A catch-up turns a missed year into a timing difference. Whether the seller gets it, and how it is drafted, can be worth more than the headline rate of the earn-out.
An earn-out catch-up pays the seller, at each test date, the greater of that year's earn-out and the earn-out computed on cumulative performance, less what has already been paid. On an illustrative three-year earn-out of 3.0 million a year, a slow second year costs the seller 1.091 million without a catch-up. With one, a strong third year recovers it, and the seller receives the full 9.000 million instead of 7.909.
Worked in full in Closing the Deal by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Earn-outs are usually tested year by year because each payment then follows an audited set of accounts. The weakness, for the seller, is that a single bad year is lost for good even if the business ends up exactly on plan: a contract slips from December to January and one year is short while the next is long. A catch-up is the drafting answer. It is worth knowing precisely what it does, because there are three clauses that look alike and pay differently.
| Year | Target EBITDA | Floor (80% of target) | Actual EBITDA | Maximum payment |
|---|---|---|---|---|
| 1 | 10.0 | 8.0 | 10.6 | 3.0 |
| 2 | 11.0 | 8.8 | 10.2 | 3.0 |
| 3 | 12.0 | 9.6 | 13.1 | 3.0 |
| Cumulative | 33.0 | 26.4 | 33.9 | 9.0 |
Each year pays nothing at or below the floor, the full 3.0 million at or above target, and a straight line in between. The business beats its plan over the three years by 0.9 million of EBITDA; it simply did not do so evenly.
Annual payment = maximum × min(1, max(0, (actual − floor) ÷ (target − floor)))
Catch-up payment in year t = max(annual payment, cumulative entitlement to t − amounts paid before t)
where the cumulative entitlement applies the same formula to cumulative actual against cumulative target and floor, times the cumulative maximum. In Excel: =MAX(Annual,CumMax*MIN(1,MAX(0,(CumAct-CumFloor)/(CumTarget-CumFloor)))-PaidBefore).
Year 1. 10.6 is above the 10.0 target: 3.000 paid under every version.
Year 2, annual test. (10.2 − 8.8) ÷ (11.0 − 8.8) = 0.6364 of the maximum, so 1.909. Without a catch-up that is final.
Year 2, catch-up test. Cumulative EBITDA is 20.8 against a cumulative target of 21.0 and a cumulative floor of 16.8. (20.8 − 16.8) ÷ (21.0 − 16.8) = 0.9524, so the cumulative entitlement is 0.9524 × 6.0 = 5.714. Less the 3.000 already paid: 2.714, which is more than the annual 1.909, so it applies. Year 1's surplus is already helping.
Year 3. Cumulative EBITDA of 33.9 beats the cumulative target of 33.0, so the entitlement is the full 9.000. Less 5.714 paid: 3.286. The total is 9.000.
| Clause | Year 1 | Year 2 | Year 3 | Total | Present value |
|---|---|---|---|---|---|
| Annual tests, no catch-up | 3.000 | 1.909 | 3.000 | 7.909 | 6.559 |
| Annual tests with catch-up | 3.000 | 2.714 | 3.286 | 9.000 | 7.439 |
| Carry-forward of surplus only | 3.000 | 2.727 | 3.000 | 8.727 | 7.235 |
| Single cumulative test at the end | 0.000 | 0.000 | 9.000 | 9.000 | 6.762 |
The catch-up adds 1.091 million in cash, 0.88 million in present value. The carry-forward, which moves year 1's 0.6 million of surplus into year 2's test (10.8 instead of 10.2), helps year 2 but can never reach back: year 3's surplus is lost, and the seller ends 0.273 short. A single cumulative test pays the full amount too, but only at the end, which is why it is worth less than annual tests with a catch-up even though the totals match.
The arithmetic that matters. For full recovery the seller needed cumulative EBITDA of 33.0, so 12.2 in year 3: only 0.2 above that year's target. Year 1's beat did most of the work. Under annual tests that surplus is simply wasted.
| Year 3 EBITDA | Cumulative | No catch-up | Catch-up | Carry-forward | Single test |
|---|---|---|---|---|---|
| 11.0 | 31.8 | 6.659 | 7.464 | 7.477 | 7.364 |
| 12.0 | 32.8 | 7.909 | 8.727 | 8.727 | 8.727 |
| 12.5 | 33.3 | 7.909 | 9.000 | 8.727 | 9.000 |
| 13.1 | 33.9 | 7.909 | 9.000 | 8.727 | 9.000 |
Below plan, the clauses converge and the catch-up is no longer the best for the seller: at 11.0 the carry-forward pays marginally more, 7.477 against 7.464. The difference is made in year 2, 2.727 against 2.714: both tests leave year 2 0.2 million short of target once year 1's surplus counts, but the cumulative test prices that shortfall at 6.0 million over a 4.2 million band, 1.43 per million of EBITDA, while the annual test with the surplus carried in prices it at 3.0 over 2.2, 1.36 per million. A year 3 below its own target cannot repair it. Above plan, the gap between no catch-up and catch-up is fixed at the year 2 shortfall. A buyer expecting to deliver the plan can concede a catch-up at little cost on its own forecast; a buyer expecting a slow year 2 and a strong year 3, perhaps because it intends to move contracts or costs, is conceding real money.
A catch-up converts a missed year into a timing difference: here 7.909 becomes 9.000, worth 0.88 million in present value, because the business met its plan over three years. Ask for it on annual tests, define cumulative floor and "paid", and price the alternatives side by side. The earn-out shapes from Closing the Deal are in the free workbook for this case, and the cliff against the straight line shows how much the payment curve itself is worth.
A catch-up re-tests cumulative performance and can pay back an instalment already missed. A carry-forward only moves surplus EBITDA from one year into the next year's test. On the illustrative figures a carry-forward lifts year 2 from 1.909 to 2.727 million but cannot recover the rest, so the seller receives 8.727 million in total against 9.000 with a catch-up.
It pays the same total when the business ends up on plan, but later. On the illustrative case both pay 9.000 million, yet at a 10 per cent discount rate the single test is worth 6.762 million today against 7.439 with annual tests and a catch-up, because nothing is paid until the end of year 3.
Only what the business earns back. In the illustrative case the seller recovers the full 1.091 million missed in year 2 once cumulative EBITDA reaches 33.0 million, which needs 12.2 million in year 3, 0.2 above that year's target, because the 0.6 million beat in year 1 already counts. A buyer who expects to deliver the plan pays nothing extra for the clause on its own forecast.
This article is one calculation from Closing the Deal. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: corporate finance, valuation and markets → · All 1340 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.