Quick Answer: An earnout is a contingent payment in a business sale, tied to the company’s performance after closing. The buyer pays part of the purchase price at close and the rest becomes available if the business hits agreed-upon revenue, EBITDA, or milestone targets over the next one to three years. Earnouts are most often used to bridge a valuation gap between buyer and seller.
What Is an Earnout in a Business Sale?
An earnout is a contract provision that ties part of the purchase price in a business sale to the company’s performance after the deal closes. The seller receives a portion of the total consideration at closing, and the rest is paid later, only if the business hits specific financial or operational targets over a defined period.
In practical terms, an earnout splits the purchase price into two parts. The first is a guaranteed payment at close. The second is contingent: it gets paid only if the business achieves agreed-upon results, typically over one to three years. If the targets are missed, the contingent payments shrink or disappear. The mechanism is sometimes called a “win-win” structure, because it gives the buyer protection against overpaying and gives the seller a path to a higher total price.
For sellers, “what is an earn out” really comes down to a simple trade. You accept some uncertainty about part of the purchase price, in exchange for the chance to capture more total value than the buyer would otherwise pay up front.
Why Earnouts Are Used in M&A
Earnouts solve specific deal problems in mergers and acquisitions. The most common reasons a transaction uses one:
Bridging a valuation gap. This is the classic case. The seller believes the business is worth $4 million; the buyer believes it is worth $3 million. They can agree on a guaranteed $3 million at close, plus an earnout of up to $1 million paid over 1-2 years if the business hits specific performance targets. The seller has a path to their number; the buyer pays the higher price only if the business delivers what the seller promised.
Mitigating buyer risk. A buyer who has concerns, customer concentration, key-person dependence, an unproven product, integration uncertainty, can shift some of that risk to the seller by structuring part of the price as an earnout. If the risk materializes and earnings suffer, the buyer pays less.
Aligning incentives during transition. When the seller is staying on for a period after close, an earnout gives them a direct financial stake in continued success. Buyers value this alignment, particularly when the business depends on the seller’s relationships, expertise, or leadership.
Closing deals that would otherwise fail. Some transactions, particularly those involving high-growth businesses, distressed sellers, or buyer-seller insiders without enough cash to pay full value up front, simply cannot close on an all-cash basis. Earnouts make these deals possible.
Mitigating asymmetric information. When the buyer cannot fully verify the seller’s claims about future performance, even after a quality of earnings analysis, an earnout effectively says: “if your projections are right, you’ll be paid for them.”
How an Earnout Works: Structure and Typical Terms
While every earnout is custom to its deal, most share a similar architecture:
Earnout portion of purchase price. Earnouts typically represent 15% to 30% of the total deal value in lower middle-market transactions, though this can range higher (up to 50% or more) when the deal carries significant uncertainty or the valuation gap is large.
Performance metric. The single most important design choice. Options include revenue or top-line sales (simpler to measure, harder for the buyer to manipulate, generally favored by sellers), gross profit (a middle ground), EBITDA or net income (reflects bottom-line performance but is highly sensitive to how the buyer runs and integrates the business), and non-financial milestones (customer retention, product launches, regulatory approvals). Most experienced advisors lean toward simpler, top-line metrics. The more complex the calculation, the more disputes the structure invites.
Earnout period. Typically 1 to 3 years. Longer earnouts (5 years or more) exist but are rare and tend to generate disputes as the business naturally evolves under new ownership.
Caps, acceleration, and operating covenants. A cap limits the buyer’s total earnout exposure. Acceleration provisions pay the earnout in full on triggers like a subsequent sale or termination of the seller without cause. Operating covenants constrain how the buyer can run the business during the earnout period, preventing decisions that would defeat the earnout (shifting revenue elsewhere, loading the business with allocated costs).
What an Earnout Actually Pays: The Risk Sellers Should Know
The single most important data point for any seller considering an earnout is what they actually pay out historically. The numbers are sobering.
Studies of completed M&A transactions consistently find that:
- Roughly 60% of deals with earnouts result in any earnout payment at all.
- Among deals where any earnout is paid, the average payout is about half of the maximum possible amount.
- Across all U.S. deals using earnouts, the average payout is approximately 21% of the maximum potential.
In other words: a seller who signs up for a $1 million earnout should not plan on receiving $1 million. The realistic expectation is closer to a few hundred thousand, and there is a real chance of receiving nothing at all. This is not an argument against earnouts; it is an argument for negotiating the rest of the deal as if the earnout might not pay, and treating any earnout that does pay as upside.
Common Earnout Disputes (and How to Prevent Them)
While earnouts are simple in concept, they are one of the most-litigated provisions in M&A. The recurring sources of conflict:
Accounting interpretation. What counts as “revenue” or “EBITDA” can be defined many ways. Different cost allocations, different recognition timing, and different treatment of integration costs can swing the earnout payout substantially. The fix is precise language: define exactly which accounting policies apply, how disputes will be resolved, and which adjustments are or are not permitted.
Buyer decisions that affect performance. After closing, the buyer typically wants flexibility to run the business as they see fit, integrating systems, reorganizing teams, shifting strategy. Some of those decisions can directly affect the earnout. The fix is operating covenants that specify what the buyer can and cannot do during the earnout period.
Subjective metrics. Vague targets (“hit growth goals”) invite disputes. Specific, measurable, objective metrics tied to verifiable financial data are far more enforceable.
Implied good-faith claims. Even where the contract is silent, courts will often imply a duty of good faith and fair dealing, and sellers can sue if the buyer takes actions that they argue defeat the earnout. The fix is to address operating discretion explicitly in the contract rather than leaving it to be litigated.
The lesson is consistent across decades of earnout litigation: simpler structures with crisp, objective metrics produce fewer disputes than complex, multi-variable formulas.
When to Use an Earnout, and When Not To
Earnouts work well in specific situations and poorly in others.
Good fit:
- A genuine valuation gap that both parties want to close
- A business with growth potential the seller believes in and the buyer is hesitant to pay full price for
- A seller staying on through the transition who can directly influence outcomes
- Clear, measurable performance metrics available
- A short-to-medium earnout period (1-3 years)
Poor fit:
- The seller is leaving immediately and has no influence over post-closing performance
- The business operates in a highly volatile or unpredictable industry
- Performance metrics are subjective or difficult to measure
- The buyer plans significant operational changes that will affect the earnout
- The trust between the parties is already thin
For sellers in the second category, alternatives like a seller note (a structured payment over time, not tied to performance) or rolled equity (a continuing minority stake in the acquired entity) may make more sense than an earnout.
How an Earnout Fits Into Your Deal
For owners thinking about selling, the question is rarely “what is an earnout in the abstract” but rather what the total deal structure should look like, given the business, the buyer pool, and the seller’s goals. An earnout might be the right tool to bridge a real valuation gap. It might also be a buyer’s way of shifting risk that a stronger sale process would never have created in the first place.
This is one of the practical reasons sellers benefit from experienced advisors and consultants in a sale. Knowing when to accept an earnout, how to structure one, and when to push back is exactly the kind of judgment an advisor brings. It also connects directly to the upstream work of arriving at a defensible business valuation in the first place, because a strong, supportable number reduces the size of any valuation gap a buyer might try to bridge with an earnout.
Selling Your Business? Talk With MBO Ventures
An earnout is one tool in a much larger M&A toolkit, and it works best when it is part of a thoughtful overall deal strategy. From understanding what the business is worth, to weighing how a letter of intent or final agreement should be structured, to working with the right team, the quality of guidance shapes the outcome.
For a wider view of the process, see our guide on how to sell your business.
If a business sale is on your horizon, this year or several years out reach out to talk through your situation and your options.
FAQs About Earnout?
What is an earnout?
An earn out is a contractual provision in a business sale that ties part of the purchase price to the company’s performance after closing. The seller receives a guaranteed portion at close and an additional contingent payment if the business hits agreed-upon revenue, EBITDA, or milestone targets over a defined period (typically one to three years).
What percentage of a deal is typically an earnout?
In lower middle-market M&A, the earnout portion of the purchase price typically falls between 15% and 30% of the total deal value. Deals with more uncertainty or larger valuation gaps can see earnouts of 50% or more. The exact percentage reflects how much risk the buyer perceives and how confident both sides are in the seller’s projections.
Are earnouts usually paid in full?
No. Across U.S. M&A deals, only about 60% of earnouts result in any payment at all, and the average payout is roughly 21% of the maximum potential. Sellers should treat the earnout as upside, not as a portion of guaranteed proceeds, and structure the rest of the deal accordingly.
What is the difference between an earnout and a seller note?
An earnout is contingent: payment depends on the business hitting future performance targets, and the seller may receive nothing if it misses. A seller note is a structured debt payment from buyer to seller over time, typically with interest, that does not depend on performance. Seller notes are more predictable; earnouts offer higher potential upside but carry real risk of non-payment.
Can I negotiate the metrics used in an earnout?
Yes, and you should. The choice of metric (revenue vs. EBITDA vs. milestones), the calculation method, the accounting policies applied, and the operating covenants that constrain the buyer’s actions are all heavily negotiated. Simpler, top-line metrics with crisp definitions produce fewer disputes than complex bottom-line formulas.