Earnouts Explained – and How to Avoid Them When You Sell
- Venture 7 Advisors
- Nov 18
- 4 min read
When it comes to structuring a business sale, every business owner wants to be paid in full at closing and every buyer wants to limit risk and conserve cash. The tension between those conflicting goals is often resolved through an earnout.
What is an earnout?
An earnout defers part of the purchase price and makes it contingent on the company’s performance after the sale.
For buyers, an earnout is an effective tool to:
Reduce the amount of cash they need at closing .
Shift post-closing business performance risk to the seller .
Provide the seller with an ego-boosting, high “purchase price”, but only if the business meets its targets.
Buyers portray earnouts as a tool to bridge valuation disagreements. In reality, an earnout is a risk-management tool for the buyer and it’s often a symptom of the seller’s weak negotiating position.
Earnouts are most likely to be included in a deal when:
There are only one or two buyers at the table.
The seller is negotiating without professional representation.
The business was poorly prepared for the market, allowing the buyer to see risks more clearly than value.
Earnouts typically account for 10% to 30% of the total acquisition price and they usually run for one to three years. Most earnout targets are related to revenue or earnings but targets may also include customer retention, staff retention, technical projects or any milestone that is meaningful to the buyer. Roughly 2/3rds of earnouts have multiple triggering events. For example, an earnout may be based a combination of revenue AND earnings or revenue AND completion of a key project.
Earnout structure – simple is better.
When earnouts are proposed, they should be kept as simple as possible. The more complex the formula, the more fertile the ground for disputes.
You can prevent earnout disputes after the closing by:
Defining every earnout target in plain language and referencing Generally Accepted Accounting Principles explicitly.
Aligning incentives by agreeing on a good-faith operation clause requiring the buyer to manage the business consistently with past practices and not to take actions primarily to avoid earnout payments.
Establishing quarterly reporting, a clear escalation path, and— if possible — naming a neutral accountant to certify results.
Earnout Risks for Sellers—and for Buyers.
In any earnout, most of the business and payment risk falls on the seller. The seller needs to manage these risks:
Loss of control: After closing, the buyer controls decisions that affect results, and therefore affect earnout payments.
Accounting manipulation: Changes in cost accounting, overhead allocations, revenue recognition and other accounting policies can impact how results are measured.
Delayed or denied payment: Earnout disputes may reduce or materially delay payment. If the buyer runs into financial difficulty, they may not be able to pay the earnout regardless of whether the targets were achieved.
Emotional toll: Watching others steer your company can be uncomfortable. When a substantial portion of your payout is dependent on their decisions, the stress is higher.
Sellers should attempt to balance those downside risks in the following ways:
Minimum floor payments should be established whenever possible.
Earnouts should allow for bonus payments if targets are exceeded.
The buyer should be required to secure earnout payments through escrowed funds or letters of credit to guarantee payment.
Earnouts present some risks to buyers as well, including:
Integration paralysis: Sellers may resist operational changes that could hurt short-term metrics. For example, consolidating manufacturing operations or migrating to the buyer’s ERP system could present risks to some earnout targets and be resisted by the seller.
Perverse incentives: Management might accelerate revenue or defer expenses to hit targets.
Relationship breakdown: Misaligned expectations and earnout disputes can erode trust and post-closing collaboration.
Conclusion
Earnouts aren’t evidence of creative deal-making—they’re evidence of weak seller negotiating leverage. Earnouts arise when sellers accept a buyer’s view of business valuation and risk. For most sellers, the goal of a sale isn’t merely closing a transaction; it’s converting years of work into secure, immediate wealth. The way to accomplish that is to plan well and create buyer competition for the business. When a well-prepared company is offered to a broad market, buyers offer their best price and terms, and accept post-closing business risks that might otherwise be transferred to the seller through an earnout.
To sell successfully and avoid earnout, you should:
Create an exit plan years before a planned sale. Early exit planning creates a more valuable company and a better-prepared owner.
Get A business valuation. Owners who understand their company’s market value can make changes to enhance that value, and enter the sale process with confidence.
Invest in accounting systems. When accounting systems are robust and accurate, buyers will see value and clarity instead of risk.
Resist the temptation to engage with unsolicited buyers. Buyers that approach you are hoping to exploit an inexperienced owner and acquire below market value.
Make buyers compete for your business. An experienced M&A Advisor will prepare your company well and create a confidential competitive market for your company — the single most effective way to avoid an earnout.
With strong representation, disciplined preparation, and buyer competition, sellers can—and usually do—avoid earnouts and walk away with most of the purchase price in cash at closing.
About Venture 7 Advisors:
Venture 7 Advisors is a team of merger and acquisition advisors who assist the owners of small and mid-sized companies to plan and complete the sale of their business. We find the best buyer to meet each business owner’s financial and legacy goals. We represent clients in consumer products, distribution, manufacturing, B2B services, construction, telecommunications, and eCommerce from offices in Burlington, Vermont, the Hudson Valley, New York, and Western Massachusetts.
We're here to talk about your situation, provide information, discuss your options, and put things in perspective. Contact us at any time:
Bryan Ducharme
Managing Partner
Mobile: 802 578 6462
