Earnouts have become increasingly common in Mergers and Acquisitions, especially as business valuations climb and fluctuate. In simple terms, an earnout is a provision in a purchase agreement that allows a seller to receive additional compensation after closing if certain performance milestones are met.
When structured carefully, an earnout can bridge the gap between what a buyer is willing to pay today and what a seller believes their business is worth tomorrow. But earnouts also introduce risk, complexity, and potential for conflict after the deal closes.
Before you sign on the dotted line, here are five key questions every seller should ask when considering an earnout:
1. What happens if I don’t hit the earnout target?
Earnouts are never guaranteed. Sellers should carefully evaluate the financial impact if the earnout metrics are missed. Even strong companies can experience short-term dips or operational shifts that make targets difficult to achieve. Ask yourself: Can I live with the base purchase price alone? If not, the deal may carry too much risk.
2. Are the performance metrics the right ones for my business?
Most earnouts are tied to financial measures like revenue, EBITDA, or net income. But these aren’t always the best indicators of performance. For some businesses, milestones such as product launches, customer growth, or project delivery timelines may better reflect success. The key is aligning the earnout metrics with how your business truly creates value.
3. How will the buyer’s post-closing plans affect my earnout?
Once the deal closes, the buyer controls the business, and their decisions could directly impact whether you hit your earnout. For example, if they cut staff, change pricing, or shift manufacturing, your performance numbers could be affected. Sellers should work with counsel to understand how operational changes might influence the earnout calculations.
4. Can I negotiate protections during the earnout period?
Some sellers are able to negotiate buyer covenants that prevent major changes to operations, pricing, or staffing during the earnout period. These provisions can help preserve fairness, but many buyers will resist them. You’ll need to determine whether limited operational covenants make sense for your situation.
5. Are the targets achievable or is it wishful thinking?
Earnouts can be emotionally appealing because they offer the promise of a higher total payout. But unrealistic targets lead to disappointment and disputes. Sellers should push for measurable, attainable milestones that reflect historical performance, not best-case scenarios.
The Bottom Line
Earnouts can make a deal possible, but only if they’re grounded in clear metrics, realistic targets, and fair operating conditions. Before agreeing to one, make sure you understand every assumption, risk, and variable that could impact your payout.
At Doida Crow Legal, we help sellers navigate complex M&A terms, from earnouts and working capital adjustments to buyer covenants and post-closing obligations. Our team ensures that what’s promised on paper can actually be achieved in practice.
Ready to discuss your deal? Contact us at info@doidacrow.com or (720) 306-1001.
