Why Are Buyers Obsessed with Earnouts?
An In-Depth Guide to Earnouts in M&A: How They Work, Why Buyers Love Them, and What Sellers Need to Watch Out For
Understanding Earnouts in M&A
If you’re selling your business, you’ve likely heard buyers throw around the term earnout. But what does it really mean? Why do buyers insist on them, and are they always a good deal for sellers?
Earnouts are performance-based payments in mergers and acquisitions (M&A) where a portion of the purchase price is contingent on the business meeting specific financial or operational milestones post-sale. This deal structure is particularly common in SME acquisitions, where buyers and sellers often struggle to agree on valuation. Earnouts create a bridge—offering sellers the potential for higher payouts while giving buyers a safety net.
But before you commit to an earnout, it’s critical to understand both its benefits and risks. Let’s break it down.
How Earnouts Work in Business Sales
Earnouts are structured as additional payments made to the seller if certain performance conditions are met. These can be tied to:
Revenue-Based Earnouts
Payments triggered when the company hits specific revenue targets.
EBITDA or Profit-Based Earnouts
The seller gets paid when the business achieves a defined profit or EBITDA level.
Client Retention or Performance-Based Earnouts
Earnouts linked to customer retention, staff retention, or product milestones.
Typically, earnouts last between 1 to 5 years, giving sellers an incentive to help transition the business smoothly while ensuring buyers don’t overpay for a company that underperforms.
Why Buyers Love Earnouts
1. Risk Mitigation
Buyers use earnouts to protect themselves from overpaying. If the acquired business fails to meet performance expectations, the buyer isn’t on the hook for the full purchase price.
2. Bridging Valuation Gaps
Sellers often base their price on future potential, while buyers rely on historical performance. Earnouts help reconcile these differences, ensuring that any premium price is earned, not just promised.
2. Preserving Cash Flow
With part of the payment deferred, buyers can allocate capital more efficiently, keeping funds available for working capital, expansion, or other investments.
2. Ensuring Seller Commitment
Most earnouts require the seller or key management to stay involved post-sale to help the company hit performance targets. This ensures continuity, reducing the risks of a messy transition.
Benefits and Risks of Earnouts for Sellers
Benefits for Sellers
- Potential for Higher Payouts – If the business performs well, earnouts can significantly increase the seller’s total compensation.
- Validation of Business Valuation – Sellers can prove their growth projections were accurate, leading to bigger payouts.
- Smoother Transition – Staying involved post-sale helps integrate the business under new ownership.
Risks for Sellers
- Uncertain Payouts – Market downturns, operational challenges, or buyer mismanagement could prevent sellers from receiving their full earnout.
- Potential for Disputes – Differences in financial reporting, unexpected expenses, or strategic shifts can impact earnout calculations, leading to disagreements.
- Loss of Control – Once the business is sold, the buyer makes decisions that could directly impact whether the earnout is achieved.
Real-World Examples of Earnouts
Example 1: Healthcare M&A Earnout
A private equity firm acquired a chain of specialty clinics for $50M, with a $10M earnout tied to patient volume growth over two years. The sellers successfully maintained operational excellence and received the full $10M earnout payout.
Example 2: Tech Industry Earnout
A SaaS startup with $5M in revenue was acquired for $20M upfront + $10M earnout over three years. The founder stayed on as a consultant to oversee integration. Due to shifting market conditions and strategic pivots by the buyer, only $6M of the earnout was ultimately paid.
How to Structure a Successful Earnout Agreement
Clearly Defined
Performance targets, payment schedules, and metrics must be precise to prevent conflicts.
Realistic & Achievable
Overly ambitious targets often lead to disputes and missed payouts.
Fairly Measured
Sellers should negotiate protections to prevent buyers from artificially manipulating financials to avoid payout obligations.
Time-Bound
The earnout period should be reasonable, ensuring accountability without long-term entanglements.
Final Thoughts: Are Earnouts a Win-Win?
Earnouts have become a go-to tool in M&A deals, offering a balance between seller upside and buyer risk mitigation. While they provide a chance for sellers to maximize their deal value, they also come with uncertainty.
For sellers
Earnouts can be a great way to secure a higher price—but only if structured carefully with legal and financial safeguards.
For Buyers
They provide a safety net and ensure performance-based payments, but must be managed transparently to avoid disputes.