An earnout agreement ties part of the purchase price of a business to how the business performs after the sale. It can help bridge a gap between what a seller wants and what a buyer is willing to pay up front, but it can also lead to disputes if it is not drafted carefully.
What an earnout agreement is
In an earnout, the buyer pays an agreed amount at closing and promises additional payments later if the business reaches defined targets, such as revenue or profit over a set period. The seller gets a chance at a higher total price, and the buyer shares the risk that the business will not perform as hoped.
Earnouts are most common when the future of the business is uncertain or when the buyer and seller disagree about its value.
When an earnout agreement makes sense
Earnouts can help when a business is growing, depends heavily on the current owner, or has recent changes that make past results a poor guide. They are less suitable for stable businesses with clear earnings, where a simple price is easier.
Compare the idea with other structures, such as seller financing, which our guide to deal structures explains.
Terms to define clearly
Most disputes come from vague language, so be specific about every measure and rule.
- The metric used, such as revenue, gross profit, or net profit
- How the metric is calculated and which expenses count
- The measurement period and payment dates
- Caps and minimums on the earnout payments
- Who controls the business during the earnout period
- What happens if the business is sold or the buyer changes strategy
Risks for sellers
After closing, the buyer controls the business, and decisions that affect the target may no longer be yours. Sellers should ask for covenants that prevent the buyer from deliberately reducing results, and for rights to review financial reports.
Consider how much of the price you can afford to leave dependent on future performance, and weigh that against the benefit of a higher potential total.
Risks for buyers
Buyers must be able to run the business as they see fit, but still honor the agreement in good faith. Large earnouts can create conflict if the seller stays involved and disagrees with changes. Make sure the metric cannot be gamed and that disagreements go to a defined resolution process.
Get advice on any earnout agreement
An attorney and an accountant experienced in business sales should review the earnout agreement before anyone signs. Clear definitions and good records protect both sides, and a short investment in advice can prevent costly disputes later.
More reading on the earnout agreement and deal structure
- How to Buy an Existing Business: A Due Diligence Guide
- How to Value a Business Before You Buy: Multiples and Seller’s Discretionary Earnings
- Working With a Business Broker: How to Find One and What It Costs
- SBA guide to planning your business
- How to Find a Business for Sale: Where to Look First
- Letter of Intent for a Business Purchase: What It Should Say
- How to Sell a Distributorship: Prepare, Price, and Transfer
For more background: Deloitte.
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