Earnout Agreements Explained
An earnout is the portion of the purchase price the buyer pays only if the business hits agreed targets after closing. It solves one specific problem: buyer and seller disagree about what the future looks like. The seller believes the growth is real; the buyer wants proof before paying for it. An earnout lets both of them be right — or wrong — on their own timeline.
How an earnout works
At closing, the buyer pays a base price. A portion of the total is deferred and paid over an earnout period — commonly 1 to 3 years — based on a performance metric. Hit the targets, the seller gets paid. Fall short, the buyer keeps that money. Simple in theory. The devil, as always, is in how you define the metric and who controls the levers that move it.
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, cap the downside of overpaying, and keep the seller motivated through the transition. Sellers get to argue for their full asking price without discounting — and signal that they actually believe their own projections. Pair an earnout with seller financing and you can take the majority of the price off the closing table entirely.
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 work best when there's a genuine, defensible gap between what the buyer sees and what the seller believes is coming — strong recent growth, a pipeline of unsigned contracts, a new product still ramping. They're a poor fit for stable, flat businesses where the earnings are already proven; there, a straight price with seller financing is cleaner and less litigious. Always have an M&A attorney paper the earnout. Nearly every earnout dispute traces back to ambiguous drafting, not bad intent.
How to Apply This Guide
Before proposing an earnout, decide what uncertainty it is solving. If the seller claims next year's growth is already locked in, tie the earnout to the contracts or revenue that prove it. If customer retention is the issue, tie payment to retained gross profit rather than vanity revenue.
Model earnouts as contingent, not guaranteed. Show the base purchase price, maximum earnout, expected earnout, and zero-earnout case separately. This keeps the buyer from overestimating funding certainty and helps both sides see whether the structure actually bridges the valuation gap.
Implementation Checklist
Use this guide as a working note during deal review. Write down the seller's claim, the document that supports it, the financial model input it changes, and the decision it affects. If a point does not change valuation, financing, diligence scope, legal terms, or post-close operations, it is probably background information rather than a deal issue.
For each material assumption, build three cases: seller case, verified base case, and downside case. The seller case shows the story being marketed. The verified case reflects documents you have seen. The downside case shows what happens if revenue, margin, add-backs, financing, or customer retention is weaker than expected.
The goal is not to make the deal look better or worse. The goal is to know which facts must be true for the acquisition to work. Once those facts are visible, you can negotiate price, seller financing, earnouts, escrows, transition support, and closing conditions with a clear reason for each term.