Earnouts in M&A: How They Work and When They Make Sense
Every deal eventually runs into the same tension: the seller believes the business is worth one number, and the buyer isn't ready to pay it upfront. An earnout is often the bridge that gets both sides to a signed agreement — but it's also one of the most misunderstood tools in M&A.
What an Earnout Actually Is
An earnout structures part of the purchase price as a future payment, contingent on the business hitting agreed-upon performance targets after closing. Instead of the seller walking away with 100% of the price at the table, a portion — often 10% to 30% of the total value — is paid out over one to three years, tied to metrics such as revenue, EBITDA, or customer retention.
For sellers, it's a way to capture upside they believe is coming. For buyers, it's a way to de-risk the deal: if the business performs as promised, the seller gets paid for that performance. If it doesn't, the buyer isn't stuck overpaying for projections that never materialized.
Why Earnouts Show Up in a Deal
Earnouts tend to appear in a few specific situations:
A valuation gap. The buyer and seller can't agree on price because they disagree on future performance, often because the business is growing fast, entering a new market, or has volatile historical earnings.
Buyer financing constraints. Spreading payment over time reduces the cash a buyer needs at closing, which can make an otherwise unaffordable deal work.
Key-person risk. When the seller's continued involvement matters to the business's success, an earnout keeps them financially motivated to stay engaged through the transition.
Where Earnouts Go Wrong
Earnouts have a reputation problem in M&A circles, and it's earned. The most common failure point isn't the concept; it's the details. Vague metrics, unclear accounting definitions, and a lack of control for the seller over the very numbers the earnout depends on are the usual culprits.
A seller who no longer controls hiring, pricing, or marketing decisions has limited ability to hit a revenue target set before the sale. Disputes over what counts toward EBITDA — one-time expenses, allocated overhead, new buyer initiatives — are where relationships and earnout payments both tend to break down.
What Makes an Earnout Work
The deals that avoid these problems tend to share a few things in common:
Simple, objective metrics. Revenue is easier to verify than adjusted EBITDA. The simpler the formula, the fewer the disputes.
Clear operational boundaries. Sellers negotiate specific protections — a say in budget decisions, staffing levels, or product lines — that affect their ability to hit the target.
Defined accounting standards, in writing. How the metric is calculated, who calculates it, and how disputes get resolved should all be spelled out in the purchase agreement, not assumed.
Realistic targets. An earnout tied to a hockey-stick growth projection isn't a bridge to a deal; it's a delayed disagreement.
Should You Use One?
For sellers, the right question isn't "will I get paid the full number?" — it's "do I have enough control and enough confidence in these projections to bet part of my payout on them?" For buyers, it's whether the earnout genuinely reduces risk or is just a way to avoid negotiating a fair price today.
Earnouts aren't a workaround for a bad valuation conversation. Used well, they're a legitimate way to align incentives and close a gap that would otherwise kill a deal. Used carelessly, they become the source of the next year's dispute.
At Masterworks Capital, we help business owners and buyers structure deal terms, including earnouts, that hold up after closing, not just at the signing table. If you're navigating a valuation gap in your next transaction, we can help you find structure that works for both sides.