5 Earnout Structures for SMB Acquisitions

Earnouts can help buyers and sellers agree on a business's value by tying part of the sale price to future performance. Here's a quick breakdown of the five main earnout structures and how they work:

• Performance-Based Earnout: Payments depend on meeting specific financial metrics (e.g., revenue growth). Great for high-growth businesses, but requires clear goals to avoid disputes.
• Reverse Earnout with Escrow Holdback: Buyer pays upfront but can recover part of the price if performance targets aren't met. Ideal for quick deals but shifts risk to the seller.
• Milestone-Based Earnout: Payments are tied to achieving specific goals (e.g., product launch). Works well for businesses in development but requires precise milestone definitions.
• Revenue and Profit Sharing Earnout: Sellers receive a percentage of future revenue or profit. Aligns incentives but can lead to disputes if metrics aren't clear.
• Equity Rollover Earnout: Sellers retain a minority stake in the business. Allows sellers to benefit from future growth but ties their success to the buyer's strategy.

Quick Comparison:

Structure	Key Feature	Best For	Risk
Performance-Based Earnout	Tied to financial performance	High-growth businesses	Disputes over unclear metrics
Reverse Earnout with Escrow	Upfront payment, risk on seller	Quick deal closures	Seller refunds if targets missed
Milestone-Based Earnout	Linked to specific goals	Development-phase businesses	Unrealistic milestones
Revenue/Profit Sharing Earnout	% of future revenue or profit	Ongoing independent operations	Metric manipulation
Equity Rollover Earnout	Seller retains minority stake	Sellers confident in future growth	Buyer strategy risk

Earnouts can bridge valuation gaps and align incentives, but success requires clear metrics, timelines, and documentation. Choose the structure that best fits the deal's goals and risks.

Structure your first "M&A EARN-OUT" - without all the legal fees (here's how...)

1. Performance-Based Earnout

A performance-based earnout is one of the simpler structures used in small and medium-sized business (SMB) acquisitions. It ties additional payments to how well the company performs after the acquisition. Essentially, future payouts are directly linked to the company's post-sale results.

Mechanics

The key to making this structure work is negotiating clear, measurable metrics - like a "15% year-over-year revenue increase" - that determine whether earnout payments are triggered. If the company meets these targets, payments are made. If it misses the mark, payments may be delayed or canceled. In some cases, exceeding the targets can even result in bonus payments.

The success of a performance-based earnout hinges on creating a formula that's easy to measure, objective, and resistant to manipulation. For example, instead of relying on vague terms like "substantial growth", it's better to set specific goals such as "a 15% increase in revenue year-over-year." Clear metrics like these help reduce ambiguity and ensure both parties are on the same page.

This structure allows buyers to mitigate risk while giving sellers a chance to benefit from the company's future growth. It’s especially effective in certain situations, detailed below.

When to Use

Performance-based earnouts work well in cases where a company is likely to see rapid growth in the near future or when the seller’s involvement is critical to the business during the transition period. They’re particularly helpful when there’s uncertainty about factors that could significantly impact the company’s value after the sale.

Buyers often favor this structure when acquiring businesses with high growth potential but relatively low current revenue. It reduces the upfront financial risk for the buyer while giving sellers the chance to share in the future upside.

Example

A notable example of a performance-based earnout occurred in 2014 when Fidelity National Financial acquired Lender Processing Services for $2.9 billion. An earnout clause in the deal provided an additional $800 million, contingent on achieving sequential earnings-per-share improvements of 25%, 30%, and 35% over three years.

Advantages and Disadvantages

Performance-based earnouts come with their own set of pros and cons for both buyers and sellers.

For Sellers	For Buyers
• Opportunity to earn more if performance targets are met. • A chance to maximize compensation based on future success.	• Helps avoid overpaying by tying the final price to actual results. • Acts as deferred acquisition financing, linking payments to the business's future performance.
• Payments are uncertain and depend on meeting targets. • Loss of control over business operations after the sale.	• Sellers might manipulate operations to meet short-term goals. • Disputes may arise over how performance is measured.

The success of this structure relies heavily on clear communication, well-defined goals, and a foundation of trust between the buyer and seller throughout the earnout period.

2. Reverse Earnout with Escrow Holdback

A reverse earnout with escrow holdback flips the script on the traditional earnout model. Instead of tying part of the purchase price to future performance, the buyer pays the entire amount upfront - including what would typically be the earnout portion. If the business underperforms, the buyer can recover a portion of that payment. This setup shifts the risk to the seller while ensuring they receive immediate cash flow - unlike a traditional earnout.

Mechanics

Here’s how it works: the buyer pays the full purchase price at closing, but a portion is held in escrow or structured as an adjustable promissory note. If the business doesn’t hit the agreed-upon performance targets, the seller must refund part of the purchase price. The escrow holdback is usually a percentage of the total purchase price. For instance, data from 2014 shows that, on average, 9.14% of the purchase price was placed in escrow, with a median of 7.5%. Timing is critical here - capital losses can only be carried back for three years. If the refund happens after that window, the seller may face a capital loss that can’t be offset.

When to Use

This structure works well when buyers want to close deals quickly while still protecting themselves from potential underperformance. It’s particularly useful in asset sales or situations where traditional earnouts might feel too restrictive. Sellers who are confident in their projections and prefer receiving full payment upfront are likely to find this arrangement appealing.

Advantages and Disadvantages

The reverse earnout introduces a unique balance of risks and rewards for both parties:

For Sellers	For Buyers
• Get the full purchase price upfront, improving immediate cash flow	• Must allocate more initial capital to pay the full purchase price upfront
• Potential to benefit from favorable dividend features, when applicable	• Protected from underperformance through escrow recovery options
• Take on the risk of refunding part of the payment if performance targets aren’t met	• Can close deals faster without lengthy earnout negotiations
• May face capital loss issues if refunds occur after the three-year limit
• Limited upside compared to traditional earnouts

This structure shifts the burden of performance risk to the seller, requiring them to refund part of the payment if targets aren’t achieved. For buyers, it’s a way to show commitment while safeguarding their investment. It’s a win for sellers who value upfront payment but comes with its own set of risks.

3. Milestone-Based Earnout

A milestone-based earnout links part of the purchase price to achieving specific goals or events, rather than relying on ongoing financial performance metrics. Unlike revenue-based earnouts, which focus on continuous financial outcomes, this approach rewards sellers for reaching clearly defined milestones - whether that’s securing a key contract, launching a product, or achieving a targeted market share.

Mechanics

In this structure, the buyer withholds a portion of the purchase price at closing and releases payments once the agreed-upon milestones are met. These targets, determined before the deal closes, set clear expectations for both parties. Milestones can be financial, like revenue thresholds, or non-financial, such as product launches or regulatory approvals.

A 2017 study by SRS Acquiom found that 64% of deals tied earnouts to revenue milestones, while 36% used other criteria, such as improving gross margins or meeting sales quotas. Payments are triggered upon achieving the milestones, rather than requiring sustained performance over time. This clarity makes milestone-based earnouts particularly effective when the focus is on specific, measurable achievements.

When to Use

This type of earnout works best for businesses with well-defined, measurable goals that directly affect their value. It’s especially useful for companies in the development phase, where hitting milestones - like securing regulatory approval or launching a new product - can significantly impact growth. It also encourages sellers to stay engaged post-closing, ensuring they complete critical tasks like retaining key clients or finalizing in-progress projects. These milestones often serve as a bridge between pre- and post-closing performance.

Example

A notable case is Sanofi’s acquisition of Genzyme, which included a $14 per share earnout tied to specific regulatory and production milestones. These included obtaining FDA approval for Alemtuzumab by March 31, 2014, and meeting key production goals. When Genzyme failed to meet these milestones, no additional payments were made, leading to legal disputes.

Advantages and Disadvantages

Milestone-based earnouts can align buyer and seller objectives, but they aren’t without risks. Here’s a breakdown:

Advantages	Disadvantages
Helps bridge valuation gaps between buyer and seller expectations	Sellers may face delayed payments, which could be problematic if they need cash upfront
Encourages sellers to achieve specific, measurable goals post-closing	Overly optimistic milestones may result in non-achievement
Protects buyers from overpaying by tying payments to actual outcomes	Potential manipulation by either party to influence milestone results
Offers flexibility to include both financial and non-financial targets	Disputes may arise over milestone definitions and interpretations

The key to success lies in defining milestones precisely. Unrealistic or misaligned targets can lead to disputes or unintended outcomes. To avoid these pitfalls, milestones should be clear, measurable, and aligned with the long-term interests of both parties.

When structuring milestone-based earnouts, it’s crucial to involve legal, business, and technical experts. This ensures that the milestones are not only achievable but also clearly documented, reducing the chances of disputes later on.

4. Revenue and Profit Sharing Earnout

Unlike milestone-based earnouts that reward specific achievements, revenue and profit sharing earnouts allow the seller to share in the business’s ongoing success. Under this structure, the seller receives a percentage of the company’s revenues or profits over a set period after the acquisition is finalized. This approach ties the seller’s earnings directly to the business’s performance, creating a shared incentive for growth.

Mechanics

In this setup, the seller is entitled to a portion of the revenues or profits generated during a defined timeframe - usually between one and three years. Clear and objective metrics are crucial to avoid disputes. These metrics can include revenue, gross profit, or net profit, though revenue-based earnouts are generally less susceptible to manipulation compared to profit-based ones. A well-defined formula ensures transparency and reduces the likelihood of disagreements down the line.

When to Use

This type of earnout is particularly effective for businesses that continue operating independently after the acquisition, especially if the existing management remains in place. Such continuity makes performance tracking more straightforward. Revenue and profit sharing earnouts are often seen in industries like healthcare, law, accounting, and high-tech sectors, where retaining customers and employees is critical. They are also a practical choice for startups with limited operating history but strong growth potential.

For buyers with limited cash on hand, this structure is especially appealing as it ties payments to the actual performance of the business, offering greater financial flexibility.

Advantages and Disadvantages

While revenue and profit sharing earnouts can align the interests of buyers and sellers, they also carry certain risks. Here’s a breakdown:

Advantages	Disadvantages
Payments are tied to the business’s actual performance, aligning interests between buyer and seller	Profit-based earnouts can be manipulated through increased spending on expenses like marketing, R&D, or salaries
Encourages buyers to grow the business while giving sellers a chance to maximize sale value	Sellers might prioritize short-term results over the long-term health of the business
Helps bridge valuation gaps and broadens the range of potential deals	Disputes may arise, leading to costly arbitration or litigation
Offers flexibility by sharing risks and rewards in uncertain scenarios	Differing interpretations of financial metrics like EBITDA or allowable expenses can lead to conflicts
Identifies key growth drivers and sets clear performance expectations	Revenue-based metrics are less prone to disputes, but profit-based metrics may create tension

Profit-based earnouts are particularly vulnerable to manipulation. Buyers might reduce payouts by inflating expenses, while sellers could sideline long-term investments to secure higher short-term earnings.

The success of a revenue and profit sharing earnout relies heavily on careful planning. This includes defining every element of the calculation, setting clear payment schedules, and outlining control provisions to minimize misunderstandings and disputes in the future. Thoughtful drafting is essential to ensuring both parties feel confident in the agreement.

sbb-itb-97ecd51

5. Equity Rollover Earnout

An equity rollover earnout gives sellers the opportunity to hold on to a minority stake in their business after it's acquired. This setup allows sellers to share in the company’s future growth. Instead of receiving the entire sale price upfront, the seller gets a partial payment at closing while retaining an ownership share that could increase in value over time.

How It Works

In this structure, the buyer acquires a majority stake in the business at the time of closing, while the seller keeps a smaller share - usually between 8% and 40%. For instance, a buyer might purchase 70% of the company, leaving the seller with the remaining 30%. This retained equity can often be structured in a tax-deferred manner.

The equity retained by the seller can take various forms, such as subordinated equity, equivalent units, or vesting arrangements tied to performance milestones or time-based conditions. Buyers, particularly financial ones, often expect key management, founders, and sometimes investors to participate in these rollover arrangements as part of the deal structure. These mechanics help determine when an equity rollover might be the right choice for both parties.

When It’s a Good Fit

Equity rollover earnouts work well in private equity platform investments and large add-on acquisitions. Buyers often favor this approach to ensure operational continuity and keep sellers engaged. It’s particularly appealing in situations where sellers want to remain involved in the business, and buyers are looking to reduce their upfront financial risk.

Private equity firms often use this strategy to align the management team's interests with the success of the deal. It also serves as a form of seller financing, lowering the buyer’s initial cash outlay. This can be especially useful in transactions with aggressive pricing or when there’s a large valuation gap between the buyer and seller.

For sellers who believe in the future growth of their company, this structure offers a chance to benefit from potential increases in value under new ownership or with additional capital investments.

Real-World Example

Take Jim Smith, the owner of a software solutions company generating $25 million in annual revenue. When a private equity firm acquired his business, Smith retained 30% equity while cashing out the other 70%. The acquiring firm aimed to triple the company’s revenue within five years through strategic investments and operational improvements.

Fast forward five years, and the company’s revenue had grown to $75 million. The business was sold for $220 million, and Smith’s 30% equity stake was now worth $66 million. This example highlights how sellers can realize substantial gains by opting for an equity rollover.

Pros and Cons

Here’s a breakdown of the advantages and disadvantages of equity rollovers:

Advantages	Disadvantages
Allows sellers to receive partial liquidity while benefiting from future growth	Success depends on the buyer’s ability to execute their growth strategy
Reduces the buyer’s upfront financial commitment and risk	Sellers lose control but remain financially tied to the business’s performance
Aligns seller incentives with the company’s long-term success	Sellers must carefully assess the buyer’s track record and business plan
Can replace the need for extensive post-closing incentive plans	Requires thorough due diligence on the buyer’s proposed debt and equity setup
Signals the seller’s confidence in the company’s potential to buyers	Involves navigating complex agreements and potential employment terms post-sale

The success of this structure largely depends on the buyer’s capabilities and track record. Sellers should conduct thorough financial and legal due diligence, examining the buyer’s business plan, debt structure, and equity arrangements. It’s also important to negotiate clear terms for transaction, equity, and employment agreements to ensure a favorable post-closing experience.

For sellers, this isn’t just about the numbers. It’s equally important to consider how life under the new ownership will look - especially when comparing multiple offers.

Important Earnout Structure Factors

A well-thought-out earnout depends on several key factors. Getting these right is essential to making the structure work effectively. When earnouts are poorly planned, they can lead to disagreements, missed payments, and strained relationships between buyers and sellers.

Selecting the Right Performance Metrics

At the heart of a successful earnout lies the choice of clear, measurable metrics. Common financial metrics like revenue and EBITDA are often used, but each comes with its own set of risks and benefits.

"A good earnout formula is easily defined, measured, objective, and not capable of being manipulated by either party", says Jacob Orosz, President of Morgan & Westfield.

In industries such as technology and pharmaceuticals, operational metrics tied to milestones are often preferred. It's crucial for both parties to agree on definitions that are simple and measurable. Buyers should prioritize straightforward metrics when structuring earnout payments, while sellers should push for metrics they can directly influence. Additionally, both sides must clearly outline who has the authority to make operational decisions that could impact these metrics.

Defining Time Horizons

Earnout periods generally range from one to five years after the deal closes, with most falling between one and three years. The timeline is critical: a short period might not give the seller enough time to hit meaningful targets, while a long one could lead to a loss of motivation. Research shows that targets are often easiest to achieve in the first year and become harder as time goes on. Striking the right balance between a seller’s ability to meet goals and a buyer’s tolerance for risk is key. Once the timeline is set, precise documentation becomes vital to ensure everyone is on the same page.

Preventing Disputes Through Clear Documentation

Disputes often stem from vague performance metrics or differing interpretations of financial results. To avoid these pitfalls, the earnout agreement should clearly define which revenue streams count toward targets, specify the accounting standards to be used, and outline detailed measurement timelines. These steps help minimize ambiguity and reduce the likelihood of conflicts.

The contrast between successful and problematic earnouts highlights the importance of clarity. For instance, Electronic Arts structured its acquisition of PopCap with clearly defined cumulative EBIT targets, which reduced financial risk while encouraging growth. On the other hand, Genzyme’s earnout agreement with Sanofi faced legal challenges when vague performance criteria led to unmet milestones and disputes.

Key Documentation Requirements

A strong earnout agreement must include detailed definitions of metrics, calculation methods, timelines, and adjustments to avoid misunderstandings. Clearly defined conditions for triggering earnout payments are essential to prevent misinterpretation. The agreement should also account for external factors, such as shifts in market conditions or competitive pressures, that could affect performance. Setting achievable yet ambitious goals and linking payments to specific milestones are crucial components of a successful earnout.

Maintaining thorough financial records, operational data, and contemporaneous documentation is critical to upholding the terms of the earnout and resolving any disputes that might arise. These foundational elements create a solid framework for managing earnout agreements effectively.

Using Deal Platforms for Earnout Implementation

Deal platforms simplify the management of earnouts by centralizing performance tracking and documentation. This digital framework ensures transparency and consistency, which are critical for successful earnout agreements.

Simplified Deal Discovery and Analysis

Platforms like Kumo have transformed the early stages of acquisitions involving earnouts by pulling together business listings from countless brokers and organizing unstructured data. This process makes it easier to spot opportunities that align with earnout structures. For instance, Kumo enhances visibility for businesses that are more likely to accommodate earnout agreements.

With AI-driven analysis, buyers can quickly determine if a business fits the criteria for an earnout-friendly deal. Businesses with steady revenue or clear growth potential can be identified through filters that sort by metrics like asking price, EBITDA, and industry. This streamlined approach builds on earlier advice to establish clear, measurable goals for earnouts.

Improved Metric Tracking and Documentation

One of the biggest challenges in earnout agreements is maintaining accurate documentation. Deal platforms solve this by offering centralized systems to store financial and performance data. These tools track changes to critical metrics over time, giving both buyers and sellers real-time updates on earnout progress.

"Earnouts are a type of structure in an acquisition where a portion of the price is tied to some future factor. This factor could be financials (e.g., revenue or EBITDA targets) or nonfinancial (e.g., retaining a key customer, securing a new license or regulatory approval)", explains Mathew Burpee, Managing Director at Kepler Capital Corporation.

By centralizing data and performance metrics, these platforms help reduce disputes, ensuring everyone is on the same page when it comes to earnout milestones.

Essential Platform Features for Earnouts

The best deal platforms offer secure data storage, automated reporting, and tools for precise earnout calculations. These features not only simplify the process but also guard against potential manipulation, a common concern in earnout agreements. Clear calculations and detailed documentation ensure a smoother process for both parties.

Many platforms also include communication tools that facilitate collaboration - especially important when sellers remain involved in the business to meet earnout targets. By integrating financial tracking with communication features, these platforms keep both parties aligned throughout the earnout period.

Real-World Benefits of Implementation

In practice, these tools allow both buyers and sellers to focus on growing the business, rather than getting bogged down in disputes over metrics.

"I think it is important to keep the earnout focused on areas where the seller will have some influence or control post-closing and to keep the calculation as clear and simple as possible. If you spend time arguing about the earnout post-closing, you take away time from growing the business."

Access to real-time data ensures fewer disputes and keeps the focus on business growth. Additionally, the comprehensive audit trails and documentation provided by these platforms are invaluable for resolving disagreements, especially in multi-year earnout agreements with complex performance metrics.

Conclusion

The five earnout structures discussed here highlight how these tools can bridge valuation gaps and align the interests of buyers and sellers in small and medium-sized business (SMB) acquisitions. Each structure is tailored to specific scenarios - whether it’s performance-based earnouts that incentivize growth or equity rollovers that keep sellers engaged for the long haul.

As the market evolves, the increasing use of earnouts underscores their value beyond just being a negotiation tool. Recent trends show that earnouts are gaining traction as buyers and sellers recognize their potential to create win-win situations. However, success hinges on having clear documentation and measurable, well-defined objectives.

Different situations call for different earnout approaches. Whether dealing with steady cash flows or businesses poised for rapid growth, earnouts can be customized to fit the deal. With the right legal, financial, and operational support, these structures can turn potential challenges into opportunities, ensuring both parties remain focused on growing the business rather than debating metrics.

As SMB acquisitions grow more competitive, mastering these five earnout structures provides a strong foundation for crafting creative and effective deals that benefit everyone involved.

FAQs

How can I choose the right earnout structure for my business acquisition?

Selecting the right earnout structure for a business acquisition involves weighing a few essential factors. First, look closely at the valuation gap - earnouts are often used to bridge differences in how the buyer and seller perceive the business's value. Then, pinpoint the performance metrics that will determine payout triggers. These could include revenue, EBITDA, or specific milestones like achieving certain levels of customer retention. Lastly, think about the earnout duration and decide whether payments will be made in one lump sum or spread out over multiple installments.

By addressing these factors thoughtfully, you can craft an earnout structure that supports your strategic objectives while balancing risks for everyone involved.

What should you consider when setting performance metrics for a successful earnout agreement?

To make an earnout agreement work effectively, it’s crucial to establish specific and measurable performance metrics. These could include targets like revenue, EBITDA, or particular operational milestones. Defining these metrics clearly helps prevent misunderstandings or disputes down the line.

It’s equally important to outline a transparent payment structure and timeline. Both parties should have a clear understanding of how and when payments will be made based on performance achievements. This level of clarity not only minimizes potential risks but also encourages a cooperative relationship between the buyer and seller during the earnout period.

What steps can buyers and sellers take to avoid disputes over earnout agreements?

To steer clear of disputes in earnout agreements, it's essential to prioritize clear documentation and open communication from the start. Begin by crafting a well-defined agreement that lays out performance metrics, timelines, and calculation methods in precise detail. This way, both parties are on the same page about how success will be evaluated, leaving little room for confusion.

It's also important to maintain consistent communication throughout the earnout period. Set up regular check-ins to review progress, address any concerns, and adjust for operational changes that could affect the agreement. Taking a proactive approach fosters trust and reduces the chances of misunderstandings or conflicts.

Related posts

• 7 Key Metrics for Evaluating Business Acquisition Targets
• Business Valuation Methods: Expert Q&A Guide
• What Is Strategic Fit in SMB Acquisitions?
• Key Terms to Negotiate in Seller Financing