Earnout Agreements Explained

An earnout is the part of a purchase price that the buyer pays only if the business hits agreed targets after closing. It's how buyers and sellers bridge a gap when they disagree about what the future holds: the seller believes growth is coming, the buyer wants proof before paying for it. The earnout lets both be right.

How an earnout works

At closing, the buyer pays a base price. A portion of the total is then deferred and paid over an "earnout period" (commonly 1–3 years) based on a performance metric. If the business hits the targets, the seller collects the earnout; if it falls short, the buyer keeps that money. The result: a lower guaranteed price for the buyer, and upside for the seller if the business performs.

Common earnout structures

• Percentage of the price — e.g. 20% of a $2M deal ($400K) is held back and paid if targets are met.
• Fixed dollar milestones — $100K paid each year the business clears a revenue threshold.
• Revenue-based — a percentage of revenue above a baseline. Simple to measure, harder to manipulate.
• EBITDA/profit-based — rewards real profitability but invites disputes over how costs are allocated post-closing.
• Milestone-based — tied to non-financial events (a contract renewal, a regulatory approval, a customer retention rate).

A worked example

A business sells for $2,000,000. The buyer pays $1,600,000 at closing and structures a $400,000 earnout: the seller receives it in full if revenue averages at least $3,000,000 over the next two years, on a sliding scale down to zero at $2,400,000. If the seller's growth story is real, they get the full price. If revenue stalls, the buyer paid only $1.6M — appropriate for the business they actually received. Model this interaction in the deal calculator using the earnout toggle.

Why both sides like earnouts

Buyers reduce closing cash, lower the risk of overpaying, and keep the seller invested in a smooth handover. Sellers can achieve their full asking price and signal confidence in the business. An earnout also pairs naturally with seller financing — together they can take most of the price off the closing table.

The pitfalls — and how to avoid them

• Control conflicts. After closing the buyer runs the business, but the seller's payout depends on its performance. Define who controls what, and cap discretionary changes during the earnout.
• Metric manipulation. Buyers can suppress measured profit by loading costs; sellers can stuff channel sales. Choose the cleanest metric (often revenue) and define it precisely.
• Accounting ambiguity. Specify the exact accounting method, who prepares the statements, and the seller's audit rights.
• No dispute mechanism. Build in a clear resolution path (independent accountant, arbitration) before you need it.
• Unrealistic targets. A target neither side believes in just creates resentment. Anchor it to documented trends.

When to use one

Earnouts shine when there's a genuine, defensible gap between buyer and seller expectations — strong recent growth, a pipeline that hasn't closed, or a new product line. They're a poor fit for stable, flat businesses where the value is already known; there, a straight price with seller financing is cleaner. Always paper an earnout with an M&A attorney — the dispute risk lives entirely in the drafting.