Earnout
An earnout is a piece of the purchase price the seller only collects if the business hits agreed targets after close. It's a way to bridge a valuation gap: the seller thinks the business is worth more than you do, so you agree to pay the difference, but only if their optimism turns out to be right.
Why it matters to a buyer
Earnouts let a deal happen when buyer and seller can't agree on price. You're not betting your whole purchase on the seller's projections, you're tying part of the payment to real results. That protects your downside: if revenue or profit comes in soft, you pay less. It also keeps a departing owner motivated to hand off cleanly, since their last payment depends on it.
The traps to avoid
- Vague metrics: tie the earnout to a number that can't be argued about. "Revenue" is cleaner than "profit," because you control the expenses after close and a seller will dispute every cost you add.
- Control conflicts: once you own the business, you make the decisions. If your plans (raising prices, cutting a product line) would lower the earnout metric, expect a fight. Spell out who controls what.
- Timeframe: shorter is usually better. A 12-month earnout has less room for disputes than a 3-year one.
Worked example
You value a business at $2M. The seller wants $2.4M, citing a big contract they say is about to close. You agree to pay $2M at close plus a $400K earnout: $200K if revenue holds above $3M next year, and another $200K if that contract actually signs. If neither happens, you paid a fair price. If both do, the seller earned the premium and you got a business that grew. The earnout terms get hammered out in the LOI, not the final agreement, so negotiate them early.