The Earnout That Was Never Going to Pay Out

I have seen a lot of deal structures. Some creative, some fair, some that look fair until you read the definitions section. This story is about a deal I analyzed where the seller accepted an earnout that, on close examination, was structured in a way that made it nearly impossible to collect.

The seller thought they were getting a premium price. They were getting a low price with a large contingent component that the buyer controlled. That is a very different thing.

I walked from the deal for unrelated reasons. But the earnout structure is worth unpacking because I see versions of it constantly.

How earnouts are supposed to work

An earnout is a deferred payment mechanism. The buyer pays a base price at close and agrees to pay additional consideration if the business hits certain performance targets post-close. In theory, earnouts bridge valuation gaps. The seller believes the business is worth X. The buyer believes it is worth less. The earnout lets the seller prove out the higher number if they are right.

In practice, earnouts are frequently a tool for reducing the effective purchase price while making the headline number sound larger.

The key is in the definitions. What exactly counts as revenue toward the earnout target? What costs can the new owner load into the business before calculating the metric? Who controls the accounting decisions that determine whether the target is hit? These are not small questions.

What I found in this deal

The earnout in this deal was tied to gross revenue in the 24 months post-close. The seller had accepted this because gross revenue felt like an objective metric. It is not.

Under the purchase agreement, the buyer had discretion over pricing decisions, contract terms, and which customers to pursue. They also had the right to add product lines and change the revenue mix. Any of those decisions could shift the revenue trajectory in ways the seller had no control over and no visibility into.

The buyer could slow-walk new business development in year one, reducing revenue below the earnout threshold, then accelerate in year three once the earnout period expired. Nothing in the agreement prevented this. Nothing required the buyer to operate the business in a way that maximized earnout payments.

That is the structural problem with earnouts tied to metrics the buyer controls. The seller is betting on the buyer’s motivation to pay them out. In some deals that motivation exists. When the earnout is large and the buyer has the flexibility to influence the outcome, it frequently does not.

What sellers should insist on

I am not saying never accept an earnout. Sometimes they are the right structure. But if you are going to take one, here is what you need to protect yourself.

• Tie the earnout to gross profit or EBITDA, not gross revenue. Revenue is too easy to manipulate through pricing and mix decisions. Gross profit is harder, though not impossible. Ideally, the metric should be one where the buyer’s interests are aligned with hitting the number, not one where the buyer can influence it freely.
• Require the buyer to operate the business in the ordinary course. The agreement should explicitly restrict the buyer from making material operational changes, cutting marketing spend, or restructuring the customer base in ways that would suppress the earnout metric during the measurement period.
• Get monthly reporting rights. You should be able to see the financials during the earnout period, not just at the end of it. If the business is tracking below target, you want to know while there is still time to flag it.
• Cap the earnout period. Two years maximum. The longer the period, the more things can change, the harder it is to hold the buyer accountable, and the more the earnout starts to feel like a consulting arrangement rather than deferred purchase consideration.
• Understand the tax treatment. Earnout payments are often taxed as ordinary income rather than capital gains, which can change the effective economics meaningfully. Know this before you accept the structure.

The real lesson

Sellers often focus on the headline deal value. Buyers focus on the effective deal value. The gap between those two numbers is where earnouts live.

A $6M deal with $4M at close and a $2M earnout is not a $6M deal. It is a $4M deal with an option to collect $2M more, subject to terms the buyer drafted and conditions the buyer influences. When you read it that way, the structure looks different.

Read every earnout definition carefully. Get a lawyer who has been through this before. And be very clear on what control you are giving up, and what control the buyer is keeping, before you sign.

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If you didn’t know, now you know.

* Every deal I look at is under NDA. The stories I discuss are real. Some identifying details — company name, specific geography, exact numbers — may have been changed to protect the seller. The lessons haven’t.