Earnouts show up in more business transactions than most sellers expect, and understanding how they work can mean the difference between a deal that pays off and one that leaves money on the table.
An earnout is a portion of the purchase price that gets paid after closing, based on the business hitting certain performance targets. Buyers use them to manage risk. Sellers accept them to bridge valuation gaps. And when they’re structured well, earnouts can actually help both sides get a deal done that might not happen otherwise.
I’ve been involved in business transfers since 1990 and have helped structure hundreds of transactions. Earnouts come up regularly in the $2 million to $50 million range. They’re not something to fear. But they are something to understand before you agree to one.
Key Takeaways:
- Earnouts tie a portion of the purchase price to post-closing business performance, typically measured by revenue or EBITDA targets
- They’re a legitimate deal tool that bridges the gap when buyer and seller disagree on value or when certain business attributes carry uncertainty
- Sellers should negotiate earnout terms carefully, including how milestones are measured, what the buyer can and can’t change, and how disputes get resolved
- The percentage of purchase price structured as an earnout varies widely, but keeping it as small as possible reduces your risk
- Having an experienced M&A advisor and attorney review earnout language before signing protects you from common pitfalls
How Earnouts Work in a Business Sale
The concept is straightforward. The buyer pays a portion of the purchase price at closing. The remaining portion gets paid over time, but only if the business meets agreed-upon performance targets.
Here’s a simple example. You sell your distribution company for $10 million. The buyer pays $8 million at closing. The remaining $2 million is structured as an earnout tied to the business maintaining at least $2.5 million in EBITDA over the next two years. If the business hits that target, you receive the full $2 million. If it falls short, you receive a reduced amount.
That’s the basic framework. But the details inside that framework are where things get complicated.
Earnout provisions in business sales can be structured around revenue targets, EBITDA thresholds, customer retention rates, contract renewals, or just about any measurable business metric. The specific milestones depend on what’s driving the valuation gap between buyer and seller.
And that’s the key point. Earnouts exist because the buyer and seller see the business differently. The seller believes the business is worth $10 million based on its trajectory. The buyer thinks it’s worth $8 million based on what they can verify today. The earnout bridges that $2 million gap by letting the business prove itself after closing.
Why Buyers Propose Earnouts
Understanding the buyer’s perspective helps you negotiate better.
Buyers propose earnouts when they see risk in some part of the business that they can’t fully evaluate before closing. Maybe you have a large contract up for renewal six months after the sale. Maybe your revenue has been growing fast but the trend is only 18 months old. Or maybe a significant customer relationship is tied heavily to you personally.
In each case, the buyer is saying: I believe in this business, but I’m not comfortable paying full price for something I can’t verify yet.
That’s not unreasonable. And recognizing it as a legitimate concern rather than an insult puts you in a better position to negotiate terms that work for both sides.
Buyers also use earnouts when they’re financing the acquisition and need to manage their debt obligations. Deferring part of the payment reduces their upfront capital requirement and ties future payments to cash flow the business actually generates.
What Percentage of the Purchase Price Becomes an Earnout?
This varies significantly by deal size, industry, and how much disagreement exists on value.
| Earnout as % of Total Price | Common Scenario |
| 5-10% | Minor uncertainty, mostly a goodwill gesture to close the gap |
| 10-20% | Moderate risk area like a key customer renewal or recent growth trend |
| 20-30% | Significant valuation disagreement or unproven business attribute |
| 30%+ | High-risk deal where buyer needs major performance validation |
In my experience with lower middle market transactions, earnouts in the 10-20% range are the most common. Anything above 25-30% should give you pause. When a buyer wants to put a third or more of the purchase price at risk, you need to ask whether this deal truly reflects the value of your business or whether the buyer is shifting too much risk back to you.
The earnout percentage of purchase price matters because it determines how much of your payout depends on factors you may no longer control after closing.
And that’s the real tension in any earnout deal.
Protecting Yourself as a Seller in an Earnout Agreement
Once you hand over the keys, the buyer runs the business. They make the hiring decisions, the spending decisions, the strategic decisions. And those decisions directly affect whether you hit the earnout milestones.
This is where sellers get burned. Not because the buyer acted in bad faith, but because the earnout terms didn’t account for changes the buyer would naturally make after taking over.
Here’s how to protect yourself when negotiating earnout terms as a seller:
Define the metrics precisely. Don’t accept vague language like “the business performs at expected levels.” Tie the earnout to specific, measurable targets. Revenue of $X. EBITDA of $Y. Customer retention above Z%. The more specific, the less room for disagreement.
Restrict what the buyer can change. If your earnout is tied to EBITDA and the buyer loads the company with new overhead, allocates corporate expenses to your business unit, or redirects your sales team, your EBITDA drops through no fault of yours. Negotiate restrictions on material changes to the business during the earnout period. This is perhaps the most important protection you can get.
Establish clear accounting rules. Specify which accounting methods will be used to calculate the earnout metrics. If the buyer switches from your current method to a different one, the numbers can shift significantly without any actual change in performance.
Include dispute resolution provisions. Disagreements over earnout calculations happen frequently. Your agreement should specify how disputes get resolved, whether through a third-party accountant, arbitration, or another mechanism. Without this, you’re looking at potential litigation.
Negotiate a floor or minimum payment. Some sellers negotiate a minimum earnout payment regardless of performance. This doesn’t always work, but it’s worth pursuing. Even a partial floor reduces your downside risk.
Protecting yourself in an earnout deal isn’t about being adversarial. It’s about making sure the agreement reflects reality and accounts for the fact that you won’t be making the decisions anymore.
When Earnouts Actually Benefit the Seller
I want to be clear about this. Earnouts aren’t inherently bad for sellers.
In some deals, accepting an earnout provision lets you capture value that a buyer would never agree to pay upfront. If your business has been growing 20% year over year and you believe that trajectory will continue, an earnout lets you get paid for that future growth rather than accepting a price based only on trailing performance.
I’ve seen sellers earn significantly more through well-structured earnouts than they would have received in an all-cash deal. The total payout exceeded the buyer’s initial offer because the business performed above the agreed targets.
Earnouts can also save deals that would otherwise fall apart. If you and the buyer are $1.5 million apart on price and neither side will budge, an earnout tied to reasonable milestones keeps the transaction alive. Walking away from a good deal over a valuation gap that an earnout could bridge doesn’t serve anyone.
The question isn’t whether to accept an earnout. The question is whether the specific terms protect your interests and give you a realistic path to earning the full payout.
The Role Your M&A Advisor Plays in Earnout Negotiations
Earnout negotiations are where an experienced M&A advisor earns their fee.
The language in an earnout agreement is technical and the implications are significant. Your advisor should be reviewing the proposed milestones, the measurement methodology, the restrictions on buyer behavior, and the dispute resolution process. They should also be pushing back on terms that shift too much risk to you.
I’ve negotiated earnout structures where the initial buyer proposal would have made it nearly impossible for the seller to earn the full payout. Not because the business couldn’t perform, but because the measurement terms were stacked against the seller. That’s not bad faith on the buyer’s part. It’s just each side protecting their interests. But you need someone in your corner who understands how these provisions play out in practice.
Your attorney should review the legal language. Your M&A advisor should review the business logic. Both perspectives matter.
FAQ
How do earnouts work in a business sale?
An earnout is a portion of the purchase price paid after closing, contingent on the business meeting specific performance targets. The buyer pays part of the price at closing and the remainder over a defined period, typically one to three years, based on metrics like revenue or EBITDA. If the targets are met, the seller receives the full earnout amount.
What percentage of the purchase price is typically structured as an earnout?
In lower middle market transactions, earnouts commonly represent 10-20% of the total purchase price. The percentage depends on the level of risk or disagreement between buyer and seller. Smaller earnouts of 5-10% may bridge minor gaps, while larger earnouts above 25-30% signal significant valuation uncertainty.
How can a seller protect themselves in an earnout agreement?
Negotiate specific and measurable performance targets, restrict the buyer’s ability to make material changes that would affect earnout metrics, establish clear accounting rules for calculating performance, include dispute resolution mechanisms, and pursue a minimum floor payment where possible. Having both an M&A advisor and attorney review the terms is critical.
What happens if the buyer changes the business and the earnout milestones aren’t met?
Without protective language in the agreement, you may have limited recourse. This is why negotiating restrictions on buyer behavior during the earnout period matters so much. If the buyer adds overhead, redirects resources, or changes accounting methods, your earnout metrics can suffer through no fault of yours. Build these protections into the agreement before signing.
Should I walk away from a deal that includes an earnout?
Not necessarily. Earnouts are a standard tool in M&A transactions and can benefit sellers when structured properly. The question is whether the terms are fair, the milestones are achievable, and you have adequate protections. Walk away if the earnout shifts an unreasonable amount of risk to you or if the terms make it unlikely you’ll ever receive the full payout.
Make Sure the Earnout Works for You
Earnouts are a legitimate part of M&A deal-making. They bridge valuation gaps, manage risk for buyers, and can help sellers capture value they’d otherwise leave behind. But the details matter more than the concept.
Before you agree to any earnout provision, make sure you understand exactly what’s being measured, how it’s being measured, and what the buyer can and can’t change during the earnout period. Build in protections. Define your metrics clearly. And work with advisors who have negotiated these structures before.
The sellers who come out ahead in earnout deals are the ones who treated the earnout terms with the same seriousness as the purchase price itself.
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