Earnouts in M&A: A Guide to Structuring Performance-Based Payouts

Earnouts are a common mechanism in M&A transactions that help bridge valuation gaps between buyers and sellers. By tying a portion of the purchase price to the future performance of the business, earnouts provide an opportunity for sellers to achieve a higher total payout while mitigating risk for buyers. While earnouts can create alignment between both parties, they also introduce complexity and potential for disputes if not structured carefully.

This article explores how earnouts work, their benefits and risks, key structuring considerations, and best practices for both buyers and sellers in an M&A transaction.

What Is an Earnout and Why Are They Used?

An earnout is a contractual provision in which a portion of the purchase price is contingent on the acquired business meeting specific financial or operational targets post-closing. Earnouts are often used when the buyer and seller have differing views on valuation, particularly in cases where future performance is uncertain, such as high-growth businesses, cyclical industries, or companies with significant customer concentration.

For buyers, earnouts help ensure they are not overpaying for a business that fails to meet its projected performance. From the seller’s perspective, an earnout offers the potential to receive additional compensation if the business performs as expected—or better—under new ownership. However, earnouts introduce risks, as sellers often lose control over the business post-closing, leaving them reliant on the buyer’s management decisions to meet the earnout targets.

Common Earnout Metrics

Earnouts can be structured around various performance metrics depending on the nature of the business and the buyer’s objectives:

Revenue-Based Earnouts – These earnouts tie payouts to achieving specific revenue thresholds. They are useful when the business has strong sales potential but unpredictable margins. However, they do not account for profitability, which could lead to disputes over revenue quality.
EBITDA or Net Income-Based Earnouts – These structures ensure the seller benefits only if the business maintains strong profitability. However, they can be subject to manipulation if operating expenses, capital expenditures, or corporate allocations are adjusted post-sale.
Customer Retention or Contract-Based Earnouts – In service-based industries or businesses with key customers, earnouts may be tied to retaining clients or securing new contracts.
Operational Milestones – Some earnouts are based on non-financial targets, such as launching a new product, obtaining regulatory approvals, or expanding into a new market.

The chosen metric should align with the buyer’s post-closing goals while remaining achievable and measurable for the seller. A well-structured earnout ensures that both parties have clarity on expectations and performance benchmarks, reducing the potential for disputes.

Risks and Challenges of Earnouts

While earnouts can be beneficial in theory, they introduce risks and potential areas of conflict. Sellers often lose control over operations once the business is sold, making it difficult to ensure that earnout targets are met. Accounting disputes can arise over how revenue or earnings are calculated, particularly if there is ambiguity in expense allocations and financial reporting. Additionally, buyers may make strategic decisions that impact performance, such as reducing investments in key areas, shifting costs, or restructuring operations. External factors, such as economic downturns, industry disruptions, or regulatory changes, can also affect performance in ways neither party anticipated.

Given these risks, sellers should carefully assess whether an earnout aligns with their financial goals and risk tolerance. If they lack confidence in the buyer’s ability or willingness to operate the business in a way that supports earnout success, they may be better off negotiating for more upfront cash rather than relying on uncertain future payments.

Best Practices for Structuring Earnouts

To maximize the likelihood of a successful earnout, both buyers and sellers should take a structured approach to negotiating terms:

Use Objective, Measurable Criteria – Earnout provisions should be based on clearly defined metrics to reduce ambiguity. If EBITDA is used, the agreement should specify which expenses and adjustments apply to prevent post-closing accounting disputes.
Set a Reasonable Timeframe – The timeframe for earnout measurement should be long enough to demonstrate performance but not so long that market conditions create undue risk. Most earnouts last between one and three years.
Include Protections for Sellers – Sellers may negotiate provisions to prevent the buyer from taking actions that could artificially depress earnout performance, such as shifting expenses or reducing investment in growth initiatives.
Cap Financial Exposure for Buyers – Buyers may want to place a cap on the total earnout payout to limit financial risk while still providing an incentive for strong performance.
Establish Dispute Resolution Mechanisms – Including independent third-party audits, arbitration clauses, or detailed financial reporting requirements can help mitigate conflicts before they escalate.

A well-drafted earnout agreement reduces uncertainty and ensures that both parties are aligned on expectations, reducing the likelihood of post-closing disputes.

When Earnouts Make Sense (and When They Don’t)

Earnouts are most effective when there is genuine uncertainty around valuation and both parties are motivated to ensure a smooth transition. They work well when the business has strong growth potential but lacks a predictable earnings history or when the buyer is concerned about customer retention and revenue sustainability. Earnouts also make sense when the seller remains involved post-closing and can directly influence performance outcomes. Additionally, they are most successful when both parties have a shared understanding of how the business should be operated to achieve the earnout milestones.

However, earnouts may not be the best option in certain situations. If the seller wants a clean break with no post-closing involvement, or if the buyer intends to integrate the acquired business into a larger organization—making it difficult to track earnout-related performance separately—then an earnout structure may not be practical. High risks of operational changes that could impact performance calculations or concerns about the buyer’s intentions in administering the earnout can also make this structure less desirable.

In cases where an earnout seems risky, sellers may be better off negotiating for more upfront cash rather than relying on uncertain future payments.

Conclusion

Earnouts are a valuable tool in M&A transactions but require careful structuring to be effective. While they can bridge valuation gaps and create alignment between buyers and sellers, they also introduce risks that must be managed through clear contract terms and realistic expectations. Sellers should ensure that earnout metrics are well-defined, achievable, and protected from undue influence, while buyers should use earnouts to incentivize long-term success without creating unnecessary post-closing conflicts.

By understanding the complexities of earnouts and negotiating fair, transparent terms, both buyers and sellers can use performance-based payouts to create win-win M&A transactions.