Earnouts in Business Sales: What Main Street Sellers Need to Know (and Watch Out For)

Back in January 2023 we wrote a short article explaining earnouts entitled Resolving Valuation Deadlocks in M&A: The Strategic Role of Earnouts HERE>. Now, let’s dig in a little more detail on earnouts to cap out 2024!

Picture this: You’ve built a solid HVAC business doing $2 million in revenue annually, and you’re ready to sell. A buyer offers $4 million, but you believe it’s worth $5 million based on your growth trajectory. Instead of walking away, you agree on a $4 million base price plus a $1 million earnout if the business hits $2.5 million in revenue next year. Sound appealing? It can be, but earnouts are trickier than most Main Street sellers realize.

What Exactly Is an Earnout?

An earnout is a “pay me later if the business performs” arrangement. Instead of getting all your money at closing, you receive a base amount upfront, with additional payments tied to future performance milestones. Think of it as the buyer saying, “I’ll pay you the extra money you want, but only if the business proves it’s worth it after I own it.”

Most earnouts run 1-5 years (typically 3 years) and can be based on revenue, profit, customer retention, or other measurable goals. The key word here is “measurable”, vague targets like “significant growth” are a recipe for disputes.

Why Earnouts Exist (And Why Buyers Love Them)

Earnouts solve a common problem in business sales: valuation disagreements. You know your business intimately, you see the untapped potential, the loyal customer relationships, the growth opportunities. The buyer sees financial statements and wonders if past performance predicts future results.

Rather than fight over price, earnouts let both parties bet on the business’s future. If you’re right about the growth potential, you get paid for it. If not, the buyer didn’t overpay.

From the buyer’s perspective, earnouts are fantastic risk management. They get to own and operate your business while you bear some of the performance risk. They also preserve cash at closing and ensure the seller has “skin in the game” if they’re staying involved post-sale.

The Seller’s Upside: When Earnouts Work in Your Favor

Higher Total Sale Price: Earnouts can bridge significant valuation gaps. That $1 million difference in our HVAC example might be impossible to negotiate directly but achievable through performance milestones.

Confidence in Your Business: If you genuinely believe your business will outperform current metrics, an earnout lets you profit from that confidence. It’s particularly powerful if you’ve been conservative with growth investments or see clear expansion opportunities.

Smoother Negotiations: Buyers often accept higher total valuations when part of the price is contingent. It removes the pressure of justifying maximum value upfront.

The Dark Side: Major Risks Every Seller Must Understand

Here’s where things get complicated, and frankly, where most sellers get burned.

Risk #1: Earnouts Aren’t Guaranteed Money

The biggest mistake sellers make is counting earnout payments as guaranteed income. They’re not. Market downturns, integration challenges, management changes, or simple bad luck can prevent you from hitting targets through no fault of your own. Always plan financially as if you’ll only receive the base purchase price.

Risk #2: You Lose Control Over Your Own Success

Once you sell, the buyer controls operations, staffing, pricing, marketing, everything that affects performance. They might cut costs to improve short-term profitability, hurting revenue growth. They might integrate your business with theirs, making earnout calculations impossible. You’re depending on someone else’s decisions to determine your payout.

Risk #3: Revenue vs. Profit Metrics Create Major Disputes

This is where sellers get outmaneuvered most often. Sellers prefer revenue-based earnouts because revenue is straightforward to calculate and harder for buyers to manipulate. Buyers prefer profit-based earnouts (EBITDA, net income) because they account for the true economics of the business.

Here’s the problem: A buyer can easily reduce profitability post-closing by increasing management salaries, adding corporate overhead charges, or making discretionary investments, all legitimate business decisions that kill your profit-based earnout.

Risk #4: The “Sliding Scale” Trap

Many earnouts include partial payments if you hit, say, 80% of the target. Sounds fair, right? In practice, buyers often structure these so you receive little or nothing unless you hit 90-95% of the goal. Miss the target by $100,000? You might lose a $500,000 earnout entirely.

Red Flags: When to Walk Away from Earnout Deals

• Integration Plans: If the buyer plans to immediately integrate your business with theirs, earnout calculations become subjective and disputed.
• Vague Metrics: Targets like “maintain customer satisfaction” or “achieve growth” are lawsuit magnets.
• Unrealistic Timelines: One-year earnouts rarely account for normal business fluctuations.
• Buyer Financial Weakness: If the buyer might not be able to pay the earnout even if earned, you’re adding credit risk to performance risk.
• No Seller Involvement: If you’re not staying with the business post-closing, you have zero influence over earnout achievement.

What Every Seller Must Negotiate

When structuring an earnout, fight for these protections:

Clear, Objective Metrics: Insist on specific, measurable targets with detailed calculation methods. Define exactly what revenue, EBITDA, or other metrics include and exclude.

Baseline Operations Covenant: Require the buyer to operate the business in a manner consistent with past practices. This prevents them from making changes specifically designed to reduce earnout payments.

Regular Reporting: Demand monthly or quarterly reports on earnout progress with the right to audit calculations.

Escrow or Security: Consider requiring the buyer to escrow earnout amounts or provide security for payment obligations.

Dispute Resolution: Include specific arbitration procedures for earnout disputes rather than expensive litigation.

The Seller’s Earnout Protection Checklist

Before agreeing to any earnout structure:

• Have your attorney review all earnout calculation methods and definitions
• Understand exactly what the buyer can do post-closing that might affect your earnout
• Negotiate revenue-based metrics whenever possible, or strong profit metric protections
• Ensure you have ongoing access to business performance data
• Include “carve-outs” for extraordinary expenses or buyer-driven cost increases
• Set realistic minimum performance thresholds (not 95% of target)
• Consider whether you need to remain involved post-closing to protect your interests
• Verify the buyer’s financial capacity to pay earnouts when due
• Plan your personal finances assuming you’ll only receive the base purchase price

Making the Right Decision for Your Situation

Earnouts work best when you’re selling to a buyer who plans to operate your business as a standalone entity, when you’ll remain involved post-closing, and when the performance metrics are genuinely outside the buyer’s ability to manipulate.

They’re problematic when buyers plan immediate integration, when you’re exiting completely, or when the earnout represents money you need for retirement or other commitments.

Remember: an earnout is essentially seller financing with performance conditions. You’re giving the buyer time to pay while they control the factors that determine whether they have to pay. Make sure the base purchase price reflects fair value for your business as it stands today.

Every earnout negotiation should involve experienced legal counsel who understands the nuances of performance-based consideration and can structure protections that actually work in practice.