Earn-outs explained, and how not to get burned

What an earn-out actually is

An earn-out is simple in theory. You don't pay the seller the whole price on day one. You pay some now and the rest later, based on how the business performs after the deal.

Hit the targets and the seller gets the full number. Miss them and they get less. On paper it's fair. The seller believes their business is worth X, you're not sure, so you both agree to let the results decide.

In practice, an earn-out is where good deals go to die. The idea is fine. The detail is what gets done badly, in a hurry, by two people who are sick of negotiating and just want to sign.

Why they exist, and why they're useful

Earn-outs solve a real problem. The gap between what a seller thinks their business is worth and what a buyer will risk.

They do two useful things. They protect you from overpaying for a business that turns out to be softer than the story. And they keep the seller pulling in the same direction after the deal, because their money still depends on it going well. That second bit matters more than people realise. A founder who's been fully paid out on day one has no reason to care whether the handover goes smoothly. A founder with money still on the table cares a great deal.

An earn-out isn't a discount. It's a way to make the seller prove the story they've been telling you.

Used well, it turns a nervous "maybe" into a "yes" that both sides can live with. Used badly, it turns a partner into an enemy about eight months in.

Where they go wrong

Almost every earn-out disaster comes down to the same handful of mistakes. Learn them before you sign, not after.

• Vague targets. "Based on profit" means nothing. Whose definition of profit? Before or after the costs you're about to add? If the metric isn't defined so tightly a stranger could calculate it, you've built an argument, not an agreement.
• The buyer controls the outcome. After completion, you run the business. You decide what to invest in, what to charge to which account, what costs to load where. The seller watches their earn-out shrink because of decisions they can't control, and they scream that you've engineered it. Sometimes they're right.
• Targets the seller can't influence. If the payout depends on things the founder has no hand in after they've stepped back, it's a lottery ticket, and it breeds resentment.
• Too long. A three-year earn-out ties a founder to a business they've mentally left. Motivation fades. Friction grows. The longer it runs, the more chance the world changes and the target stops making sense.
• All or nothing. A cliff where they hit the number and get everything, or miss by a hair and get zero, turns a near-miss into a lawsuit.

How to structure one that pays out cleanly

The fix for every problem above is clarity agreed up front, when everyone's still friends.

Pick a metric that's hard to argue about. Revenue and gross profit are cleaner than net profit, because net profit is where you and your clever accounting can move the goalposts without meaning to. If you must use a profit figure, define exactly what's in and what's out, and ring-fence it from the changes you're planning to make. Don't let your own investment in the business be the thing that sinks the seller's payout.

Keep it short. Twelve to twenty-four months is usually plenty. Long enough to prove the business is real, short enough that the founder stays engaged and the world doesn't shift underneath the deal.

Use a sliding scale, not a cliff. If they hit 90% of target, they get most of the money. Straight-line it. That kills the incentive to fight over the last inch and keeps everyone honest.

And write down how it gets measured, who calculates it, and what happens if you disagree. Name the referee before the match, not during it.

Protect yourself, not just them

This cuts both ways. Earn-outs protect the buyer too, and you should use that.

Tie the money to the things that scared you in diligence. If you were worried the revenue leans on the founder's relationships, make continued revenue from those customers part of the earn-out. Now the founder is paid to hand those relationships over properly instead of walking off with them in their head.

If a chunk of the value walks out with one person, the earn-out is how you keep that person tied in long enough to transfer what's in their skull to your team. That's just matching the money to the risk, which is the whole point.

The real test

Here's the question to ask before you agree any earn-out. If this business does exactly averagely, not brilliantly, not badly, does the structure feel fair to both sides?

If it only works when everything goes perfectly, it's a trap waiting to spring. A good earn-out survives a mediocre year without either side feeling robbed. A bad one needs a fairy tale to pay out, and fairy tales don't survive contact with a real trading year.

Get this wrong and your first acquisition becomes a two-year argument. Get it right and it becomes the template for every deal after it.

If you've got a number on the table and you're not sure the structure's fair, get it looked at before you sign. That's part of what we do on a strategy call. Book one and let's stress-test it while it's still changeable.