Earnouts

Anchored to
The bridge across a disagreement about the future

Why one gets proposed

Earnouts appear when the parties agree about the past and disagree about the future. The seller says the business will keep growing and the pipeline is real. The buyer says the growth depends on the seller's relationships and will not survive the handover. Rather than split the difference on price, the earnout says: if you are right, you get paid.

They also appear for the reason nobody states out loud, which is that a buyer cannot fund the price the seller wants. That is a different problem wearing the same clothes, and it is worth identifying which one is actually on the table. If the constraint is financing rather than belief, the honest instruments are a seller note or a lower price.

The three terms that decide everything

What is measured. Revenue is easy to verify and hard to manipulate, and it ignores whether the business made any money. Profit reflects value better and is exposed to every cost decision the new owner makes, from allocated head office charges to a decision to invest in growth that suppresses this year's earnings. Gross profit is often the least bad compromise. Whatever is chosen must be defined in the agreement in arithmetic, not in adjectives.

Over what period. Twelve months rewards a handover that has barely happened. Three years exposes the seller to a business they no longer influence. Anything longer is a lottery ticket. A shorter period with a lower threshold usually serves a seller better than a longer one with an ambitious target.

What shape the payment takes. A cliff, where the whole payment turns on a single threshold, converts a small shortfall into a total loss and gives the buyer an obvious incentive at the margin. A sliding scale that pays proportionally above a floor removes most of that. If a cliff is unavoidable, a partial payment just below it is worth more than arguing about where the line sits.

The control problem

This is the heart of it. The seller's remaining consideration depends on a business the buyer now runs, and every ordinary commercial decision moves the number. Hiring, pricing, a new location, absorbing a cost from a wider group, changing the sales compensation plan. None of these need be hostile to reduce the earnout.

Protections exist and are worth negotiating: an obligation to operate the business in the ordinary course consistent with past practice, a prohibition on reallocating revenue or loading unrelated costs, a right to see the underlying figures rather than a summary, and an independent expert to resolve disputes quickly. What no clause can restore is the seller's ability to make the number happen. That is the risk being accepted.

Why they disappoint

Because the seller mentally banks the maximum and the buyer prices the probability. When an owner says the business sold for a certain figure, they usually mean the headline including the full earnout. The buyer's model rarely assumed all of it.

Because the thing that made the business grow was often the owner, and the earnout period is precisely the window in which that stops being true. And because disagreement about measurement arrives at exactly the moment the relationship has ended.

When they are worth doing

When the contingency is genuinely specific and short: a contract in final negotiation, a regulatory approval expected, a customer that has signalled expansion. Those are events with a date, and an earnout tied to one is really a deferred payment with a condition, not a bet on operating performance.

When the seller is staying involved with real influence over the measured outcome. And when the amount at risk is a portion the seller can afford never to receive. The test is simple and unsentimental: if the earnout paid nothing, would you still have done the deal at that price. If the answer is no, the structure is wrong, whatever the headline says.