An earn-out closes a price gap only because buyer and seller value it differently. The sizing is the search for a clause where that difference exceeds the gap between the two sides' limits, with room to spare.
To size an earn-out that bridges a valuation gap, value the same clause twice, once on the seller's forecast and once on the buyer's, and look for terms where the seller's value clears its minimum while the buyer's expected cost stays under its maximum. On an illustrative 100 against 120 million gap, an earn-out of 10x EBITDA above 10.0 million, capped at 20.0, is worth 14.63 million to the seller and costs the buyer 6.88. That difference in views, not the headline, is what closes the deal.
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 proposed as a split of the difference: the buyer pays what it believes today, and pays the rest if the seller's plan comes true. The proposal is correct in spirit and loose in arithmetic. Both parties say yes or no to a number, so each needs to know what the clause is worth on its own view of the business, and the clause can be shaped to make those two numbers further apart.
| Input | Value |
|---|---|
| Agreed multiple of EBITDA | 10x |
| Last twelve months EBITDA, the buyer's basis | 10.0 |
| Next year's EBITDA in the seller's plan | 12.0 |
| Buyer's price / seller's price | 100.0 / 120.0 |
| Seller's view of next year's EBITDA: mean, standard deviation | 12.0, 1.0 |
| Buyer's view: mean, standard deviation | 10.5, 1.5 |
| Discount rate, payment one year after completion | 10% |
| Seller's minimum / buyer's maximum, in present value | 115.0 / 108.0 |
In cash alone there is no deal: the seller needs 115.0, the buyer will not pay more than 108.0, a gap of 7.0. The distributions are illustrative; in practice they come from each side's downside and upside cases.
Payment = slope × [max(EBITDA − L, 0) − max(EBITDA − H, 0)], a straight line from threshold L to cap H
Expected payment = slope × [C(L) − C(H)], with C(K) = (μ − K)Φ(d) + σφ(d) and d = (μ − K) ÷ σ
In Excel: =(Mu-K)*NORM.S.DIST((Mu-K)/Sd,TRUE)+Sd*NORM.S.DIST((Mu-K)/Sd,FALSE) for each C(K).
Step 1: the natural clause. Pay 10x every euro of EBITDA above the buyer's 10.0, up to the seller's 12.0: a maximum of 20.0, exactly the gap.
Step 2: the seller's value. With a mean of 12.0 and a standard deviation of 1.0, C(10) = 2.0085 and C(12) = 0.3989. The expected payment is 10 × 1.6095 = 16.10, or 14.63 discounted one year at 10 per cent. The seller sees 100.0 + 14.63 = 114.63.
Step 3: the buyer's cost. With a mean of 10.5 and a standard deviation of 1.5, C(10) = 0.8814 and C(12) = 0.1250. Expected payment 7.56, present value 6.88. The buyer sees a cost of 106.88.
Step 4: read the gap of views. The same clause is worth 7.76 more to the seller than it costs the buyer. The seller gives the full payment a 50.0 per cent chance and nothing at all only a 2.3 per cent chance; the buyer sees 15.9 and 36.9 per cent. With 100.0 upfront the clause leaves the seller at 114.63, just under its 115.0 minimum. Yet the gap of views, 7.76, is larger than the 7.0 between the two limits, so a deal exists: what remains is where to set the upfront, and how much room the clause leaves.
Upfront cash adds the same amount to both sides' figures, so it cannot decide whether a deal exists, only where it lands. A deal exists when the gap of views exceeds the 7.0 between the seller's minimum and the buyer's maximum, and the excess is the room the parties have to agree the upfront figure. The seller also holds a 100.0 cash bid, so it will not take less than that upfront.
| Structure | Maximum earn-out | Seller's value | Buyer's cost | Gap of views | Room | Upfront that works |
|---|---|---|---|---|---|---|
| A: 10x from 10.0 to 12.0 | 20.0 | 14.63 | 6.88 | 7.76 | 0.76 | 100.37 to 101.12 |
| B: 12x from 10.0 to 12.0 | 24.0 | 17.56 | 8.25 | 9.31 | 2.31 | 97.44 to 99.75 |
| C: 12x from 10.5 to 12.5 | 24.0 | 14.53 | 5.83 | 8.69 | 1.69 | 100.47 to 102.17 |
| D: 20x from 11.0 to 12.0 | 20.0 | 12.44 | 4.66 | 7.78 | 0.78 | 102.56 to 103.34 |
Structure A works, but only just: 0.76 of room, which a small change in either forecast would erase. Raising the slope to 12x (B) widens the gap of views to 9.31, but the buyer's cost rises with it and the upfront that works falls below the 100.0 cash bid the seller already holds. Moving the band up to 10.5 to 12.5 (C) puts the payment where the two forecasts disagree most: it starts at the buyer's own mean, so on the buyer's view much of the curve is unlikely to be reached, while the seller, centred on 12.0, still expects most of it. The room rises to 1.69 with an upfront above 100.0. At 101.0 upfront the seller sees 115.53 and the buyer 106.83, each inside its limit. A steep, narrow band (D) adds almost no room and needs more cash upfront.
The headline is a third number. Structure C announces 125.0 million: 101.0 upfront plus a 24.0 maximum. Neither party should believe it. The seller's value is 115.53 and the buyer's cost 106.83. The 125.0 is what the press release says.
| Seller's standard deviation | Earn-out value | Total to seller |
|---|---|---|
| 0.5 | 15.91 | 116.91 |
| 1.0 | 14.53 | 115.53 |
| 1.5 | 13.57 | 114.57 |
| 2.0 | 12.98 | 113.98 |
A capped earn-out is worth less the more uncertain the business, because the cap cuts off the good outcomes while the threshold leaves the bad ones in place. A seller who is truly confident in 12.0 can accept structure C; one whose plan has a wide range should not, and should push for a lower threshold or more upfront instead.
An earn-out bridges a gap because seller and buyer price the same promise on different forecasts. Value it on both, then move the threshold and slope into the range where the forecasts disagree: here that turns a 7.0 cash gap into a clause worth 115.53 to the seller and costing 106.83 to the buyer. The earn-out workbook in the free companion files for Closing the Deal runs the payment shapes on the book's own case.
Because each side values it on its own forecast. A seller who expects 12.0 million of EBITDA sees a 50.0 per cent chance of the full payment; a buyer who expects 10.5 sees 15.9 per cent. On the illustrative clause, 10x EBITDA above 10.0 capped at 20.0, that difference makes the same promise worth 14.63 million to the seller and 6.88 to the buyer, a gap of views of 7.76 million.
No. The maximum is what the buyer pays if everything goes right, not what the clause is worth. In the illustrative deal a structure with a 24.0 million maximum makes a headline of 125.0 million, but it is worth 115.53 million to the seller on its own forecast and 106.83 to the buyer on its forecast. Negotiating on the headline overstates the price for both.
A capped earn-out loses value as the seller's own uncertainty rises, because the cap removes the upside while the downside stays. On the illustrative structure the seller's present value falls from 15.91 million with a standard deviation of 0.5 to 12.98 million at 2.0, taking the total with 101.0 upfront below its 115.0 minimum once the standard deviation passes 1.24.
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.
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