An earnout is a portion of the purchase price that the seller receives only if the business hits specified performance targets after closing. It is written into almost every letter of intent in the lower middle market. It is a central reason the headline number in a press release is so often different from what the founder ultimately takes home. Understanding when earnouts are proposed, what they are designed to do, and how to reduce their size is one of the most valuable things a founder can learn before going to market.
Buyers propose earnouts for two reasons. The first is valuation disagreement. The buyer believes the business is worth less than the seller believes. Rather than walk away, the buyer offers a structure where the seller can reach the higher number if the business performs as promised. This is the cooperative version of the earnout. It bridges a gap and can work reasonably well when both sides negotiate the terms carefully.
The second reason buyers propose earnouts is less cooperative. When diligence surfaces risks the buyer is not willing to underwrite at the original price, an earnout is the cleanest way to shift that risk back onto the seller. Customer concentration in a book that has not been contractually protected, revenue figures that do not match tax returns, and management dependency on the founder are all classic triggers. The buyer is not saying they will not do the deal. They are saying they will only do the deal if the seller stays on the hook for the risks.
Earnout terms matter more than the earnout amount. An earnout tied to revenue is easier to manage than one tied to EBITDA, because EBITDA can be influenced by post-closing decisions the seller no longer controls. An earnout with a short measurement period is lower risk than one stretched over three or four years. An earnout that becomes payable on first-year targets is better than one that requires targets in each year. Every one of these terms is negotiable, and founders who treat the earnout as a single number rather than a structure leave money on the table.
The most effective way to reduce earnout size is to remove the reasons buyers propose them in the first place. If customer contracts are in place, the customer concentration argument loses force. If the tax returns, the P&L, and the stated revenue all match, the revenue risk argument loses force. If the management team can demonstrably run the business without the founder, the management dependency argument loses force. Each of these removals shifts risk back to the buyer, where it changes the deal from a structured earnout to a larger cash payment at close.
Sometimes earnouts are unavoidable. A founder staying on for a transition period, a business with a multi-year strategic pivot in progress, or a deal between parties with a legitimate difference in outlook may all justify an earnout structure. The goal is not to refuse every earnout on principle. The goal is to make sure the earnouts you accept are the ones you chose, for reasons you can explain, on terms you negotiated, rather than the ones the buyer slipped into the structure because diligence gave them the leverage to do so.