Maximizing Your Earnout Success

Earnouts can be a great way to bridge valuation gaps, but they're also a common source of conflict. Here's how to succeed.

Understanding Earnouts

What is an Earnout? Additional payment contingent on future performance, typically:

• 1-3 year period
• Based on revenue, EBITDA, or milestones
• 20-50% of total deal value

Why Buyers Want Them:

• Reduce upfront risk
• Align incentives
• Bridge valuation gap
• Retain key people

Why Sellers Accept Them:

• Higher total valuation
• Confidence in future performance
• Only way to get deal done
• Tax advantages

Structuring for Success

Metric Selection

Revenue-Based Pros:

• Easier to achieve
• Less buyer manipulation
• Clear and measurable

Cons:

• Doesn't reflect profitability
• Can be gamed
• May encourage bad behavior

EBITDA-Based Pros:

• Aligns with profitability
• More meaningful metric

Cons:

• Buyer controls costs
• More room for disputes
• Harder to achieve

Milestone-Based Pros:

• Clear objectives
• Not subject to manipulation

Cons:

• May be outside your control
• Binary outcomes
• Harder to structure

Best Practices:

1. Keep It Simple Complex formulas lead to disputes. Use straightforward metrics everyone understands.

2. Maintain Control Negotiate for:

• Operational autonomy
• Budget authority
• Hiring decisions
• Strategic direction

3. Short Time Period 1-2 years is ideal. Longer periods increase risk and uncertainty.

4. Acceleration Clauses Earnout pays out immediately if:

• You're terminated without cause
• Company is sold again
• Material breach by buyer
• Significant changes to business

5. Clear Dispute Resolution

• Independent accounting firm
• Binding arbitration
• 30-day resolution timeline
• Loser pays costs

During the Earnout Period

Document Everything

• Financial performance
• Key decisions
• Resource allocation
• Changes from buyer
• Impact on metrics

Communicate Regularly

• Weekly updates to buyer
• Monthly financial reviews
• Quarterly business reviews
• Proactive problem-solving

Maintain Relationships

• Build trust with new owners
• Be professional
• Collaborate on decisions
• Show good faith

Protect Your Interests

• Track earnout metrics carefully
• Flag issues immediately
• Don't accept unfavorable changes
• Consult your attorney

Common Earnout Killers

Cost Allocation Buyer allocates corporate costs to your business, reducing EBITDA.

Protection:

• Define cost allocation in agreement
• Cap allocated costs
• Require approval for new allocations

Resource Constraints Buyer doesn't provide promised resources (budget, people, technology).

Protection:

• Document resource commitments
• Include minimum investment requirements
• Tie earnout to resources provided

Strategic Changes Buyer changes strategy, making earnout targets impossible.

Protection:

• Require approval for major changes
• Adjust targets if strategy changes
• Include acceleration clause

Integration Issues Forced integration disrupts business and hurts performance.

Protection:

• Maintain operational independence
• Control integration timeline
• Adjust targets for integration impact

Key Person Departures Critical team members leave, hurting performance.

Protection:

• Retention bonuses for key people
• Earnout participation for team
• Buyer commitment to retention

Maximizing Performance

Focus on Core Business

• Don't get distracted by integration
• Maintain customer relationships
• Keep team motivated
• Execute on plan

Leverage Buyer Resources

• Access to capital
• Sales channels
• Technology
• Expertise

Manage Expectations

• Set realistic targets
• Communicate progress
• Flag issues early
• Propose solutions

Stay Professional

• Don't burn bridges
• Be collaborative
• Show good faith
• Think long-term

When Things Go Wrong

Dispute Resolution Steps:

1. Direct Negotiation

• Document the issue
• Propose solution
• Seek compromise
• Get legal advice

2. Mediation

• Hire neutral mediator
• Present your case
• Explore solutions
• Reach agreement

3. Arbitration

• Present evidence
• Expert testimony
• Binding decision
• Faster than litigation

4. Litigation

• Last resort
• Expensive and slow
• Damages relationship
• Uncertain outcome

Real-World Example

My Second Exit:

• $5M upfront
• $3M earnout (60% of total)
• Based on revenue targets
• 2-year period

Challenges:

• Buyer wanted to change pricing
• Resource constraints
• Integration distractions
• Key employee left

Solutions:

• Negotiated pricing changes
• Documented resource issues
• Maintained focus on core business
• Hired replacement quickly

Result:

• Achieved 90% of earnout
• Maintained good relationship
• Learned valuable lessons

Key Takeaways

1. Negotiate Hard Upfront The best time to protect yourself is before signing.

2. Document Everything You'll need evidence if disputes arise.

3. Stay Focused Don't let integration distract from earnout goals.

4. Communicate Proactively Surprises lead to conflicts.

5. Be Prepared to Walk Away Know when to cut losses and move on.

Earnouts can work well when structured properly and both parties act in good faith. But protect yourself—not everyone does.