Earnouts: Bonus or Trap?
When they’re used, how they work, and what to watch out for.
Sometimes, deal creativity is the only way to get something across the finish line. Buyers and sellers don’t always see eye-to-eye, and that’s okay. What matters is whether there’s a path forward. That might mean changing the tax structure to benefit both sides. Maybe it's tweaking a post-transaction consulting agreement to better align with what's actually needed. Maybe you restructure how the assets are allocated or reframe payment timing. One other lever you can pull is an earnout.
An earnout is a bit like a seller note but with a key difference: it’s not guaranteed. It’s a contingent payment, based on how the business performs after the deal closes. Used right, it can solve real problems. Used wrong, it can become a frustrating trap.
How Not to Use Earnouts
Let’s start here: earnouts should never be your Plan A. They should be reserved for situations where other deal structures can’t quite get both parties there. If a deal can be done cleanly without an earnout, it should be.
Earnouts also shouldn’t be based on bottom-line earnings. That’s a losing battle for sellers. Once the business is under new ownership, “earnings” can be manipulated. The new owner might reinvest, shift expenses, or restructure departments; all of which affect net income and could reduce or eliminate your earnout payment. If it’s not clearly defined and clearly trackable, you’re opening the door to disappointment.
When an Earnout Does Make Sense
There are really only two scenarios where an earnout should be on the table.
1. When the business has recently underperformed.
Maybe the last year wasn't great. Revenue dipped, margins compressed, or a key contract ended. The buyer doesn’t want to pay the same price they would have paid twelve months ago. The seller, on the other hand, is confident this dip is temporary. An earnout can bridge that gap. It allows the seller to capture some of the upside if the business gets back to where it used to be but doesn’t force the buyer to overpay up front.
2. When upside is just around the corner.
Maybe the business is humming along at a fair valuation but something big is about to hit. Maybe a giant contract is about to close or your backlog is larger than ever. The seller doesn’t want to walk away and miss the upside, but the buyer doesn’t want to pay for value that hasn’t materialized yet. An earnout can let the seller participate in the near-term upside while still selling today.
The Big Rule: Never Base It on Earnings
No matter which scenario you’re in, this principle holds true: don’t base the earnout on earnings. The seller will always want revenue; easy to measure, hard to manipulate. However, the buyer will push for earnings since that’s what matters most to them post-acquisition.
A fair and defensible middle ground is gross profit. Gross profit accounts for real performance while still protecting against gamesmanship with bottom-line accounting. It’s also (usually) trackable across financial statements.
So How Are Earnouts Calculated?
Short answer: however you want. There’s no standard earnout structure, and in fact, you’ll probably never see two alike. That’s part of what makes them useful; total customization.
It could be 10% of gross profit, paid quarterly, for three years.
It could be 5% of revenue from a specific client, paid monthly, over seven years.
It could hinge on units sold, projects completed, or territories expanded.
The key is to make it measurable, auditable, and aligned with the value in question.
The Bottom Line
An earnout should only be used in two ways:
- To bridge a valuation gap when there’s no other clean way to get both sides to a number that feels fair.
- To capture short-term future value when the seller wants to realize value that’s just around the corner.
Used sparingly, used intentionally, and structured correctly, an earnout can be a helpful tool to unlock a deal that otherwise wouldn’t happen. But above all, they should be used cautiously. They're not a bonus, they're a bet.
