- Mergers & Acquisitions
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When you’re in the process of acquiring a business, every detail matters. You’re not just buying tangible assets or financials; you’re investing in future performance, customer relationships, and operational mechanics. Learn the earn-out basics and how they can reduce investment risks and provide strategic flexibility with Nocturnal Legal.
Earn-Out Definition
What is an Earn-Out?
An earn-out allows a portion of the purchase price to be paid over time. This is contingent on the business meeting specific financial or operational targets after the sale. These targets are agreed upon between the parties before closing and memorialized in the purchase agreement.
Read our Earn-Outs 101 Guide: What is an Earn-Out?
While an earn-out can add complexity to a transaction, it gives buyers powerful advantages, especially in situations where it’s uncertain whether the business will continue to perform well after closing or meet last year’s financial metrics.
Here are six reasons why a buyer should consider asking for an earn-out when buying a business:
Are Earn-Outs a Smart Strategy for Business Buyers?
1. Earn-Outs Can Lower Your Upfront Purchase Price
One of the most straightforward advantages of an earn-out is the ability to lower your upfront cash obligation. Rather than paying the full amount of the agreed purchase price at closing, an earn-out mechanism allows you to defer a portion (often 10% to 40%) for a specific measurement period.
The earn-out measurement period can be as simple as one year after closing, or it can be multi-tiered, which is more common in private equity acquisitions, where the earn-out spans three or more years.
The potential amount to be earned is then paid only if the business hits the specified performance targets during the earn-out measurement period.
This approach helps you preserve working capital for daily operational needs and minimize financial exposure, especially when the seller’s valuation includes optimistic forecasts based on sudden growth in recent financial years.
Please note that if the business meets its performance targets, the amount of money held back from the payment at closing will then be due.
To avoid cash flow issues at the end of the earn-out measurement period, it’s common to place the full amount of the potential earn-out in escrow, where it will earn interest (to be paid back to you as the Buyer). This way, both parties can rest assured that the funds necessary to make any final payment based on performance are available and waiting.
It can also provide comfort that if a dispute arises between the parties, a neutral third party is holding onto the funds.
2. Earn-Outs Reduce Payments If the Business Underperforms
Linked closely to the first point, earn-outs offer a simple but powerful form of downside protection: if the business fails to perform well after closing (i.e., meet agreed-upon benchmarks), you pay less overall.
This makes earn-outs a powerful way to protect against overpaying, especially in volatile industries or when the seller’s historical performance doesn’t strongly guarantee future outcomes.
For example, a service-based business may present financial statements showing a significant spike in revenue over the trailing twelve months, which was not customary when looking at past performance over the past three or five years as a whole.
As a buyer, you may wonder if this growth is just a blip or if the business is experiencing a sustained surge in revenue that will continue year after year. The earn-out allows you to create a buffer so you’re not relying solely on projections or promises; you’re letting the numbers do the talking, post-close.
Earn-outs also protect you as the buyer from client attrition. Common in professional services businesses, such as the purchase of an accounting firm or medical practice, post-closing, the business will inevitably lose clients and patients who aren’t keen to work with a new CPA or doctor.
If the business was successful largely due to the relationship the prior owner had with his or her clients or patients, and you experience a sudden loss in revenue in the year(s) following closing.
In these instances, the earn-out ensures that you’re paying for what you get, not just what the seller believes the valuation is worth.
3. Earn-Outs Cap Seller Compensation on New Sales Leads
In many acquisitions, the seller is still involved in generating leads or helping with sales in the transition period. An earn-out allows you to clearly define what performance metrics will or won’t count toward their additional compensation.
For instance, you might choose to exclude revenue from new customer accounts or marketing initiatives you launch post-sale, or you may constrain the post-closing revenue to include solely the revenue generated from the list of clients or patients you purchased as part of the transaction.
This protects you from overpaying for results that stem from your own efforts once you step into the business as the new owner, in addition to the revenue generated from the seller’s legacy systems or relationships.
When properly drafted, the earn-out mechanism can also help control what revenue is counted during the measurement period, thereby avoiding overcompensation to the seller after implementing new systems, hiring new team members, and pursuing growth opportunities post-closing.
Think of it this way: if 100% of the revenue of the business post-closing is factored into the earn-out. What incentive would you have as a buyer to work hard and increase the performance of the business if you ultimately have to pay the seller for new sources of revenue the seller never previously enjoyed?
4. Earn-Outs Incentivize Seller Involvement After Closing
Many sellers are happy to remain involved in some capacity after the deal closes. Whether it’s as a consultant, advisor, or executive, their continued engagement can facilitate a seamless transition to you as buyer and set the foundation for strong relationships with existing vendors and customers.
An earn-out is a powerful way to align their interests with yours. The transition period post-closing can be a learning curve for both parties, and when executed poorly, it can have a negative impact on a potential earn-out.
By keeping the seller involved either for 30 days immediately after closing for transition support services or for a longer period of time post-closing to help work alongside you on client matters that require their historical knowledge and existing relationship, the seller improves the potential outcome associated with their earn-out thereby creating a strong incentive for them to genuinely care about the transition and post-closing success.
This earn-out structure creates a win-win scenario: you retain their institutional knowledge and relationships, while they stay motivated to see the business succeed under new ownership. For buyers, this can be an invaluable transition support tool, especially in the first 12–24 months post-acquisition.
Keep in mind, if you’re obtaining a Small Business Administration loan, the previous owner cannot stay on for more than twelve months post-closing.
5. Earn-Outs Resolve Valuation Deadlocks with a Performance-Based Compromise
Earn-outs are often the solution when buyer and seller can’t agree on valuation. If the seller insists the business is worth more than you believe it is (based on future potential, a pending contract, or market growth), you can offer to pay that premium only if the business delivers as promised.
This makes earn-outs a potential deal-saving mechanism, bridging valuation gaps without requiring you to pay more upfront. In effect, you’re saying: “We’re willing to meet your price, but only after your numbers are proven.”
6. Earn-Outs Mitigate Risk When Acquiring Startups Or High-Growth Companies
Acquiring a startup or high-growth company can be exciting, but also risky. These businesses often have limited operating histories, untested models, or projections that hang their hat on a hockey stick growth curve. Earn-outs can provide a safety net, helping you make bold moves without taking on excessive risk.
With the help of a carefully drafted purchase agreement, post-closing payments directly correlate with hitting benchmarks, such as customer acquisition targets, revenue milestones, or product launches (many of which are likely future events). As is the case with many young companies or startups, there are no historical financials or past events to look to as case studies to quell fear about the potential success of similar future events.
In other words, this gives you the confidence to move forward without committing to an inflated valuation based on future assumptions. If the company performs to the satisfaction of the pre-determined parameters, you’re happy to pay more. If it doesn’t, you’re protected.
Do Sellers Like Earn-Outs?
While the six points mentioned above provide a solid argument for why you, as the buyer of a business, should include an earn-out mechanism in the transaction, you should be aware, for many sellers, an earn-out is viewed as a gamble.
After all, they won’t be at the helm running the business, how can they trust you won’t act in bad faith to artificially create losses or manipulate the revenue earned during the earn-out measurement period?
Considering you will need to put the earn-out on the table early on in the negotiation process (typically in the letter of intent), you won’t have a pre-existing relationship with the seller that would potentially provide them with comfort that you know what you’re doing and will operate the business successfully post-closing.
For some sellers, they may know the last few years of revenue are higher than normal due to market events. The pandemic is a good example of a market event that caused some businesses (predominantly those tied to the home market) to see a boom that would otherwise never have occurred. Suppose a seller believes they may be selling their business at the pinnacle of its success. In that case, they may be unwilling to consider an earn-out based on the assumption that they will earn significantly less from the sale of their business when the following year comes to a close and doesn’t meet the revenue benchmarks.
In instances where a seller does not want to entertain an earn-out, they will often opt to take a lesser amount (as a whole) for the business. Similar to a house sale where one buyer offers the full asking price but has a home sale and financing contingency, and the second buyer offers $ 50,000 under the asking price but is offering all cash, the seller may opt for the lesser amount, which they view as a sure thing.
The key is to understand what matters most to the seller. If it’s total value, you can offer a higher “headline price” that includes earn-out payments while maintaining risk-adjusted value that works for your business.
Earn-Out Strategies To Avoid Disputes
Earn-outs offer real benefits, but also pose real risks if not carefully structured. Vague or overly optimistic terms can lead to disputes, missed payments, and even litigation.
To avoid these pitfalls, your earn-out provision needs to be clear, measurable, and enforceable. Here’s what that means in practice:
- Define exact metrics.
- Set a time frame.
- Clarify accounting standards.
- Specify what counts and what doesn’t.
- Include audit rights.
- Plan for disputes with mediation or arbitration clauses.
Our Team Can Help You Decide If Earn-Outs Are Right For You
Now that you know the earn-out basics, you know the best earn-outs are mutually beneficial, but tightly controlled. Our team at Nocturnal Legal provides counsel to ensure your earn-out provision protects your interests while maintaining clear boundaries and timelines to avoid future disagreements with the seller.
Earn-outs can be a powerful and protective tool in the business buyer’s toolkit. They can protect you from overpaying, keep cash on hand for operational needs (if not held in escrow), and align with the seller during the crucial transition period.
However, they’re not a one-size-fits-all solution. Earn-outs work best when:
- There’s a valuation gap between buyer and seller
- The business has future upside that’s not guaranteed
- The seller is supporting the transition process post-sale
- You want to limit cash outflow upfront
- You’re comfortable with some post-closing complexity
When structured clearly and strategically, earn-outs can help you close smarter deals, avoid unnecessary risk, and create a foundation for long-term success.
If you’re buying a business, contact Nocturnal Legal today! We can assist with drafting your purchase agreement and other key documents, drawing on years of experience to ensure you feel confident.
