How earnouts work, and when to accept one

What an earnout is

An earnout is a portion of the purchase price paid later, contingent on the business achieving something after closing. Usually a revenue or EBITDA target, measured over one to three years.

It exists because you and the buyer disagree about the future. You believe next year will be strong. They are not sure. Rather than argue to a standstill, the earnout says: if you are right, you get paid; if not, you do not.

The legitimate use

Earnouts genuinely solve certain problems. If you have just won a large contract that has not yet produced revenue, a buyer will not pay full value for it, and an earnout lets you capture it if it performs.

The same applies after a bad year caused by something specific and identifiable, or when a large share of revenue arrived very recently and has not yet proven durable.

In those situations an earnout can be the difference between a deal and no deal, and it can be the difference between a fair price and a discounted one.

The problem with them

You will no longer be in control of the business whose performance determines your payment.

The buyer will make decisions: adding overhead, changing pricing, integrating your operations into theirs, allocating corporate costs to your entity, moving a salesperson to another division. Each of those can reduce the measured result without anybody acting in bad faith.

This is why earnout disputes are common, and why they are among the most expensive things to litigate. The disagreement is usually not about whether the number was hit. It is about whether the number was measured the way both parties thought it would be.

The terms that actually decide the outcome

What is measured. Revenue is far harder to manipulate than EBITDA, because EBITDA can be reduced by costs the buyer controls. If you accept an EBITDA earnout, define precisely which costs may be charged against it, and exclude the buyer's corporate allocations, integration costs and management fees.

Over what period. Shorter is generally better for you. Three years is a long time to have money outstanding on a business you no longer run.

All or nothing, or sliding scale. A cliff structure where you get nothing at 99% of target is dangerous. A linear or tiered structure that pays proportionally is much fairer.

Operating covenants. The agreement should require the buyer to run the business in a manner consistent with past practice, maintain sales and marketing spend, and not take actions designed to reduce the earnout. These clauses are negotiable and worth fighting for.

Acceleration. If the buyer sells the business, terminates you, or fundamentally changes the operation during the earnout period, the remaining earnout should become payable in full.

Information rights. You need the right to see the books, receive regular statements, and dispute a calculation through a defined process with an independent accountant.

How to think about the decision

Treat the earnout portion as worth less than its face value, because it is. How much less depends on the structure, but a useful discipline is to ask whether the deal still makes sense if the earnout pays nothing at all.

If the answer is yes, the earnout is upside and you can accept it with a clear head. If the answer is no, you are not being paid what you think you are being paid, and the guaranteed portion needs to move.

The other question worth asking: how much of the total is at risk? Ten to fifteen percent in an earnout is common and manageable. Forty percent is not an earnout, it is a partnership you did not agree to.