out?

Revenue-Based Earn-Outs A revenue-based earn-out ties the earn-out payments to the business’s total revenue. 

This can be a good option if the buyer wants to ensure that the business continues to grow after the sale. 

However, revenue-based earn-outs can be problematic if the business has low margins or high expenses, as the revenue may not translate into profits. 

Additionally, there may be disputes over how revenue is defined, such as whether to include returns or discounts.

Gross Margin-Based Earn-Outs: A gross margin-based earn-out is tied to the business’s gross profit margin, which is the percentage of revenue that remains after deducting the cost of goods sold. 

This can be a good option if the business has high margins or if the buyer wants to incentivize the seller to focus on profitability. 

However, gross margin-based earn-outs can be problematic if the business has high fixed costs or if the buyer wants the seller to invest in growth rather than focus on profitability.

Profit Before Tax-Based Earn-Outs A profit-before-tax-based earn-out ties the earn-out payments to the business’s net profit before tax. 

This can be a good option if the buyer wants to incentivize the seller to focus on profitability and control expenses. 

However, putting profit before tax-based earn-outs can be problematic if the business has high tax liabilities or if the buyer wants the seller to invest in growth rather than focus on profitability.

Choosing the Optimal Basis: The optimal basis for an earn-out depends on the specific circumstances of the business and the goals of the buyer and seller. 

If the buyer wants to ensure that the business continues to grow after the sale, a revenue-based earn-out may be the best option. 

If the buyer wants to incentivize the seller to focus on profitability, a gross margin or profit before tax-based earnout may be more appropriate. 

Additionally, it is important to define the performance metric clearly and avoid ambiguity to reduce the risk of disputes.

Conclusion When structuring an earn-out agreement, it is important to carefully consider the basis for the earn-out payments. 

Revenue-based earn-outs can incentivize growth but may not be suitable for businesses with low margins or high expenses.

Gross margin-based earn-outs can incentivize profitability but may not be suitable for businesses with high fixed costs or where growth is a priority. 

Profit before tax-based earn-outs can incentivize profitability and expense control but may not be suitable for businesses with high tax liabilities or where growth is a priority. 

Ultimately, the optimal basis for an earn-out depends on the specific circumstances of the business and the goals of the buyer and seller.

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