Earnouts in M&A: How to Negotiate and Protect Yourself

You've negotiated a purchase price, but the buyer wants to put a portion of it into an earnout — additional payments contingent on the business hitting certain targets after closing. Is this a deal-breaker? Not necessarily. But the details matter enormously.

Earnouts are one of the most powerful — and most dangerous — tools in M&A deal structuring. They can bridge valuation gaps and align incentives, or they can become a source of frustration, litigation, and unpaid money. The difference comes down to how they're structured.

What Is an Earnout?

An earnout is a contractual provision where the seller receives additional purchase price payments based on the business achieving specified performance targets after closing. The buyer pays the "guaranteed" portion at close, and the earnout provides upside if the business performs well.

Example: A business sells for $8M total consideration — $6M at closing plus up to $2M in earnout payments over two years, contingent on the business maintaining $2M in annual EBITDA.

When Earnouts Make Sense

Bridging a Valuation Gap

The most common use case. The seller believes the business is worth $10M based on growth trajectory. The buyer sees more risk and values it at $8M. An earnout bridges the gap: $8M guaranteed plus $2M if the growth materializes.

High-Growth Businesses

When a business is growing rapidly, historical earnings understate future value. An earnout lets the seller capture the value of that growth trajectory without asking the buyer to pay for unproven projections.

Customer Concentration Risk

If a material portion of revenue depends on one or two large customers, an earnout tied to customer retention lets the buyer manage the risk while giving the seller the opportunity to earn the full price.

Owner Transition

When the business is heavily dependent on the owner, an earnout incentivizes the owner to stay engaged through the transition period and ensure the business performs.

Industry-Specific Risks

In industries with regulatory uncertainty, pending contract renewals, or technology transitions, earnouts can allocate specific risks to the party best positioned to manage them.

The Seller's Perspective: Risks and Concerns

Loss of Control

This is the fundamental tension. After closing, the buyer controls the business — hiring, spending, pricing, strategy. But the seller's earnout payments depend on business performance. If the buyer makes decisions that hurt short-term performance (investing heavily in growth, restructuring, changing pricing), the seller's earnout suffers even though those decisions might be rational for the buyer.

Measurement Disputes

How EBITDA is calculated, what expenses are included, how revenue is recognized — these accounting questions can mean the difference between hitting an earnout target and missing it. Without precise definitions, disputes are inevitable.

Integration Disruption

If the buyer integrates the acquired business into a larger platform — merging back offices, changing systems, combining sales teams — it can become impossible to measure the standalone performance of the acquired business.

Delayed Payment Risk

An earnout is essentially an unsecured promise to pay. If the buyer's broader business struggles, the earnout might not get paid even if the targets are met.

How to Negotiate an Earnout That Actually Works

Choose the Right Metric

Revenue-based earnouts are generally better for sellers because:

• Revenue is harder for the buyer to manipulate
• Revenue is less affected by discretionary spending decisions
• Revenue is simpler to measure and verify

EBITDA-based earnouts give the buyer more levers to influence the outcome through expense management, allocation of overhead, or investment decisions. If you accept an EBITDA earnout, the definitional precision becomes even more critical.

Other metrics — customer retention, contract renewals, product milestones — can work well when the earnout addresses a specific risk rather than general business performance.

Define the Accounting Methodology

The purchase agreement should specify exactly how the earnout metric is calculated, including:

• Accounting standards (GAAP? Same policies used historically?)
• What's included and excluded from the calculation
• How shared costs are allocated (if the business is integrated)
• Treatment of intercompany transactions
• Treatment of extraordinary or non-recurring items
• How acquisitions by the buyer affect the calculation (if the buyer adds another company's revenue, does that count?)

The more specific, the fewer disputes.

Protect Against Buyer Manipulation

Include operating covenants that limit the buyer's ability to take actions that would artificially reduce the earnout metric:

• Operate in the ordinary course — require the buyer to operate the business consistent with past practice during the earnout period
• Minimum investment levels — require the buyer to maintain minimum marketing spend, headcount, or CapEx
• No unfavorable intercompany transactions — prevent the buyer from shifting revenue to other entities or loading expenses onto the acquired business
• No intentional diversion — prohibit the buyer from diverting customers, contracts, or employees to other entities to reduce the earnout business's performance
• Acceleration on change of control — if the buyer sells the business during the earnout period, the maximum earnout becomes immediately payable

Structure Payment Terms

• Annual or quarterly measurement periods are better than a single period — they reduce the impact of timing anomalies
• Cumulative targets (total over the period) are better than discrete annual targets — one bad quarter doesn't eliminate the entire earnout
• Pro-rata payments for partial achievement (e.g., 80% of target earns 80% of earnout) are better than all-or-nothing thresholds
• Cap and floor — a minimum payment provides some certainty; a maximum limits the buyer's exposure

Secure the Payment

An earnout is only valuable if it gets paid:

• Letter of credit or escrow securing the maximum earnout amount
• Personal guarantee from the buyer's principals
• Security interest in business assets (subordinated to senior lender)
• Acceleration rights if the buyer defaults on other obligations

Include Dispute Resolution

Earnout disputes are common. The agreement should include:

• Detailed calculation procedures with specific timelines
• Seller's right to review books and records related to the earnout calculation
• Independent accountant resolution for calculation disputes
• Arbitration or litigation provisions for covenant disputes
• Prevailing party attorney's fees (creates incentive for the buyer to honor the terms)

Red Flags in Earnout Proposals

Watch out for:

• All-or-nothing thresholds with no pro-rata payment — hitting 95% of the target and getting zero is a bad deal
• EBITDA targets with no operating covenants — the buyer can spend their way to missing the target
• Short measurement periods — a single 12-month earnout period gives you no margin for error
• Vague calculation methodology — if the metric isn't precisely defined, assume the buyer will calculate it in their favor
• No security or guarantee — an unsecured promise from a leveraged buyer is a weak asset
• Unrealistic targets — if the target requires 30% growth over historical performance, the earnout is worth less than it appears
• Buyer's right to wind down or restructure during the earnout period — this can destroy the earnout without triggering any protections

Alternatives to Earnouts

Before accepting an earnout, consider whether other structures accomplish the same goal:

• Seller note — fixed payments over time, not contingent on performance
• Consulting agreement — guaranteed post-close payments in exchange for transition services
• Equity rollover — retain ownership in the business and participate in future upside directly
• Holdback with objective release conditions — purchase price held in escrow and released based on specific, verifiable events (contract renewal, customer retention)

The Bottom Line

Earnouts can be good deal-making tools when structured properly. The key principles:

1. Prefer revenue over EBITDA as the metric
2. Define everything with surgical precision
3. Include operating covenants that prevent buyer manipulation
4. Secure the payment with escrow, guarantees, or letters of credit
5. Build in pro-rata payments and cumulative measurement
6. Get experienced M&A legal counsel — earnout provisions are where deals are won or lost

If you're negotiating a deal with an earnout component and want advice on structuring it effectively, let's talk.