Earn-outs are how buyers & sellers sometimes bridge a disagreement over purchase price - less cash is paid at closing in exchange for future payments tied to how the business performs after the sale.
This guide walks you through what an earn-out actually is, why buyers love them, why sellers should be cautious, and the specific terms you must negotiate before you sign — so the deal you celebrate at closing isn't the one you regret two years later.
There are two kinds of earn-outs — the kind that lead to litigation, and the kind that haven't yet.
Like all good jokes, its grounded in truth. Earn-out disputes are one of the most common categories of post-closing M&A litigation. No wonder when the earn-out asks two parties with different incentives to agree on a metric, and then asks one of them — the buyer, who now controls the business — to calculate that metric and write the check.
When the earnout is clear and well-structured, both sides know what they signed up for and the risk of disputes will be minimized. When the earnout is vague and poorly structured, ambiguity gets resolved by whoever controls the books — which, after closing, is the buyer. That's not a flaw of buyer behavior; it's a feature of who has access to the information and the power.
This post walks through what an earn-out actually is, why both buyers and sellers have legitimate reasons to care about how it's structured, and the specific terms that separate a workable earn-out from one that creates disputes. Whether you're sitting on the sell-side or the buy-side of a deal with an earn-out component, the same provisions tend to determine how well the provision will perform.
We'll cover what to think about before you sign, the questions to ask your lawyer and your CPA, and the specific levers that, in our experience, separate the provisions that perform well from the ones that end in regret or a dispute.
An earn-out is a portion of the purchase price that the buyer agrees to pay the seller after closing, contingent on the business hitting certain performance targets during a defined period.
In a typical earn-out:
So a $20 million LOI might really be a $14 million-upfront-plus-$6 million-contingent/later deal.
Why earn-outs exist: they solve a real problem for both sides. Buyers and sellers often disagree about what a business is worth, and that disagreement is usually about the future.
The seller believes the business will grow; the buyer is less certain. An earn-out lets both sides be right — the seller "gets" the higher price if the business performs, and the buyer "pays" the lower price if it doesn't. Used well, an earn-out can get a deal done that wouldn't otherwise close.
Why earn-outs are also where deals most often break: an earn-out makes the seller's compensation depend on the future performance of a business that the buyer now runs. That structural asymmetry — one party benefits from a number that the other party controls — is the source of nearly every earn-out dispute.
The fix is not to avoid earn-outs; the fix is to define everything that matters before either side signs, so neither side has to rely on goodwill or ambiguity later.
The fundamental challenge with earn-outs is structural and predictable: once the deal closes, the seller no longer controls the business, but the business's performance determines whether the seller gets paid.
Consider what typically changes the moment a deal closes:
These are not abuses of power — they are the normal authority of an owner. Buyers acquire businesses precisely so they can make these decisions. The issue is that each of these day-to-day decisions can affect the earn-out metric, and reasonable people can differ on whether a given decision was made in the ordinary course or in a way that suppressed the earn-out.
The second layer of difficulty is that the metric definitions themselves require interpretation. "Revenue" can be calculated narrowly or broadly. "EBITDA" involves dozens of judgment calls — what counts as a one-time expense, how shared overhead is allocated, what add-backs are permitted. Each judgment call can be defended; each one can also affect the earn-out number meaningfully.
When the earn-out is well-structured, both sides have agreed up front on how these questions are answered. When it's not, the answers get resolved later — by whoever keeps the books, or by a court.
The takeaway isn't avoid earn-outs. The takeaway is if you're going to use one, structure it so that the math and the operational rules are clear enough that neither side has to argue about them later.
If you're a seller considering a deal with an earn-out, you likely have most of these concerns:
These are reasonable concerns and they're addressable through how the earn-out is drafted — not by avoiding the structure.
If you're a buyer considering a deal with an earn-out, you likely have most of these concerns:
Both sets of concerns are legitimate. The well-drafted earn-out addresses both — by specifying clearly what each side can and cannot do, what information must be shared, and how disputes get resolved.
These are the questions to ask your lawyer, your CPA, and yourself before agreeing to any earn-out structure:
1. What is the metric — and how is it defined?
Revenue is generally the cleanest metric because it's easier to verify and involves fewer judgment calls. EBITDA is more common but requires significantly more definitional work — what counts in the calculation, how shared costs are allocated, what one-time items are treated as.
Operational milestones (a regulatory approval, a customer renewal, a product launch) are the cleanest of all when they're available, because they're binary.
Whatever metric is chosen, it should be defined with precision in the purchase agreement — not left to "GAAP" or general standards. Definitions should cover specifically how revenue is recognized, what costs are included, how shared costs are allocated, and how unusual items are treated.
2. How long is the measurement period?
Shorter periods generally favor the seller; longer periods generally favor the buyer. Twelve months is on the short end of typical; 24 months is common; periods beyond 36 months are rare because the business has usually changed significantly by then under the buyer's ownership.
The "right" period depends on the business and the rationale for the earn-out. A short period is appropriate when the earn-out is bridging a near-term valuation question or a transition incentive; a longer period may be appropriate when the seller's continued contribution is the value being measured.
3. What operational covenants apply during the earn-out period?
Operational covenants are the restrictions on how the buyer can run the business during the earn-out period. They typically require the buyer to operate the business consistently with prior practice, restrict actions that would meaningfully affect the metric without commercial justification, and ensure the business is given a fair opportunity to hit the targets.
If the seller is staying on to manage the business through the earn-out, operational covenants would be aimed at ensuring the seller has the necessary resources and is free to make meaningful decisions. For a seller, these types of protections are likely the most valuable, but buyers do tend to strenuously resist them and they can be difficult to negotiate.
These covenants protect the seller without preventing the buyer from running the business they bought. Well-drafted operational covenants tend to reduce dispute risk because they make expectations explicit.
4. What information rights and dispute resolution apply?
The seller needs the ability to verify the metric calculation — typically quarterly financial reports, an annual reconciliation, and the right to inspect underlying records. A defined dispute-resolution process (often involving a neutral third-party accountant) keeps disagreements from escalating into litigation.
These provisions also protect the buyer by limiting the seller's involvement to defined reporting requirements, rather than open-ended demands for information.
5. What's the structure — floor, cap, and acceleration?
Most earn-outs have a cap (maximum payment) but no floor (minimum payment). Sellers can negotiate for a floor or for a portion of the earn-out to be guaranteed regardless of performance.
Acceleration triggers — events that cause the unpaid earn-out to become immediately due — typically include the buyer selling the business during the earn-out period, certain breaches of the agreement, or termination of the seller's employment without cause if the seller is staying on.
Whether to accept an earn-out, and how to structure it, depends on several factors:
1. Bargaining position. Sellers with multiple bidders have more leverage to shape earn-out structures. Sellers with a single committed buyer have less.
2. Post-closing role. A seller who's staying on with meaningful operational control may be comfortable with an earn-out tied to performance they can influence. A seller who's walking away has less protection against decisions they can't control.
3. The metric's verifiability. Some businesses have metrics that are inherently easier to verify and harder to dispute (long-term recurring revenue contracts, binary regulatory outcomes). Others have metrics that depend heavily on judgment.
4. The buyer's history. Some buyers have track records on earn-outs that can be researched — particularly PE buyers, where prior portfolio companies' experiences are often discoverable. A pattern of disputed earn-outs is a meaningful data point.
5. Alternatives. A lower all-cash offer from a different buyer may, on a probability-weighted and tax-adjusted basis, be worth more than a higher headline price with a substantial earn-out component.
What is an earn-out in a business sale?
An earn-out is a portion of the purchase price that's paid to the seller after closing, contingent on the business hitting certain performance targets (usually revenue, EBITDA, or operational milestones) over a defined period.
Why are earn-outs used?
Earn-outs serve two main purposes: they allow buyers and sellers to bridge valuation gaps when they disagree about future performance, and they help align the seller's incentives with the buyer's interests after closing. Used appropriately, they can get deals done that wouldn't close on all-cash terms.
Are most earn-outs paid in full?
A meaningful share of earn-outs are not paid in full. The reasons vary — the business genuinely underperforms, the metric was defined ambiguously, the buyer takes actions that affect the metric, or disputes arise about how the calculation is done. Well-structured earn-outs are paid more often than poorly-structured ones.
What metric is best for an earn-out?
Revenue is generally easier to verify than EBITDA. Operational milestones (specific binary outcomes) are the cleanest when available. EBITDA-based earn-outs are common but require detailed definitional work to be enforceable.
How long should the measurement period be?
Most well-structured earn-outs run between 12 and 24 months. Periods beyond 36 months are uncommon because the business has typically changed significantly by then.
What are operational covenants?
Operational covenants are restrictions on how the buyer can operate the business during the earn-out period. They typically require the buyer to operate the business consistently with prior practice and avoid actions that would unreasonably affect the metric. They protect the seller's interest in the earn-out without preventing the buyer from running the business.
What is an acceleration trigger?
A provision that causes the unpaid portion of an earn-out to become immediately due upon certain events — typically including the buyer selling the business during the earn-out period, certain breaches of the agreement, or termination of the seller's employment without cause.
Earn-outs are a useful and common tool in M&A. Whether they work — for either side — depends on whether the structure is clear enough that both parties know what they signed up for. When the metric is well-defined, the operational covenants are explicit, the information rights are proportionate, and the dispute resolution process is built in, earn-outs do what they're supposed to do.
When any of these elements is vague, the earn-out becomes a future dispute that hasn't happened yet.
The work of getting an earn-out right happens at the front end — groundwork laid as early as the letter of intent, detail determined by the time definitive agreement is finalized.
The provisions that can make or break and earn-out are not necessarily big asks; they're the ordinary precautions that experienced M&A counsel build into deals routinely. As with most things in deal-making, the cost of negotiating them up front is trivial compared to the cost of litigating them later.
Thinking About a Sale That Includes an Earn-Out?
Whether you're sitting on the sell-side or the buy-side, the same set of provisions tends to determine whether an earn-out structure works as intended. We work with business owners to think through these questions before the LOI is signed, when there's still room to shape the structure.