Structuring an Earnout That Works for Buyers and Sellers

Buyers and sellers often agree on the quality of a business but disagree on its value. Different expectations about future performance frequently create that gap. A seller may expect continued growth based on recent performance and identified opportunities. Meanwhile, a buyer may hesitate to pay today for results that have not occurred.

An earnout may help resolve this disagreement. A carefully designed earnout structure makes a portion of the purchase price contingent on future performance. In effect, the seller receives additional consideration if the business achieves mutually-agreed upon performance objectives after closing. The buyer, however, avoids paying the full amount unless those objectives materialize.

This arrangement may help bridge a valuation gap, but it also creates new risks. Once the transaction closes, the seller may no longer control decisions affecting earnout performance. For this reason, buyers and sellers should negotiate the earnout terms as carefully as the purchase price. Several provisions deserve particular attention.

Performance Metrics: The parties should select objective, measurable, and clearly defined performance metrics. Revenue, gross profit, EBITDA, or customer retention may provide appropriate measures.

Measurement Period: The agreement should establish when performance begins and ends. It should also define how frequently the parties calculate results.

Accounting Policies: Both parties should agree on accounting principles and calculation procedures before closing. Clear definitions may reduce disagreements over post-closing results.

Operating Control: Sellers should understand how buyer decisions could affect the earnout. Staffing, pricing, expenses, acquisitions, and resource allocation may influence performance.

Caps and Floors: The parties may establish minimum thresholds or maximum payments. These provisions can define the potential range of contingent consideration.

Payment Security: Depending on the circumstances, sellers may negotiate protections supporting future payments. Escrow arrangements, guarantees, or other security provisions may provide additional protection.

Dispute Procedures: The agreement should establish a process for resolving disagreements over calculations. An independent accountant may provide a practical mechanism for certain financial disputes.

Equally significant, the earnout structure should reflect objectives that the acquired business can reasonably achieve. Unrealistic targets may create conflict rather than bridge the valuation gap. Sellers should also recognize that an earnout differs substantially from cash received at closing. Future payments remain uncertain until the required performance conditions are satisfied.

Buyers face risks as well. Poorly designed earnouts may influence operating decisions, create conflicting incentives, and complicate integration after closing. For these reasons, experienced M&A, legal, accounting, and tax advisors should address earnout provisions before executing definitive agreements. Early coordination may identify potential disputes while the parties still have negotiating flexibility.

No earnout structure can eliminate every risk. However, clearly defined terms may align expectations, reduce uncertainty, and help buyers and sellers bridge differences in value.