When selling a privately held business, price is only part of the story; the structure of how that price is paid can be equally important. Beyond cash at closing, sellers may encounter indemnity holdbacks, seller notes, rollover equity, and, in many cases, an earnout.
While some business owners instinctively view earnouts with skepticism, the truth is they can be a powerful and strategic tool. With the right structure and guidance, an earnout is not something to fear, but an opportunity to unlock additional value.
What Is an Earnout?
An earnout in an M&A transaction is a mechanism designed to bridge the gap between what a buyer is willing to pay today and what a seller believes the business is worth based on future performance. Rather than forcing one party to compromise, an earnout allows both sides to “bet on the future.” If the business performs well after closing, the seller receives additional compensation. If it doesn’t, the buyer is protected from overpaying.
Typically, earnouts span one to three years post-closing and are tied to measurable performance metrics such as:
- Revenue
- Gross profit (dollars or percentage)
- Contribution margin
- EBITDA
- Customer retention
The payout structure can vary. Some earnouts are calculated as a percentage of growth (e.g., 5% of incremental revenue), while others trigger lump-sum payments upon reaching defined milestones (e.g., $500,000 if EBITDA hits $5 million).
Earnouts in Real-World Deal Comparisons
To understand the value of an earnout, consider a simple scenario where the seller has listened to friends and concluded that he/she wants to be paid out in cash at closing, with no earnout risk. After marketing and negotiation, two offers are on the table:
- Offer A: $10 million, all cash at closing
- Offer B: $10 million cash + $2 million earnout opportunity
At this point, the seller realizes that an earnout has to be considered in relation to all the proposed terms of offers received. In this scenario, there is no downside to accepting offer B; at a minimum, the cash equals the cash of offer B, and the earnout provides an opportunity for a $2 million upside.
This is where experienced guidance matters. Working with a knowledgeable advisory team, like the professionals on Our Team, can make the difference between a speculative earnout and a strategic advantage.
Alignment: The True Purpose of an Earnout
A well-designed earnout does more than just defer payment; it aligns incentives between buyer and seller. In the above scenario, the seller was convinced that the company was worth $12 million; however, the market spoke and said the value was only $10 million. The buyer in offer B was, ultimately, willing to pay the $12 million if agreed upon performance metrics are met after closing, creating a win–win for both sides.
Both parties will benefit from strong performance:
- The seller receives additional compensation
- The buyer gains a stronger, more valuable business
This alignment is particularly useful in situations where:
- The company has experienced recent volatility
- Growth is expected but not yet fully proven
- Key customer relationships or revenue streams need to be sustained
In these scenarios, an earnout ensures that value is realized and shared based on actual results.
The Importance of Precision in Earnout Terms
If there’s one rule that cannot be overstated, it is this: clarity is everything. The earnout calculation must be meticulously defined in the purchase agreement. This includes:
- Exact financial metrics
- Accounting methodologies
- Timing of calculations
- Any allowed or excluded expenses
- An example of a calculation
- Caps or thresholds
- Third-party dispute resolution
Buyers often seek a cap on earnout payments to limit their exposure, while sellers (with strong advisory support) may negotiate for uncapped or tiered upside: if the company does even better than expected, why shouldn’t the seller share in that upside?
In our experience, disputes rarely arise when earnout provisions are clearly defined. Problems tend to occur when terms are vague or open to interpretation.
How Earnout Payments Are Handled
The process for earnout calculation is typically straightforward:
- At the end of a performance period, the buyer prepares the earnout calculation (often within 60 days).
- Supporting documentation is provided to the seller and their advisors.
- The seller reviews and confirms the calculation, often with the help of their M&A advisor.
Importantly, your advisory team should remain actively involved after closing to ensure the earnout is calculated correctly and paid in full.
At Shoreline Partners, our interests remain aligned with our clients even post-transaction. We continue to advocate on their behalf, including review and verification of earnout calculations, because we participate in the success of the earnout payment itself.
When Earnouts Make the Most Sense
Earnouts are not always necessary, but they can be especially valuable when:
- There is uncertainty around near-term performance
- The business is transitioning leadership
- Growth projections are meaningful but not guaranteed
- The buyer and seller have differing views on value
In these cases, an earnout transforms disagreement into opportunity. If the company performs well, the seller captures additional value. If performance falls short, the structure remains fair to both parties.
Earnouts as a Strategic Tool, Not a Risk
The negative perception of earnouts often comes from poorly structured deals or insufficient advisory support. But when thoughtfully negotiated, an earnout is not a concession; it’s a value-enhancing strategy.
Just as selecting the right advisor is critical in other aspects of a transaction, as discussed in our article “Industry Specialist vs Generalist M&A Advisor: Who’s Best?”, the same holds true for navigating earnout provisions. Experience and attention to detail can significantly impact outcomes.
Final Thoughts
An earnout should never be dismissed outright. Instead, it should be evaluated as part of the broader transaction structure, with careful attention to:
- Achievability of performance targets
- Clarity of terms
- Alignment of incentives
- Role and responsibilities of the seller after closing
- Ongoing advisor involvement
When these elements are in place, an earnout becomes a powerful way to maximize value and share in future success.
If you’re considering a sale and want to explore whether an earnout structure could benefit you, we invite you to Contact Us for a conversation.