Earnouts in M&A: What Every Business Owner Should Consider Before Selling

If you’re thinking about selling your business, there’s one term you’re almost guaranteed to hear during negotiations: earnout.

Earnouts are extremely common in lower middle market M&A transactions and for good reason. They help bridge the gap between what a seller believes a company is worth and what a buyer is willing to pay at closing. In today’s market especially, expecting 100% cash at close is often unrealistic. Understanding how earnouts work and how to structure them strategically can make a significant difference in your final payout.

What Is an Earnout in a Business Sale?

An earnout is a structure where a portion of the purchase price is paid after closing, based on the business achieving specific financial performance targets. These targets are typically tied to revenue, gross profit, or EBITDA over a defined period following the sale.

From a buyer’s perspective, earnouts reduce post-close risk. They provide reassurance that the business will continue to perform as expected after the transition. If performance meets agreed-upon benchmarks, the seller receives additional compensation. If it doesn’t, the buyer is protected from overpaying.

From a seller’s perspective, an earnout can increase total deal value but it also introduces uncertainty. Your final payout is no longer fully guaranteed at closing. That’s why thoughtful structuring is critical.

Why Earnouts Are Common in the Lower Middle Market

In lower middle market transactions, future growth potential, customer retention, and operational stability often drive valuation debates. Buyers may hesitate to pay full value upfront if performance projections are aggressive or dependent on key relationships.

An earnout allows both parties to share the risk and the upside. It aligns incentives and keeps sellers invested in a smooth transition. When structured properly, it can expand your buyer pool and make a deal possible that otherwise might stall over valuation differences.

However, not all earnouts are created equal.

Revenue vs. EBITDA Earnouts

One of the most important decisions in structuring an earnout is determining which financial metric will trigger payment.

Many buyers prefer EBITDA-based earnouts because they measure overall profitability. But EBITDA can be influenced by discretionary spending, accounting adjustments, changes in overhead allocation, or strategic investments made by the new owner. Once you’ve sold the business, you may no longer control those decisions.

For that reason, sellers often benefit from earnouts tied to top-line revenue instead. Revenue is generally less subject to manipulation and provides a clearer measure of sales performance and customer demand. It reflects whether the business is continuing to generate income, regardless of post-sale cost management decisions.

Another seller-friendly alternative is structuring the earnout around gross profit. Gross profit accounts for direct costs of goods sold while excluding administrative and overhead expenses. This approach still ties payouts to operational performance but reduces exposure to post-closing expense decisions that could distort EBITDA.

The key is not just which metric is used but how clearly it is defined.

The Importance of Clear Earnout Terms and Documentation

Disputes over earnouts are surprisingly common, and most arise from vague definitions or incomplete documentation. Precision matters.

Every earnout agreement should clearly define performance targets, measurement periods, and calculation methods. Reporting obligations should be outlined so sellers have access to the financial data necessary to verify performance. There should also be a clear dispute resolution mechanism in case disagreements arise.

Acceleration clauses are another important consideration. If the buyer resells the company or undergoes a change in control during the earnout period, sellers should consider negotiating protections that trigger accelerated payment.

Clarity upfront prevents conflict later.

The Reality of Today’s M&A Market

In the current deal environment, sellers should prepare for creative deal structures. Earnouts, seller financing, and hybrid arrangements are increasingly common as buyers manage risk and capital availability.

Rather than viewing an earnout as a concession, it can be seen as a strategic tool. When structured thoughtfully, it can increase total deal value, align incentives, and help close deals that might otherwise fall apart.

The key is entering negotiations informed and prepared.

Structuring an Earnout to Protect Your Upside

If you’re considering selling your business and an earnout is part of the discussion, careful planning is essential. The structure, metrics, definitions, and protections built into the agreement will ultimately determine whether the earnout works in your favor.

A well-designed earnout balances risk and reward for both parties. It protects the buyer from overpaying while giving the seller a fair opportunity to achieve additional value.

Considering a transaction? Let’s talk about options and potential deal structures and make sure they support your goals, both at closing and beyond.

Contact Touchstone Advisors for a confidential conversation about our Exit Advantage℠ program—a proven 10-step process designed specifically for business owners planning to exit in the next 2 to 5 years or beyond. This strategic framework helps you prepare your company for sale, protect your legacy, and maximize the value of your life’s work.

Originally published on Touchstone Advisors’ Blog.  Republished here with permission for the benefit of the Exit Advantage audience.

Steven Pappas, M&A MI
Partner, Managing Director
Touchstone Advisors
860-669-2246
spappas@touchstoneadvisors.com