Why Earnouts Are Used
Buyers and sellers often disagree on what a business is worth — particularly when the seller's projections are more optimistic than the buyer's. An earnout lets both parties defer the dispute: "If you're right about the growth, you get paid more. If the buyer's model is right, they paid less." In theory it's elegant. In practice, it's complicated.
Earnouts are also common when:
- The business has a key customer relationship that may or may not transfer
- A key product launch or contract is pending at the time of sale
- The seller is staying in a management role post-close
- The acquirer wants to incentivize the seller to drive performance during transition
How Earnouts Are Structured
Most LMM earnouts are 1–3 years in duration, tied to EBITDA or revenue. Key variables:
- Metric: Revenue-based earnouts are simpler to measure; EBITDA-based earnouts create disputes about expense allocation under new ownership
- Threshold: The minimum level of performance required before any earnout is paid
- Cap: The maximum total earnout payment
- Payment timing: Annual vs. quarterly vs. at the end of the earnout period
Earnout Protections Sellers Should Negotiate
- Operating covenants — Buyer agrees to operate the business in a "commercially reasonable manner" and not make decisions solely to reduce earnout payouts
- Expense caps — Limits on new overhead allocated to the acquired business during the earnout period
- Dispute resolution mechanism — Independent accountant to resolve disagreements on metric calculations
- Anti-sandbagging clause — Prevents buyer from deliberately mismanaging the business in the earnout period
- Acceleration on change of control — If buyer sells the business during earnout period, seller gets paid out in full
When Earnouts Work vs. When They Don't
Work well: Revenue-based metric, short (12-month) duration, seller retains operational control, buyer is passive.
Work poorly: EBITDA-based metric, 3+ year duration, buyer integrates the business into a larger platform, seller has limited post-close decision rights.
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