In many middle-market M&A transactions, buyer and seller do not initially agree on the purchase price. One way to bridge this difference is to structure an earnout.
An earnout is a purchase price mechanism in which the buyer makes additional payments to the seller based upon the post-closing performance of the newly acquired business. Earnouts can be essential to completing M&A transactions when the buyer and seller have different views of value, particularly when part of that value depends on future performance.
For private company owners, especially in the lower middle market and middle market, earnouts are often used when a buyer recognizes the strength and potential of a business but wants part of the purchase price tied to results that have not yet occurred. This may arise when a business has strong growth prospects, new customer opportunities, recent investments, or projections that have not yet been fully reflected in historical financial results.
Earnouts are often designed to help both parties move forward. The seller may receive additional consideration if the business achieves agreed-upon goals after closing, while the buyer reduces the risk of paying the full value upfront for performance that remains uncertain.
There are several advantages to structuring an earnout. Earnouts can reduce negotiation time in cases where neither buyer nor seller can agree on a valuation. An earnout can help the selling party receive additional value for their business by having the buyer make specific payments, over time, based on the business achieving defined performance criteria.
Through the use of an earnout, the selling company may receive more money, or in some transactions additional shares or equity value, than it would have if the acquisition were structured as a one-time payment at closing. Buyers like the use of earnouts because it reduces the risk of overpaying for an investment that does not achieve its financial projections.
For this reason, earnouts are often used to move a transaction forward when the parties agree on the quality of the business but disagree on how much future performance should be paid for at closing.
For example, a founder-owned business services company may have $4 million of EBITDA and recently signed several new customer contracts expected to increase earnings over the next two years. The seller may believe those contracts justify a higher valuation today. The buyer, however, may prefer to pay for that growth only after the revenue is realized. In that case, the parties may structure part of the purchase price as an earnout tied to revenue or EBITDA targets.
Earnouts are particularly relevant in private company transactions because many lower-middle-market and middle-market businesses are founder-led, relationship-driven, and dependent on future growth assumptions. A seller may believe strongly in the company’s future, while a buyer may focus more heavily on historical EBITDA, customer concentration, margin trends, or other risks.
In these situations, an earnout can allow both parties to proceed with a transaction. The buyer pays a meaningful amount at closing, while the seller has the opportunity to receive additional value if the business performs as expected.
Earnouts may be based on revenue, EBITDA, gross profit, customer retention, new contract wins, or other agreed-upon milestones. The appropriate structure depends on the nature of the business, the buyer’s concerns, the seller’s role after closing, and the degree to which the seller can influence future performance.
For example, a middle-market manufacturing company may have recently invested in new equipment that increases production capacity, but the financial impact may not yet appear in trailing twelve-month EBITDA. A buyer may be unwilling to pay full value for the expected margin improvement at closing. An earnout tied to gross profit or EBITDA may allow the seller to participate in the upside if the investment produces the expected results.
Similarly, a healthcare services company with a strong pipeline of new client relationships may be attractive to strategic and financial buyers, but the buyer may want protection if those relationships do not convert into revenue. An earnout tied to client retention, new contract wins, or revenue growth may help align both parties.
Experienced M&A advisers can help structure and negotiate an earnout that will be acceptable to both buyer and seller. A well-structured earnout can be beneficial to all parties involved. The buyer feels confident it is not overpaying for the company because the seller has to achieve certain performance thresholds in order to receive additional payments. The seller is satisfied because additional consideration will be paid if the business achieves its forecasts.
However, private business owners should understand that the details of an earnout are very important. The parties should clearly define the performance targets, measurement period, accounting methodology, payment timing, reporting process, and dispute resolution procedures.
For example, a revenue-based earnout may be easier to measure, but it may not fully reflect profitability. An EBITDA-based earnout may better reflect business performance, but it can be affected by expenses, accounting treatment, integration decisions, or corporate overhead allocations.
The seller should also consider how much control or influence they will have after closing. Once the transaction is completed, the buyer may control staffing, pricing, sales strategy, marketing spend, capital investment, accounting policies, and other operational decisions. These decisions can affect whether the earnout is achieved.
For this reason, sellers should not focus only on the headline purchase price. They should evaluate how likely it is that the earnout will actually be paid and whether the structure gives them a fair opportunity to achieve the agreed-upon targets.
A $30 million purchase price with $8 million tied to an uncertain earnout may not be as attractive as a $27 million purchase price with more cash paid at closing. The true value of an offer depends not only on the total potential consideration, but also on the certainty, timing, and terms of payment.
The earnout has the added benefit of demonstrating to the buyer that the seller believes in the forecasts and that the seller is willing to support the business after closing. In many transactions, the founder or seller of a company stays with the company during the earnout period to help ensure that the company will achieve the desired results.
This can be valuable for both parties. The buyer benefits from the seller’s knowledge, customer relationships, and operational experience. The seller benefits from having an opportunity to influence the company’s post-closing performance and potentially receive additional consideration.
At the same time, the seller’s post-closing role should be carefully documented. The parties should understand the seller’s responsibilities, authority, compensation, reporting relationship, and ability to influence the business during the earnout period.
For example, if a founder-owned distribution company depends heavily on long-standing customer relationships, the buyer may want the founder to remain involved for one or two years after closing. In that case, the earnout may be tied to customer retention or revenue from key accounts. The seller should understand what authority they will have to manage those relationships and what support the buyer will provide during the earnout period.
Earnouts can be an effective way to address purchase price differences in lower-middle-market and middle-market M&A transactions. They can help sellers receive additional value for future performance while helping buyers reduce the risk of overpaying at closing.
When properly structured, an earnout can help both parties reach a fair compromise on purchase price and move a transaction forward. However, earnouts should be negotiated carefully, with close attention to performance metrics, payment terms, operating control, reporting rights, and the seller’s post-closing role.
For private company owners considering a sale, an earnout should be evaluated not only by the potential dollar amount, but also by the certainty of payment and the practical ability to achieve the required targets.
Versailles Group helps private business owners evaluate transaction structures, negotiate key deal terms, and understand how buyers may view value, risk, and post-closing performance. If you are considering a sale or evaluating an acquisition proposal, a confidential conversation can help clarify your options before entering negotiations.