Earn-outs can be a useful tool in M&A negotiations—but they’re also one of the most misunderstood and misused.
Done right, an earn-out aligns incentives and bridges valuation gaps. Done poorly, it creates tension, distracts from growth, and sparks legal disputes.
So how do you know when an earn-out is the right move—and when it’s better to steer clear?
Let’s break down the risks, rewards, and real-world use cases.
What Is an Earn-Out?
An earn-out is a deferred payment to the seller, contingent on the business hitting certain post-close performance targets.
Example: You agree to buy a business for $2M—$1.5M at close, with the remaining $500K payable over two years if revenue exceeds a set threshold.
Earn-outs can be structured around:
- Revenue growth
- EBITDA or net income
- Customer retention or expansion
Milestone-based goals (like launching a new product or renewing a key contract)
Why Buyers Like Earn-Outs
Bridge the Valuation Gap
Sellers often price their business based on potential. Buyers price it based on actuals. Earn-outs help bridge that gap.
Instead of overpaying based on seller projections, you tie part of the purchase price to actual performance.
Reduce Risk at Close
By deferring part of the payment, you reduce upfront capital needs and protect against downside. If the business underperforms, you’re not on the hook for the full price.
Keep the Seller Engaged
If the seller is staying involved short-term, an earn-out can incentivize them to keep pushing.
Why Earn-Outs Often Go Wrong
Misaligned Expectations
Sellers may assume they’ll hit the targets easily. Buyers may expect a buffer. If there’s no shared definition of success, disputes follow.
Control and Influence
If the seller is no longer running the business, they may feel outcomes are out of their hands. If they’re still involved, they may make decisions that prioritize short-term gain over long-term value.
Measurement Disputes
How will you calculate revenue? What counts as an expense? Are new initiatives included or excluded? Without clear definitions, things get murky fast.
Legal Complexity
Earn-outs add layers to your purchase agreement. That means more negotiation, more legal fees, and potentially more friction if performance falls short.
When Earn-Outs Make Sense
The Seller Will Stay Involved
Earn-outs are most effective when the seller has continued influence over the outcome—especially in sales, operations, or customer retention.
There’s a Clear Path to the Target
The best earn-outs are tied to metrics that are straightforward to track and hard to dispute. Think: recurring revenue, gross profit, or specific contract renewals.
There’s a Real Valuation Gap
If both sides want to do the deal but disagree on price, an earn-out can move you from stalemate to signed LOI.
There’s Trust
Earn-outs require transparency, open communication, and a good-faith partnership. If there’s tension or mistrust early on, it will only get worse post-close.
When to Avoid Earn-Outs
The Seller Is Exiting Immediately
If the seller won’t have influence post-close, tying compensation to performance can create resentment or unrealistic expectations.
The Business Is Highly Variable
If revenues fluctuate significantly month-to-month, or performance is tied to seasonality or external factors, earn-outs become harder to track and justify.
There’s No Clear Measurement Framework
Vague or subjective targets are a recipe for trouble. If you can’t define it clearly in the contract, don’t tie money to it.
The Cost of Disputes Outweighs the Benefit
In smaller deals, the legal costs of structuring and potentially enforcing an earn-out may outweigh the value it provides.
How to Structure an Earn-Out Properly
- Be Clear on Metrics: Define revenue, profit, and any exclusions in detail.
- Keep It Simple: Avoid overly complex, multi-variable earn-outs that are hard to manage.
- Cap the Amount: Set a maximum earn-out payout so there’s no ambiguity.
- Align Timeframe: Tie the earn-out period to the expected transition timeline—usually 12–24 months.
- Clarify Dispute Resolution: Include clear language for resolving disagreements (mediation, arbitration, etc.).
- Use Escrow or Holdback If Needed: This can add credibility and enforceability.
Final Thoughts
Earn-outs aren’t good or bad—they’re a tool. The key is knowing when and how to use them.
If you’re facing a stubborn valuation gap, need seller support post-close, or want to hedge some risk, an earn-out can be the bridge.
But if you’re unsure about trust, control, or measurement, don’t force it. A clean deal is often better than a clever one.
