What Is an Earnout Provision?
An earnout provision is a contractual arrangement in a business sale where a portion of the purchase price is contingent upon the future performance of the business. Instead of receiving the full sale price at closing, the seller receives additional payments later if the business hits specific financial or operational targets.
These targets are typically tied to revenue, gross profit, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), or the retention of key clients over a defined period—usually one to three years post-sale.
Why Do Buyers Propose Earnouts?
Buyers often suggest earnouts for several strategic reasons:
- Bridging the Valuation Gap: If the seller believes the business is worth more based on future projections, but the buyer only wants to pay for historical performance, an earnout bridges that gap.
- Risk Mitigation: It reduces the buyer's upfront financial risk. If the business underperforms after the transition, the buyer pays less.
- Seller Motivation: If the seller is staying on for a transition period, an earnout keeps them highly motivated to ensure the business continues to grow and succeed.
- Financing the Deal: In some cases, tying part of the purchase price to future cash flow makes it easier for the buyer to finance the acquisition.
The Risks for Business Sellers
While earnouts can help close a deal and potentially increase the final payout, they come with significant risks for sellers. Once the business is sold, the seller loses control over operations, which means their future payout is largely in the hands of the new owner.
A common risk is that the buyer may increase expenses—such as hiring new management, investing in marketing, or changing suppliers—which can lower net profit and cause the seller to miss their earnout targets, even if revenue increases.
Additionally, if the buyer integrates the business into their existing operations, tracking the specific performance metrics tied to the earnout can become complicated and lead to disputes.
Key Elements to Negotiate in an Earnout
If you agree to an earnout, careful negotiation and precise legal drafting are essential. Key elements to focus on include:
The Performance Metric
Revenue-based earnouts are generally safer for sellers than profit-based earnouts, as revenue is harder for a buyer to manipulate through accounting changes or increased expenses.
The Earnout Period
Shorter earnout periods (one to two years) are usually preferable for sellers. The longer the period, the more variables and risks are introduced.
Measurement and Reporting
The agreement must clearly define how the metrics will be calculated, who will provide the financial reports, and how often the seller will receive updates on progress toward the goals.
Operational Control Covenants
Sellers should negotiate protective covenants that prevent the buyer from intentionally sabotaging the earnout. This might include requirements to maintain adequate marketing budgets, keep key employees, or run the business in the ordinary course.
How to Protect Yourself Post-Sale
To maximize the chances of receiving your earnout payments, it is critical to stay involved or establish clear audit rights. You should have the ability to review the financial statements used to calculate the earnout and a defined dispute resolution process if you disagree with the buyer's calculations.
Never accept an earnout structure that requires an "all or nothing" result. Instead, negotiate a tiered or sliding-scale earnout where you still receive partial payments if you hit a percentage of the target goal.
Alternatives to Earnout Provisions
If an earnout feels too risky, there are other ways to bridge a valuation gap:
- Seller Financing: A promissory note provides a fixed, guaranteed payment schedule with interest, regardless of the company's future performance.
- Consulting Agreements: A guaranteed consulting contract for the seller during the transition period provides fixed income without performance risk.
- Retained Equity: The seller rolls a portion of their equity into the new entity, allowing them to share in the upside when the buyer eventually sells the business again.
Preparing for a Successful Business Sale
Earnouts can be a valuable tool in M&A transactions, but they must be structured carefully to protect the seller. Working with an experienced M&A advisor and transaction attorney ensures that the metrics are clear, the risks are mitigated, and your financial interests are protected long after closing.
