A recent piece on price versus terms introduced the earnout as one way part of a purchase price can depend on what happens after closing. It deserves a closer look, because an earnout does something the other structures don’t. It moves risk from the Buyer to the Seller, and it does so in areas the Seller can no longer control.
What an Earnout Is and When It Shows Up
An earnout is a portion of the purchase price paid after closing, and only if the business hits targets the Buyer and Seller agreed to in advance. Those targets are usually tied to revenue, gross profit, or earnings over a period of a few years. Hit them, and the Seller receives the additional payment. Miss them, and some or all of it never arrives.
Earnouts tend to show up when a Buyer sees something in the business they can’t yet be sure will hold. Sometimes it’s growth. Say a Seller believes the business is worth $6 million, based on a strong recent year and a healthy pipeline. The Buyer is comfortable at $5 million, because they can’t yet know whether that growth will last. Other times it’s a large share of revenue tied to one or two customers, a few employees the business depends on, or a relationship that may not survive the handoff. Different situations, same underlying question: will this keep happening once the Seller is gone?
How an Earnout Transfers Risk to the Seller
An earnout answers that question with time. In the example above, the deal becomes $5 million at closing, with the final $1 million paid if the business delivers the results the Seller is projecting. Framed that way, it sounds like a fair compromise, and often it is. It is also a transfer of risk. The Buyer avoids paying in full for something that hasn’t been proven. The Seller takes on the possibility that it won’t be, and with it the possibility of never seeing that last million dollars.
The difficulty is that once the Seller leaves the business, nearly everything that determines whether the targets get hit is out of their hands. The Buyer sets prices, decides who to hire and who to let go, chooses where to invest, and may fold the business into other operations entirely. A key employee leaves. A major customer is lost in the transition. Costs rise, or the economy softens. Some of these are simply bad luck, and some are reasonable decisions by the Buyer that happen to hurt the earnout. Either way, the Seller carries the consequence, because they agreed to be paid on the results of a business they no longer run.
Why the Details Matter More Than the Headline Number
That’s why the details matter more than the headline number. The metric the earnout is measured against can change the outcome entirely. Revenue is relatively hard to influence after closing, but profit can be shaped by how the Buyer allocates overhead, books one-time costs, or chooses to reinvest. A Seller who agrees to an earnout based on profit should know exactly how profit will be calculated, and who gets to decide. Vague definitions are where most earnout disputes begin.
The surrounding terms matter just as much, because they’re the only way a Seller gets any protection from the risk they’ve taken on. How long does the earnout run? What is the Buyer expected to do, or not do, to the business during that period? What reporting will the Seller receive so they can see how the numbers are tracking? What happens to the remaining payments if the Buyer sells the company again? None of these questions are unusual, but each one is far easier to answer before signing than after a disagreement has started.
Treat the Earnout as Money at Risk
None of this makes an earnout a bad idea. For the right Seller in the right deal, it’s the difference between a transaction that happens and one that stalls over a gap in value. The useful way to think about it is to treat the earnout portion as money that is at risk, not money that is owed. A good test is whether the deal still works for the Seller if that portion never pays out. If it does, the earnout is a reasonable bet. If it doesn’t, the Seller is relying on something they can’t control.
Equity rollovers work differently, since the Seller isn’t waiting to be paid but choosing to stay invested. That’s the subject of the next piece in this series.
When it comes to selling your business, there are no do-overs. When an earnout appears in an offer, the Business Seller Center looks well past the dollar figure. We pressure-test how the metric is defined, who controls the inputs, what the Buyer can and can’t change during the earnout period, and whether the deal still works for our client if the final payment never arrives. We walk clients through all of this early, so by the time an earnout is on the table, they know exactly what to push on.
Why a Higher Offer Isn’t Always the Better One
Why the structure of an offer matters as much as the number.
What Happens After You Sell Your Business?
What your role looks like once the deal closes.
The Business Seller Center, located in Cheshire, Connecticut, is a business brokerage and M&A advisory firm working with established companies generating $1 million to $20 million in annual revenue (approximately $1 million to $20 million in enterprise value). We work with businesses in the lower middle market across the Northeast.