Closing the Gap – Part 1: Earn-outs and Four Other Ways to Bridge a Business Deal Gap

In brief: An earn-out, and four related deal structures, exist to close the gap between what a seller thinks a business is worth and what a buyer will pay.

• Why does the business deal gap happen? It is rarely a disagreement about the business today. You can see the cash and the growth are real. The buyer, working from a data room and a diligence report, can only price the risk that the cash stops. The gap is a disagreement about risk, dressed up as a disagreement about value.
• How do you close it? Two honest moves: walk away, or use a deal structure that shifts some of that risk onto you, so the buyer pays closer to your number. There are five: the earn-out, the vendor loan, the retained stake, the holdback, and the staged sale.
• When should you not? When the buyer is discounting something real, a business that cannot run without you, or a single dominant client. No structure fixes that. The better move can be to fix the problem and return in two years, or not to sell.

Their low-ball has been and gone. And you’ve accepted that fairy-godmothers are rare and given up on your premium ask. The haggling and positioning have done everything they can, and what is left is your genuine view of value against the buyer’s genuine view of price, and the gap is large enough that both of you aren’t prepared to close it on your own.

From here, there are only two honest moves: walk away, or find a way to close the gap together. Sometimes walking is right, and this series will come back to that. But if the deal deserves to live, you need to understand what the gap actually is.

The gap is about risk, not value

The value of any business is a product of three things: the cash it generates, it’s genuine prospects for growth, and the risk that the cash stops. You are valuing the first and second with the benefit of everything you know as the current owner. The buyer is pricing the third with nothing but what they can verify. You have run the business for years and know the growth is real. They have a data room and a diligence report and a sceptical investment committee. The gap is rarely a disagreement about the current position of the business. It is a disagreement about the risk, masquerading as a disagreement about value.

Five bridges across the business deal gap

That distinction matters, because risk disagreements are typically bridgeable. Risk can be moved, shared, deferred and tested, and the history of deal-making has built a whole menu of structures for doing exactly that:

• The earn-out: makes part of the price contingent on future performance
• The vendor loan: fixes the amount but delays the cash
• The retained stake: pays you partly in the buyer’s upside
• The holdback: parks money against specific events
• The staged sale: prices part of the business now and the rest once the results are in

Every one of them can close the gap. And every one of them works by moving risk from the buyer’s side of the table to yours. The buyer pays closer to your number because you have agreed to carry some of the uncertainty they were pricing in.

So, the question isn’t can these structures close the gap, it’s which one gives you the best overall combination of risk and return given the nuances of your business and your personal situation and objectives.

And sometimes, if you’re really honest with yourself, the answer is none of these structures will work for you. If the buyer is discounting something real, a concentrated customer base, or a business that cannot run without you, the better move can be to fix it and come back in two years, or not to sell at all.

Over the next five articles, we will take the bridges one at a time: where each fits, where each breaks, and the one thing to get right before you sign.