An Earnout Is Not a Price. It Is an Argument You Agreed to Have Later.

An earnout is what two parties use when they cannot agree on what a company is worth. It does not settle that disagreement. It postpones it, and the postponement sits on your side of the table.

Sometimes it is the right answer. If the gap is about whether something you believe will happen actually happens, an earnout lets you be paid for being right. But it has to be drafted as though the relationship will go badly, because the ones that go badly are never the ones anybody expected to.

The question above all the others

Who controls the thing being measured?

An earnout on revenue, in a business whose new owner sets the pricing, the sales compensation, and which customers get served first, is a payment contingent on someone else’s decisions. They are not obliged to make those decisions in your favor, and mostly they will make them for their own reasons.

The further down the income statement the measure sits, the more decisions sit between you and your money. Which is why an earnout on net income is the one most likely to end in a dispute: every allocated cost, every management fee, every shared service charge is a line somebody else controls.

What the agreement has to be specific about

Vagueness here is not a drafting detail. It is the whole exposure.

The income measure, defined in the document rather than by reference to general practice. The accounting methods, fixed, so a policy change cannot change your number. Whether performance is measured annually or cumulatively. The measurement period, and what happens if the business is sold again inside it. Any cap, and any floor. Your right to see the calculation and to have it examined. When payment is due once the number is determined. And how extraordinary or one-time items are treated.

Each of those has been the subject of a real dispute somewhere, which is why the list exists.

The pitfall that catches almost everyone

Agreeing the earnout at the letter of intent and leaving the definitions to the purchase agreement.

The percentage and the measure get agreed in a sentence, because they are the parts that sound like the deal. The definitions decide whether it ever pays. By the time drafting starts you are inside exclusivity, the other side knows it, and every definition is now being negotiated from the weaker position.

Settle the definitions when you settle the number, or accept that you settled only the number.

What it does to the rest of your deal

Two consequences owners do not price.

Your advisor’s fee is calculated on all consideration, including the contingent part, and paid at closing. So you pay a fee on money you may never receive, which is the standard term and the reason to understand it going in.

And you are taxed on a gain you have realized without having received all of it. The cash in your hand on closing day is smaller than the headline by more than most owners expect, and the gap is largest in exactly the deals that look most generous.

When to take one anyway

When the disagreement is genuinely about a future event rather than about present value. When you will still be running the business and genuinely control the measure. When the period is short enough to be survivable. When the measure sits high on the income statement. And when the cap is high enough that being right is worth the wait.

A buyer who proposes an earnout is not being unreasonable. They are declining to pay today for something that has not happened yet, which is a defensible position. The question is only whether the structure they propose leaves you any realistic path to collect.

What getting it wrong costs

Not usually the whole amount. Usually most of it, slowly.

The measure comes in under target for reasons that are all individually explicable and none of which you controlled. There is no fraud and frequently no bad faith. The business got run differently, which is what happens when somebody else owns it, and the number you agreed to be measured on was never a number you could protect.

More on this: Being Paid in Paper Means Lending Part of Your Price Back.

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This is what we do. Prism Edge negotiates the definitions at the same time as the percentage, prices the contingent part against the certain part, and works out whether the structure is a genuine bridge or a discount with a story attached.

The full chapter on structuring the transaction is in The Business Sale, free to download here.

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General information, not legal, tax, or financial advice, and no advisor relationship is created by reading it. Rules change and the specifics of your situation matter. Always consult your own attorney and accountant before acting.