- An earnout makes part of the purchase price payable after closing only if the business meets agreed performance targets.
- Buyers often propose earnouts to bridge a valuation gap and reduce their exposure if projected results do not materialize.
- An earnout agreement shifts risk to you because the buyer may control operating decisions and accounting after closing.
- Most earnout structures use revenue or EBITDA, which measures operating profit before interest, taxes, depreciation, and amortization.
- Escrows and holdbacks address potential claims tied to the transaction. They do not depend on the company meeting future performance targets.
What an Earnout Is and Why Buyers Propose One
An earnout makes part of the purchase price payable after closing only if the business reaches agreed financial or operating targets, a mechanism defined in Salt Creek’s broader M&A glossary. Its value to a seller depends on who controls performance after closing and how precisely the agreement defines the payout calculation. The buyer pays the fixed portion at closing and pays the contingent portion later if the business meets the contract’s conditions. Unlike a seller note, an earnout does not create an unconditional payment obligation.
Buyers often propose earnouts when they accept the business’s current value but question its projected growth. For example, an owner may value the company at $8 million based on expected customer wins, while the buyer supports a valuation of only $6 million based on historical results. The parties could place the remaining $2 million in an earnout tied to those customer wins or the resulting revenue. Earnouts can bridge valuation gaps when projections or comparable transactions provide limited support.
An earnout also limits the buyer’s risk on future performance. If the company reaches the negotiated targets, the buyer pays the additional amount. If performance falls short, the buyer keeps some or all of that amount. The buyer may also reduce the cash and financing required at closing.
An earnout is one piece of the larger lower middle market M&A process, and sellers should treat contingent consideration as risk retained after the sale, rather than as a bonus. The buyer usually controls the company’s budget and staffing after closing. The buyer’s accounting policies and other operating decisions can also affect the payout calculation. When you compare offers, separate guaranteed cash at closing from the earnout’s potential value and assess how much control you will have over the result.
Revenue-Based vs. EBITDA-Based Earnouts
Revenue-based earnouts generally give sellers more protection from post-closing expense decisions, while EBITDA-based earnouts give buyers a clearer measure of profitability. A revenue-based earnout ties payment to sales the business generates during an agreed period after closing. The contract may require the business to exceed a minimum revenue threshold or may increase the payout as revenue rises. Sellers often prefer revenue because operating expenses and financing decisions do not directly reduce the calculation.
Revenue still requires a precise definition. An earnout agreement should explain how the buyer will recognize revenue and treat refunds. It should also cover customer credits and sales involving other buyer-owned companies. Without those rules, the parties may calculate revenue differently even when they use the same financial records.
EBITDA-based earnouts tie payment to earnings before interest, taxes, depreciation, and amortization, the same metric covered in Salt Creek’s EBITDA and business valuation basics. Buyers often prefer EBITDA because it measures whether revenue produces operating profit. The parties may set a fixed target or a graduated payout. They can also base payment on EBITDA above an agreed threshold.
Adjusted EBITDA can create more room for disagreement than revenue. After closing, the buyer usually controls the profit and loss statement, often called the P&L. The buyer may change staffing or marketing spending. It may also allocate corporate overhead to the acquired company. Each decision can lower EBITDA even when sales remain steady.
Sellers should therefore focus on which party controls the decisions that affect the earnout metric. Revenue offers the seller more protection against changes in the cost structure, although the buyer still controls pricing and sales investment. EBITDA gives the buyer a clearer measure of profitability, but the contract should state how the buyer will treat expenses and shared services. It should address acquisition-related costs separately.
The company’s revenue model and cost structure should guide the choice of earnout metric. Revenue targets may fit subscription software and service businesses where recurring sales provide a useful measure of continued performance. EBITDA targets may fit established companies with predictable margins and a stable cost base. Life sciences transactions often use product or regulatory milestones instead of either financial measure.
Revenue remains the most common financial earnout metric, followed by earnings or EBITDA, according to a review of recent M&A deal studies. Neither structure protects a seller by itself. Clear calculation rules and limits on post-closing accounting changes determine how much confidence you can place in the potential payout.
Escrow and Holdback as a Separate Risk Tool
Escrow and holdback provisions reserve part of an agreed purchase price to cover defined post-closing claims. Buyers may use these funds for indemnification claims, such as losses caused by an undisclosed liability or a breach of the seller’s statements in the purchase agreement. Unlike an earnout, payment does not depend on future revenue, profitability, or another operating result.
An escrow places the reserved funds with a neutral third-party agent, usually a bank or trust company. The escrow agreement sets the claim and dispute procedures. It also states when the agent will release the funds. A holdback leaves the money with the buyer, which exposes the seller to the buyer’s credit risk. Sellers often prefer escrow because the buyer does not control the funds directly.
A preliminary business valuation can help you gauge how much of an offer is likely to be structured as cash versus contingent consideration before negotiations start. The parties set the escrow amount and duration based on the potential claims and their negotiating power. Versailles Group guidance on escrow accounts and holdbacks cites escrow amounts around 10% to 20% of the purchase price and holding periods of 12 to 24 months, though specific terms can fall outside those ranges. A buyer may also use a separate holdback for one identified matter, such as a pending tax dispute.
The agreement should explain what qualifies as a claim and how much money remains reserved while the parties resolve it. Without a valid claim, the escrowed amount generally goes to the seller when the agreed period ends. Broad claim definitions or notices submitted near the release date can delay payment.
Representations and warranties insurance (RWI) can cover certain losses caused by inaccurate seller statements. RWI may reduce the amount held in escrow, but policies often exclude known issues. Buyers may still require a smaller escrow or a specific holdback for risks the policy does not cover.
Non-Financial Triggers and Payout Formulas
Unlike escrow release conditions, earnout triggers measure post-closing performance. Customer retention triggers measure whether specified customers are retained or a stated percentage of recurring revenue remains after closing. Product and regulatory milestones can trigger payment when the business completes development or receives regulatory approval. The parties may also tie payment to another defined event. Earnouts increasingly combine financial targets with non-financial benchmarks, particularly when future value depends on an identifiable commercial or regulatory event.
Each trigger can support an all-or-nothing payout or a graduated payment that rises as performance improves. EBITDA commonly generates more disagreement because expenses and accounting judgments affect the result. Revenue can also create disputes over recognition timing, while loosely defined product or regulatory milestones leave room for competing interpretations. Metrics lower on the income statement generally involve more judgment, so precise definitions and calculation rules deserve close attention before signing.
When an Earnout Is Likely to Appear in a Deal
Earnouts are most likely when projected results depend on events the company has not yet demonstrated through its operating history. Buyers may seek one when recent growth exceeds the pace supported by the company’s historical results, or when future results depend heavily on a new product, customer conversion, or expansion plan. Earnouts often address uncertainty in revenue, earnings, or growth prospects, according to an A&O Shearman memo published by Harvard Law School.
Business size influences the discussion, but size alone does not determine deal structure. A smaller founder-led company may depend heavily on its owner or a few customers. Less developed financial reporting can also make projected performance harder for a buyer to verify. A larger company can still face an earnout when its valuation relies on results that historical earnings do not yet support.
Buyer type can affect the proposed terms, and the tradeoffs differ enough between acquirer types to warrant a separate look at strategic buyers versus private equity buyers. A strategic buyer may tie payment to customer retention or a product milestone. It may instead use the company’s performance after integration. Private equity firms and their portfolio companies commonly use earnouts for founder-led acquisitions and add-ons when projected growth exceeds the results supported by diligence, according to an overview of earnouts in M&A. An independent sponsor may also propose an earnout to reduce the cash required at closing.
In a sponsor-backed deal, you should identify the legal entity responsible for payment. An acquisition subsidiary or portfolio company may owe the earnout rather than the private equity fund. The purchase agreement should address guarantees and available capital. It should also cover debt restrictions and the consequences if the buyer refinances or sells the company.
A clean cash-at-closing deal becomes more likely when the buyer and seller agree on value and historical performance supports the forecast. Due diligence findings should indicate little additional uncertainty. Competitive buyer interest can also improve your ability to reject contingent consideration, although the strongest offer may still combine upfront cash with other forms of payment.
Comparing Earnout and Escrow Structures
Earnouts expose the seller to post-closing performance risk, while escrows and holdbacks reserve an already agreed purchase price for transaction-related claims. The headline purchase price therefore does not show how much payment risk the seller retains.
| Structure | Payment trigger | Typical duration | Seller risk | Best-fit deal situations |
|---|---|---|---|---|
| Revenue-based earnout | Business reaches agreed revenue thresholds | Set by the purchase agreement | Moderate, since buyer decisions can affect sales | Growth businesses where revenue provides a clearer measure than profit |
| EBITDA-based earnout | Business reaches agreed earnings targets before interest, taxes, depreciation, and amortization | Set by the purchase agreement | Higher, since spending and accounting choices affect EBITDA | Businesses with stable margins where profitability drives valuation |
| Escrow or holdback | Funds are released after the claim period ends or defined conditions are satisfied | Commonly 12 to 24 months | Exposure to covered claims; a holdback also adds buyer credit risk | Indemnification obligations or defined post-closing claims |
How Earnout Disputes Arise and What Sellers Can Negotiate
Earnout disputes often begin when the purchase agreement leaves room for two reasonable interpretations. Revenue and adjusted EBITDA need precise definitions. The same applies to customer retention and milestone completion. The agreement should define the measurement period and accounting method, and it should list all inclusions and exclusions. For example, the parties should decide before closing whether acquisition costs or new corporate overhead will reduce EBITDA.
Accounting judgment creates greater risk when the earnout depends on EBITDA. A buyer may change when it recognizes revenue or how it classifies an expense. It may also allocate shared costs to the acquired business. Kroll notes that metrics lower on the income statement generally involve more adjustments and measurement ambiguity. Sellers can request calculations that follow the company’s historical accounting practices, along with detailed schedules that explain each adjustment.
Information access becomes another source of disagreement because the buyer controls the books after closing. Without review rights, you may receive a payout statement but lack the records needed to test it. An earnout agreement can give you a defined review period and access to relevant financial records and personnel. The agreement should also explain how you submit a written objection and how long both parties have to negotiate.
Buyer operating decisions can reduce the earnout metric even when the underlying business remains healthy. A buyer might defer a customer contract or move sales to another subsidiary. It might also cut marketing spending or assign new corporate charges to the acquired company. Operating covenants can require separate records and agreed operating practices, and they can bar the buyer from diverting customers or revenue. Sellers may also seek accelerated payment if the buyer sells the business or takes an action that makes the earnout impossible to calculate.
A defined dispute process can keep an accounting disagreement from becoming broader litigation. The agreement can appoint an independent accounting firm to decide specific disputed line items after direct negotiations fail. Davis Wright Tremaine’s guide to earnout disputes describes a common process in which the accountant issues a binding decision, subject to a narrow exception for clear error. The contract should state how to select the accountant and define the scope of review. It should also set the deadline and allocation of fees before either party knows which side will benefit.
Explore Your Deal Structure Options With Salt Creek
Treat an earnout as risk retained after the sale, not as cash already earned. Compare guaranteed consideration at closing with the earnout’s risk-adjusted value, accounting for payment probability, timing, and limits on the buyer’s control over the result.
A lower all-cash offer may be more valuable than a higher headline offer if the buyer controls the earnout metric or the agreement provides weak payment protections. Before choosing an offer, compare both the expected proceeds and the obligations you will retain after closing.
Where Salt Creek Advisory May Fit
You can have a confidential conversation with Jack and Connor Pitts at Salt Creek Advisory before entering negotiations or accepting an offer. Jack and Connor work directly with owners throughout the transaction. At Salt Creek Advisory, we use a success-fee model with no upfront retainer for standard M&A engagements.