Why Earnouts Are More Common Than You Think

Brandon Chicotsky
Sep 9
11 min read

Earnouts are a payment structure in business sales where part of the purchase price depends on the company’s future performance. Sellers get an upfront payment and additional payouts if specific goals like revenue or profit targets are met. This method helps buyers minimize risk and sellers maximize their payout.

Here’s why earnouts are increasingly popular, especially for smaller businesses:

Valuation Uncertainty: Smaller businesses often have unpredictable cash flows, making it hard to agree on a fair price. Earnouts bridge this gap.
Aligned Goals: Sellers stay motivated post-sale to help the business succeed, benefiting both parties.
Risk Management: Buyers avoid overpaying upfront, and payments are tied to measurable outcomes.

Earnouts typically last 1-3 years and use metrics like revenue, EBITDA, or customer retention to determine payouts. While they offer benefits, they also come with risks, such as potential disputes or reliance on the buyer’s decisions post-sale. Success depends on clear agreements, measurable targets, and transparent communication between both parties.

Main Reasons Why Earnouts Are Used More Often

Solving Valuation Disagreements

Valuation disagreements can often derail business sales, especially when the future feels uncertain. Sellers might have optimistic growth projections, while buyers may see things differently. Earnouts step in to bridge this divide by linking extra payments to specific performance goals that both parties agree on.

This method becomes particularly useful in industries experiencing rapid change. When a business's value is based more on future potential than on a proven track record, earnouts let both sides test those projections in real-world conditions before the full payment is made. It also helps balance the risks, giving both buyer and seller a fairer footing.

Matching Buyer and Seller Goals

Earnouts don’t just settle valuation disputes - they also align the goals of buyers and sellers. In an all-cash deal, sellers get paid upfront, leaving buyers to shoulder all the risks of future performance. Earnouts change the game by keeping sellers financially invested in the company’s success post-sale. This motivates sellers to ensure a smooth transition, share their expertise, and maintain critical relationships.

For buyers, tying part of the price to actual results reduces the risk of overpaying for overly optimistic expectations. For sellers, it means being rewarded for the business's tangible achievements after the sale. It’s a win-win that keeps both parties engaged.

Reducing Risk and Managing Uncertainty

In unpredictable markets, risk management is key. Earnouts provide a safety net by tying part of the payment to measurable outcomes instead of relying solely on projections made during initial negotiations. This shared approach to risk offers a cushion against unforeseen economic or operational challenges.

Earnouts can also appeal to financiers, signaling that both buyer and seller have confidence in the business’s future. By spreading payments over time and linking them to performance, earnouts give buyers the breathing room to handle integration and operational hurdles without the pressure of an upfront lump sum payment.

How to Structure and Negotiate Earnouts

Structuring an earnout effectively can mean the difference between a seamless deal and one that struggles to deliver results. The goal is to select performance measures that truly reflect the business's progress, set achievable timelines, and agree on terms that protect both parties while keeping everyone aligned. Here's a closer look at the key elements of earnouts.

Common Earnout Performance Measures

Revenue-based earnouts are popular because they’re straightforward and dependable. In these agreements, payments are tied to hitting specific revenue targets over a defined period.

Another common metric is EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), which focuses on profitability instead of just revenue growth. For example, earnout payments might be based on a multiple of EBITDA that exceeds a set baseline.

For service-oriented businesses, customer retention often becomes the focus. In other cases, earnouts may hinge on operational milestones, such as entering new markets, launching products, or securing regulatory approvals.

Once performance measures are set, the next step is to define how long the earnout will last and how payments will be structured.

Standard Earnout Timeframes and Payment Methods

Earnout periods typically span several years, giving enough time to measure performance meaningfully. Annual reviews are the norm, as they allow time for proper accounting and dispute resolution while keeping administrative burdens manageable. In some cases - especially with rapidly growing companies - more frequent evaluations may be used, but annual assessments remain the most common approach.

Payment methods vary, but they generally fall into three categories:

Cliff payments: These are only made if specific thresholds are reached.
Graduated payments: Sellers receive partial payouts based on how much of the target is achieved.
Accelerated payments: Larger rewards are triggered if performance significantly surpasses expectations.

These structures aim to create a fair balance: sellers stay motivated, while buyers maintain control over cash flow and risk exposure.

With performance measures and payment terms in place, negotiating the finer details becomes critical.

Important Factors When Negotiating Earnouts

Earnout negotiations often center around control and decision-making during the earnout period. Sellers usually want assurances that operational decisions won’t undermine performance goals, while buyers seek the flexibility to run the business efficiently. To address these concerns, agreements often include “reserved matters” - key decisions (like major spending, personnel changes, or strategic shifts) that require both parties' approval.

Dispute resolution is another crucial element. Instead of relying on costly litigation, many agreements include provisions for binding arbitration or third-party reviews, such as independent accounting assessments, to resolve conflicts quickly and affordably.

All terms should be documented clearly from the start. Buyers need to maintain separate records for earnout calculations and provide regular financial updates. Agreements should also specify the accounting standards to be followed and how any changes will be handled.

Acceleration clauses are another consideration. These clauses protect sellers by triggering immediate payment of any remaining earnout amounts if the business experiences a major change, such as being sold or restructured.

Lastly, caps and floors can help manage financial risk. Caps set an upper limit on earnout payments, ensuring costs don’t spiral out of control. Floors, on the other hand, guarantee sellers receive a minimum payout if basic performance thresholds are met.

Pros and Cons of Using Earnouts

Earnouts can be a helpful tool for managing risk, especially when future performance is uncertain. They allow buyers to avoid overpaying during times of economic instability, while also providing sellers with the chance to earn more if the business hits certain performance goals. Let’s break down the advantages and challenges for both sides.

For buyers, earnouts serve as a way to bridge valuation gaps that might otherwise prevent a deal from closing. They also ensure that sellers stay motivated to maintain the business’s performance after the sale, which can lead to a smoother transition.

Sellers, on the other hand, gain the opportunity to earn additional compensation if the business meets or exceeds performance targets. This structure can help resolve valuation disagreements and, in some cases, even lead to a higher overall payout compared to an all-cash deal.

However, earnouts come with risks - particularly for sellers. The biggest concern is the uncertainty of payment. Since earnout payouts depend on future performance, they’re not guaranteed. Sellers are also at the mercy of the buyer’s decisions post-sale. If the buyer changes strategy, cuts marketing budgets, or makes other operational shifts, sellers could lose out on their contingent payments.

Buyers aren’t without challenges either. Negotiating earnout terms can be complex, leading to longer deal timelines and higher legal costs. During the earnout period, disputes can arise if performance targets aren’t met or if accounting methods differ. There’s also the risk of sellers manipulating results to meet targets, which adds to the buyer’s oversight responsibilities. And because buyers typically control the business after the sale, sellers often have little say in decisions that impact their earnout payments, which can lead to tension.

Comparison Table: Benefits and Drawbacks of Earnouts

Buyers	Benefits	Drawbacks
Risk Management	Reduces the risk of overpaying for uncertain performance	Potential for disputes and costly litigation
Deal Structure	Helps close deals by bridging valuation gaps	Complex negotiations can delay closing
Payment Flexibility	Deferred payments improve cash flow	Future liabilities create financial uncertainty
Seller Motivation	Keeps sellers engaged post-sale	Risk of sellers manipulating results to meet targets

For sellers, the trade-offs are equally important.

Sellers	Benefits	Drawbacks
Compensation	Potential for a higher total payout than an all-cash deal	Payment isn’t guaranteed regardless of past performance
Value Recognition	Opportunity to benefit from future business success	Heavily reliant on buyer’s management decisions
Deal Completion	Resolves valuation disagreements to close deals	Delayed payments create financial uncertainty
Continued Involvement	Keeps a stake in the business’s success	Limited control over factors affecting earnout targets

Here’s a practical example to illustrate these dynamics: Imagine a seller receives $5 million upfront, with an additional $2 million contingent on hitting specific EBITDA targets over two years. If the business thrives under the new owner, the seller gets the full $7 million, reaping the rewards of strong performance. But if the buyer changes strategy or the market takes a downturn, the seller could miss the targets and lose the $2 million, underscoring the risks involved.

In times of economic uncertainty, earnouts have become more common as buyers look for ways to protect themselves. For sellers, the decision to accept an earnout comes down to balancing the potential for higher compensation against the risk of walking away with only the upfront payment. Success ultimately hinges on both parties crafting clear, fair terms and maintaining alignment throughout the earnout period.

How to Use Earnouts Successfully

Making earnouts work effectively requires careful planning and execution. While earnouts can help bridge valuation gaps and align the interests of buyers and sellers, they can also lead to disputes if not structured properly. The key is to establish clear frameworks early on and maintain transparency throughout the process. By following these practices, you can set the stage for smoother post-deal integration.

Setting Clear and Measurable Goals

Define specific, measurable targets to avoid ambiguity. Vague goals often lead to misunderstandings, so it’s crucial to outline clear metrics that both parties can easily track and verify.

For example, revenue-based earnouts are often tied to gross revenue rather than net income. This approach minimizes disputes since buyers control expenses after the deal closes. A straightforward target might be an additional payment if gross revenue exceeds a set amount within 24 months. This eliminates confusion about what counts toward the goal.

With EBITDA-based earnouts, it’s important to specify which expenses are adjustable. For instance, you might exclude discretionary items like management salaries or consulting fees from EBITDA calculations. If the target is $2.5 million in EBITDA, the agreement should clearly state that the buyer cannot inflate discretionary expenses beyond agreed-upon limits.

Customer retention metrics are another reliable option, especially for service-based businesses. For example, an earnout could be triggered if the company retains 90% of its customer base by revenue over 18 months. This kind of binary metric - customers either stay or they don’t - is harder to manipulate.

Avoid overly complicated formulas that require extensive calculations. For instance, instead of basing an earnout on "adjusted gross margin after accounting for inventory fluctuations and seasonal variations", use simpler metrics like "total units sold" or "number of active contracts." Simplicity benefits everyone involved.

Keeping Records Clear and Complete

Clearly outline performance measures, accounting standards, and reporting responsibilities in the earnout agreement. Set up a reporting schedule right away, with mandatory quarterly financial updates using consistent accounting methods. This allows sellers to monitor progress and address concerns early.

To ensure accuracy, consider independent CPA verification. This adds an extra layer of trust by verifying that both parties are working with the same numbers. Consistent reporting and detailed documentation also help mitigate risks.

Include an escalation plan in case of disputes. Start with direct resolution, then move to independent review, and, if necessary, binding arbitration. This structured approach can prevent disagreements from spiraling into costly legal battles.

Account for baseline adjustments in the agreement. For example, if the business typically experiences 20% revenue fluctuations due to seasonal patterns, the earnout should reflect this variability. Similarly, if the buyer plans to make significant changes - like adjusting pricing, expanding locations, or modifying the business model - these factors should be addressed upfront to avoid conflict later.

Working with Professional Advisors

Professional advisors can streamline the earnout process by building on clear goal-setting and record-keeping practices. Experienced brokers specialize in creating win-win earnout structures. They understand common pitfalls and know how to design agreements that protect both parties. For example, brokers at God Bless Retirement work with buyers and sellers to establish realistic performance targets based on historical data and market trends, reducing the risk of disputes.

Engage legal and financial advisors to review the agreement and verify results. An experienced attorney can ensure the contract addresses potential issues, such as business disruptions, key employee departures, or changes in market conditions that could impact performance.

Brokers like God Bless Retirement also provide access to a network of specialists, including CPAs, M&A attorneys, and financial planners. This network can help resolve complex issues before they derail the deal. For instance, a broker with deep knowledge of the seasonal cycles of a landscaping business or the customer concentration risks of a professional services firm can craft realistic earnout terms that account for these nuances.

Working with advisors also adds emotional distance to negotiations. Earnouts can become contentious when buyers and sellers negotiate directly, especially when performance targets involve significant resources. Professional intermediaries help keep discussions focused on facts and market realities, rather than personal disagreements. These measures can help ensure earnouts align interests and preserve value in lower mid-market deals.

Conclusion: Why Earnouts Help Close More Deals

Earnouts have become a practical way to overcome common hurdles in lower mid-market business deals. By helping buyers and sellers bridge valuation gaps while keeping profit potential intact, they create opportunities where traditional all-cash deals often fall short.

One of the biggest challenges in negotiations is disagreement over future business performance. Earnouts provide a way to address this. Take, for instance, a situation where a seller valued their business at $32 million, but the buyer only offered $27 million upfront. A $5 million earnout tied to first-year EBITDA targets helped close the gap[3]. This setup lets sellers maximize their payout if the business performs as expected, while buyers avoid overpaying for growth that might not materialize. It's a win-win solution for differing views on value.

Earnouts also help manage risk, which is especially important in today’s unpredictable economy. With buyers facing difficulties securing financing and projecting future cash flows, earnouts reduce the need for large upfront payments. At the same time, they give sellers a chance to share in the business’s future success[2][4].

Another advantage is how earnouts align interests between buyers and sellers. Sellers often stay involved with the business during the performance period, which smooths the transition and can lead to better outcomes. Their continued engagement helps maintain key relationships, ensures operational stability, and boosts the chances of meeting the agreed-upon targets.

Data shows that 64% of deals with earnouts use revenue milestones, while 24% rely on EBITDA or other earnings-based targets[5]. Typically, earnouts account for 10% to 50% of the total purchase price and are paid out over three to five years, offering sellers significant upside potential while protecting buyers’ interests[1].

In an uncertain economic climate, earnouts provide the flexibility and risk-sharing needed to close deals that might otherwise fall apart. Their rising popularity in the lower mid-market highlights their value as a tool for getting transactions across the finish line.

FAQs

How can sellers protect themselves from potential risks with earnouts, especially if the buyer changes business strategies after the sale?

Sellers can manage potential risks in earnout agreements by incorporating specific contractual safeguards. For instance, structuring payments based on clearly defined milestones and including clauses requiring seller approval for significant strategic decisions can provide added security. To further protect their interests, sellers might also include acceleration clauses, ensuring payments are triggered if the buyer introduces substantial unfavorable changes after the sale.

Another option to consider is earnout insurance, which can act as a safety net against non-payment, offering financial peace of mind throughout the earnout period. These measures not only help protect the seller but also promote a fair alignment of interests between both parties.

What are the best ways to set clear and measurable performance goals in an earnout agreement to avoid conflicts?

When drafting an earnout agreement, setting clear, measurable performance goals is essential to prevent disputes. Focus on objective metrics such as revenue, EBITDA, or key milestones that align with the company’s broader objectives. These targets should be realistic, achievable, and within the control of management, reducing the likelihood of conflicts.

Using precise language and clearly defined measurement criteria is equally important. Both parties need to agree on what constitutes success, as this shared understanding fosters trust and ensures the agreement is executed more smoothly.

How do earnouts affect the relationship between buyers and sellers after a business sale?

Earnouts can play a big role in fostering collaboration between buyers and sellers by aligning their interests during the transition phase. They often motivate sellers to stay actively involved and contribute to a seamless handover since their payout is tied to achieving specific performance milestones.

That said, earnouts aren’t without potential pitfalls. Disputes can arise over how performance metrics are defined or if either side perceives the terms as unbalanced. To minimize friction, it’s crucial to create detailed, straightforward agreements and keep communication transparent throughout the process.