Earnouts Can Be The Best Way To Buy A Business

Forbes

06-07-2025

A core fundamental to evaluating whether to buy a certain business is the assurance, to the best of the buyer's ability, that the business' performance will remain status quo post sale assuming no catastrophic events. While potential future growth is sexy, stability is valuable.
Earnouts, also referred to as performance-based conditions, can be an ideal way to bridge the gap between buyers and sellers and address issues that can drastically impact the value of a business post sale, either up or down. These deal terms provide the seller with the ability to earn (this the term 'earnout') the full valuation if certain targets are hit in the future and provide the buyer with protection if they don't.
Some examples of scenarios where earnouts should be considered include:Keep It Simple
Earnouts are best laid out when the conditions are clear and easily measured such as achieving specific revenue targets or retaining a certain customer after the sale.
To effectively structure an earnout, two valuations need to be compiled. The first is based on the status quo financials. The second is based on the scenario whereby whatever is measured actually happens. The delta becomes the earnout target. For example, a business generates $1.0 million in earnings and the buyer and seller agree on a 5x multiple and thus a $5.0 million purchase price. However, one customer represents 30% of the revenues and profits. As such, if that client stops buying, the profits will drop to $700,000 and the enterprise value at the same multiple will be $3.5 million. The difference, or delta of $1.5 million becomes the earnout piece. As such, the deal structure would be a $3.5 million purchase price and the opportunity for the seller to earn an additional $1.5 million if the customer continues to buy from the new owner.
The same structure can be used for the other examples noted herein. The key is to establish two valuations with the situation happening or not happening.
The word earnout on a a keyboard keySellers Cannot Guarantee A Buyer's Success
While this all sounds great from a buyer's perspective to protect their downside, the seller will have legitimate concerns. Although the buyer assumes the greater risk in these transactions, a seller cannot guarantee their success. What if the client stops buying because the new owner is incompetent? This is no fault of the seller, and they should not be penalized for it.
Conversely, where earnouts are warranted, the buyer only has the word of the seller and whatever research they have been able to compile, that certain events will or will not materialize. As such, there must be transparent and meaningful discussions between the sides to understand the level and potential impact of these concerns.
How Long Should The Measurement Period Be?
In most cases, there is a disparity between buyer and seller positions in the earnout measurement period. As a guideline, it is reasonable in most cases for this to be somewhere between 12-24 months after closing the deal.
In cases where the seller may have implemented certain initiatives that will only generate revenue after the sale and they want that factored into the valuation, it may take a longer period for those events to materialize.
In situations where the business has experienced a recent downturn, a buyer will want a shorter measurement period because if they are able to turn things around, why should the seller benefit from what they, the buyer, has done to turn things around?
All Or Nothing Doesn't Make Sense
Earnouts, in most cases, are most acceptable and fair to both sides when there is a sliding scale in place as a measurement tool. Meaning, the condition can be partially met and thus partially paid. If the earnout piece is $1.0 million and once measured it is 80 percent achieved, then 80 percent of the earnout can be paid. The suggestion is also to have a floor so there's a point at which the earnout is not paid if the metric is for example, below a certain percentage.
Know Your Lender – Earnouts May Not be Allowed
Many lenders will not fund deals where there is an earnout unless the maximum potential earnout amount is factored into their underwriting. They will not agree to an amount of leverage and debt service if the business may be faced with a future additional expense from an earnout. The best way to address this is to carve out a seller not equal to the total potential earnout that is subject to adjustment if the target is not met. Or, via the seller retaining equity in the business post sale that can be diluted based upon the results of the earnout's measurement.
A Final Word
Performance-based conditions can be an effective way to get deals to the finish line. While buyers always want to mitigate their deal risk, they must also understand that these deal terms only make sense when there is the possibility of a significant event attributable to the former owner impacting the business after the sale. Similarly, a seller must realize that a business remaining at least status quo post sale is a fundamental requirement for any prospective buyer and therefore the selling party must have flexibility and assume part of the risk if they are delivering a business that they know can change significantly in the near future and by no fault of the buyer.