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Earn-out Agreement

Also known as: Earn-out Clause, Contingent Consideration

Definition

An earn-out agreement is a business sale payment structure where the buyer pays part of the purchase price later, contingent on the business achieving agreed performance targets after completion.

For business owners with wills, this matters because outstanding earn-out payments become estate assets if you die before receiving them—creating inheritance tax implications and requiring specific provisions in your will.

What Does Earn-out Agreement Mean?

Under English contract law, earn-out agreements structure business sale consideration in two parts. According to HMRC guidance (ERSM110900), an earn-out represents part of the purchase price that is unascertainable at the sale date. The buyer pays an initial sum at completion, with additional payments due if specified performance metrics are met over a defined period—typically one to five years.

Earn-out agreements bridge valuation gaps when parties disagree on value. For example, Sarah sells her marketing agency for £400,000—£280,000 upfront plus a £120,000 earn-out contingent on revenue targets. Performance metrics usually focus on EBITDA or revenue. Typically, 15-50% of total purchase price is structured as contingent consideration.

For estate planning, if you die before receiving all payments, outstanding amounts become part of your estate for inheritance tax. Your executors must value uncertain future payments based on likelihood of targets being met, and HMRC may scrutinise valuations. The right to receive payments is a "chose in action"—an incorporeal asset in your estate. HMRC distinguishes between earn-outs taxed as capital gains (18-24%) versus employment income (up to 45%), significantly impacting your estate's tax liability. Earn-out payments don't automatically pass to business successors—you need specific will provisions directing who receives them.

Common Questions

"How does an earn-out agreement affect inheritance tax if I die before receiving all payments?"

If you die before receiving all earn-out payments, the outstanding amounts become part of your estate for inheritance tax purposes. Your executors must value the future payments based on the likelihood of performance targets being met, and HMRC may scrutinise this valuation to ensure the estate value isn't understated.

"Can I include future earn-out payments in my will?"

Yes, you can specify who should receive any outstanding earn-out payments in your will. This is particularly important for business owners who have sold their business with an earn-out arrangement but haven't received all payments yet. Without clear instructions, these payments become part of your residuary estate and may not go to your intended beneficiaries.

"What happens to earn-out payments if the buyer disputes them after my death?"

If a buyer disputes earn-out payments after your death, your executors have the legal duty to pursue these claims on behalf of your estate. The dispute would be resolved according to the original sale agreement terms. This is why it's crucial to ensure your earn-out agreement has clear dispute resolution mechanisms and that your executors understand the business context.

Common Misconceptions

Myth: Earn-out agreements are simple and rarely cause problems

Reality: Earn-outs are one of the most common sources of disputes in business sales, with the majority of arrangements leading to disagreements that often result in litigation. The complexity arises from ambiguous performance metrics, potential manipulation of results by buyers through expense allocation or revenue diversion, and conflicting interests after the sale completes. Properly drafting an earn-out requires anticipating scenarios about how profits will be calculated and what happens if external factors impact performance.

Myth: Earn-out payments automatically go to whoever inherits the business

Reality: Outstanding earn-out payments are separate from business ownership and don't automatically transfer with business assets. The earn-out is a contractual debt owed to you personally—a chose in action forming part of your estate like any other financial asset. If you die before receiving all payments, those outstanding amounts become part of your general estate unless specifically directed in your will. Without clear instructions, they could end up in your residuary estate distributed to beneficiaries with no connection to the business.

  • Business Succession Planning: Earn-out agreements are commonly used within succession planning, particularly in family business transitions and management buyouts.
  • Management Buyout: MBOs frequently use earn-out structures to reduce upfront financing needs when management teams cannot afford full payment.
  • Business Valuation: Disagreement over business valuation is the primary reason earn-outs exist—they bridge gaps between seller and buyer expectations.
  • Company Shares: Earn-outs are typically structured as contingent consideration in share purchase agreements.

Need Help with Your Will?

If you've sold or are planning to sell your business with an earn-out agreement, it's essential to address outstanding payments in your will. Understanding how contingent consideration affects your estate helps ensure these significant assets pass to your intended beneficiaries.

Create your will with confidence using WUHLD's guided platform. For just £99.99, you'll get your complete, legally binding will plus three expert guides. Preview your will free before paying anything—no credit card required.

Legal Disclaimer:

This article provides general information only and does not constitute legal or financial advice. WUHLD is not a law firm and does not provide legal advice. Laws and guidance change and their application depends on your circumstances. For advice about your situation, consult a qualified solicitor or regulated professional. Unless stated otherwise, information relates to England and Wales.