Understanding Earnouts in Business Acquisitions

What Is an Earnout?

An earnout is a deal structure where a portion of the purchase price is contingent on the business achieving certain performance targets after the sale closes. The buyer pays a base price at closing and additional payments (earnouts) over 1-3 years if the business hits agreed-upon milestones.

Example: A business is priced at $1 million. The deal is structured as:

• $750,000 paid at closing (base price)
• $125,000 paid if Year 1 revenue exceeds $800,000
• $125,000 paid if Year 2 revenue exceeds $850,000

Earnouts bridge the gap between what the seller thinks the business is worth and what the buyer is willing to pay upfront. They're particularly common when the seller's asking price is based on optimistic growth projections that the buyer isn't ready to pay for without proof.

When Earnouts Make Sense

Earnouts work well when:

• Valuation gap: Buyer and seller can't agree on price. The earnout lets the seller prove the value
• Growth story: The seller claims the business is poised for significant growth. The earnout lets them participate in that upside
• Key customer retention risk: The earnout can be tied to retaining major customers through the transition
• Owner transition: The seller is staying on as a consultant or employee. The earnout aligns their incentives with the buyer's success
• Industry uncertainty: External factors (regulations, market conditions) create uncertainty about future performance

Earnouts do NOT work well when:

• The seller wants a clean break
• Measurement metrics are subjective or easy to manipulate
• The buyer plans to significantly change the business operations
• There's a lack of trust between buyer and seller

Structuring a Fair Earnout

Well-structured earnouts include:

Clear metrics: Use objective, easily measurable targets like gross revenue, number of customers, or EBITDA. Avoid subjective metrics that create disputes.

Defined measurement period: 1-3 years is standard. Longer periods create uncertainty and potential for manipulation.

Accounting method agreement: Specify exactly how the metrics will be calculated, who prepares the reports, and dispute resolution procedures.

Cap and floor: Set a maximum earnout payment and consider a minimum payment if certain base conditions are met.

Buyer protection: Include provisions that prevent the seller from interfering with business operations or inflating metrics artificially.

Seller protection: Include provisions that prevent the buyer from deliberately suppressing performance to avoid earnout payments (e.g., shifting revenue to a related entity).

Payment timing: Specify when earnout calculations are made and when payments are due (typically within 60-90 days of the measurement period end).

Earnout Disputes

Earnouts are the most frequently disputed element of business acquisitions. Common disputes include:

• Disagreement over how metrics should be calculated
• Buyer making operational changes that negatively impact earnout metrics
• Seller claiming the buyer deliberately suppressed performance
• Changes in accounting methods that affect reported results
• External events (pandemic, economic downturn) that make targets unreachable

To minimize disputes, include a detailed earnout calculation methodology in the purchase agreement and specify an arbitration process for resolving disagreements. Have both buyer's and seller's accountants review and agree on the methodology before closing.

Next Steps

Financing a business acquisition requires planning, good credit, and a solid understanding of your options. Start conversations with lenders early, get pre-qualified before making offers, and consider combining multiple financing methods to structure the best deal.

Browse businesses for sale on BuyThe.Biz, or ask financing questions in our Q&A forum.