Somewhere in the middle of almost every deal that doesn't close at a flat purchase price, the word “earn-out” shows up. For owners who have never sold a business before, it sounds like a reasonable compromise: you get paid now, and you get paid more later if the business keeps performing. In practice, an earn-out is one of the more complicated pieces of a sale, and it's worth understanding exactly what you're agreeing to before you sign a letter of intent that includes one.
Buyers use earn-outs to bridge a gap in what the business is worth. That gap usually comes from one of two places: the buyer isn't fully convinced the seller's numbers will hold up once ownership changes, or the business depends heavily on the seller personally and the buyer wants assurance that customers, staff, and operations will transition smoothly before paying full price.
From the seller's side, an earn-out can make sense too. If you believe in where the business is headed, tying part of the price to future performance can close a valuation gap without either side having to simply split the difference and hope for the best.
The earn-out is only as good as the metric it's tied to, and this is where a lot of deals go sideways after closing. Revenue-based earn-outs are simpler to track but can reward a buyer who discounts pricing to hit volume targets they don't actually care about long term. Profit-based earn-outs are more aligned with what the seller is really owed, but profit is easy to move around once a new owner controls the books, allocating overhead, salaries, and corporate charges in ways that quietly shrink the number the earn-out depends on.
Whatever the metric, it needs to be defined in the purchase agreement in enough detail that there's no argument a year later about how it's calculated. That includes who keeps the books during the earn-out period, how disputes get resolved, and whether the seller has any visibility into the financials while the clock is running.
Once the deal closes, the buyer runs the business. That's the part sellers underestimate most. You can negotiate the best earn-out formula in the world, but if you have no say in staffing decisions, pricing, capital spending, or how the business is operated day to day, you're betting a meaningful piece of your sale price on someone else's decisions.
This is why experienced sellers push for operating covenants during the earn-out period: commitments from the buyer not to materially change the business, redirect customers to other divisions, lay off key staff, or cut the marketing and investment that keeps the numbers moving. Without some version of these protections, an earn-out can become a number that's effectively impossible to hit, regardless of how the deal was pitched during negotiations.
Earn-out periods in the deals I see typically run somewhere between one and three years. Longer periods give more time for the business to prove itself, but they also mean more time where the seller's final payout depends on someone else's management. Shorter periods reduce that risk but may not be enough time to demonstrate the kind of performance the buyer wants to see before releasing full value.
The portion of the deal tied to the earn-out matters just as much as the timeline. An earn-out that represents a small piece of the total price is a reasonable way to bridge a valuation gap. An earn-out that makes up a large share of what you're actually getting paid is a different kind of risk, and it deserves a different level of scrutiny before you agree to it.
Get the definition of the earn-out metric in writing, with examples of how it would have been calculated using the business's actual historical numbers. Ask who controls the business during the earn-out period and what commitments the buyer is willing to make about how it will be run. Understand what happens if the business is sold again, merged, or restructured before the earn-out period ends, since that can eliminate the very performance the earn-out was supposed to reward.
An earn-out isn't a reason to walk away from a deal, and it's not something to accept on faith either. It's a negotiated piece of the purchase price, and it deserves the same scrutiny you'd put into the base number. Understand exactly what you're agreeing to measure, who's measuring it, and how much control you're giving up to get there, and you'll know whether the earn-out is bridging a real gap or just deferring a disagreement about value to a date down the road.
Thinking through a sale, a succession plan, or what your business might be worth? A conversation costs nothing and stays confidential.
Connect with Scott →