Earnouts in M&A: When They Work, When They Don’t, and How to Structure Them So Both Sides Win

Earnouts are one of the most useful tools in M&A and one of the most reliable sources of post-closing litigation. Both things are true at the same time. An earnout can bridge a valuation gap that would otherwise kill a deal, and an earnout can become a multi-year dispute that consumes the seller’s time, the buyer’s attention, and a meaningful chunk of the consideration that was supposed to flow.

The difference between an earnout that works and an earnout that doesn’t comes down almost entirely to how it is structured at the time of signing — not how it is administered after closing. By the time a dispute arises, the language is the language. The drafting decisions made before the ink is dry determine which side is right.

When earnouts actually make sense

Earnouts work best in a narrow set of circumstances. They make sense when there is a genuine, identifiable reason the buyer and seller disagree on value — not just because the parties want to split the difference. Common scenarios where earnouts are well suited:

• The seller is launching a new product, service line, or market that has not yet produced meaningful revenue but has clear pipeline visibility.
• A specific large customer relationship or contract is in late-stage negotiation but not yet signed at closing.
• The business is in a clear growth trajectory but with limited operating history, and the buyer is unwilling to underwrite the projection.
• The seller will remain meaningfully involved in the business post-closing and can directly influence the metrics that determine the earnout.

Earnouts work less well — and often poorly — when the seller is fully transitioning out of the business at closing, when the metrics depend on factors outside the seller’s control, or when the buyer plans to materially restructure or integrate the acquired business into a larger operation.

Choosing the right metric

The choice of earnout metric matters more than almost any other decision in the structure. The three most common metrics each have their issues.

Revenue

Revenue is the simplest metric and the hardest to manipulate, which is why sellers tend to prefer it. The downside for buyers is that revenue does not equal profit. A seller motivated to hit a revenue target can take low-margin deals, extend payment terms, or push price concessions in ways that hurt the business after the earnout ends. Revenue earnouts often need guardrails around discounting, customer mix, and credit terms.

EBITDA

EBITDA aligns more directly with what the buyer is actually paying for, but it is enormously sensitive to accounting choices. Allocations of corporate overhead, treatment of one-time expenses, capitalization versus expensing of investments — each of these can swing EBITDA meaningfully. Sellers signing EBITDA earnouts need detailed protection on accounting methodology and on which costs the acquired business will and will not be allocated.

Operational milestones

Milestone earnouts — landing a specific customer, obtaining regulatory approval, completing a product launch — work well when the milestone is binary and verifiable. They work poorly when the milestone is partially subjective or depends on actions by both parties. The classic failure mode is a milestone that the seller can mostly achieve but where the final step requires buyer cooperation that does not materialize.

An earnout is only as good as the operational covenants protecting it.

Operational covenants: the seller’s only real protection

Once the deal closes, the buyer owns the business and makes the decisions. The seller’s earnout depends on those decisions being made in a way that does not destroy the earnout. The mechanism for that protection is a set of operational covenants in the purchase agreement — agreed restrictions on what the buyer can and cannot do during the earnout period.

Sellers should think carefully about which covenants matter most for their specific business. Common ones include:

• Operate the acquired business as a separate division or segment, with separate accounting, for the duration of the earnout.
• Maintain agreed levels of marketing spend, sales staffing, or R&D investment.
• No transfer of customers, contracts, or product lines out of the acquired entity.
• No allocation of corporate overhead beyond a defined cap.
• Reasonable cooperation with the seller’s reasonable requests for information during the earnout period.

Buyers will resist many of these — they bought the business and want flexibility to run it. The negotiation is where each side has to be specific about what they actually need. A blanket ‘operate consistent with past practice’ covenant sounds protective but is one of the most-litigated phrases in M&A. Specificity is what holds up.

The accounting question that determines who wins

Every earnout based on a financial metric needs a defined accounting methodology. Will the metric be calculated under GAAP? Under the seller’s pre-closing accounting policies? Under the buyer’s policies? With what adjustments?

This single decision drives more earnout disputes than any other. The seller assumes the methodology that was used to build the projections. The buyer applies the methodology that aligns with the buyer’s broader financial reporting. The two are different, and the difference is real money.

The right approach is to define the methodology in detail in an exhibit to the purchase agreement. Specify which accounting principles apply, list any agreed adjustments, identify how new accounting standards adopted after closing will be treated, and lock in the categories of expenses that can and cannot be allocated to the acquired business. The longer the exhibit, the fewer the disputes.

Dispute resolution: build the road before the accident

When earnout disputes arise, the seller almost always wants a quick, business-focused resolution and the buyer almost always wants a slow, document-intensive one — because delay favors the side holding the money. The way to prevent that asymmetry is to define the dispute process in the agreement.

The most workable structure is a two-step process: first, a defined period for the parties to attempt to resolve the dispute in good faith; second, escalation to an independent accounting firm whose decision is binding on quantitative issues. Keep legal disputes out of court when possible — accounting firms understand the math and resolve disputes in weeks rather than years.

The conversation founders should have with themselves

Before agreeing to an earnout, founders should ask themselves a direct question: am I willing to spend the next two or three years working under someone else’s direction, watching them run my business, while a meaningful piece of my compensation depends on outcomes I can no longer fully control?

If the answer is yes — because the upside is significant, because the buyer is the right partner, because the work is satisfying — an earnout can be the right structure. If the answer is no, the seller is better off negotiating a lower headline price paid entirely at closing. Earnouts only work when both sides actually want the relationship the earnout creates. When one side is just trying to bridge a price gap they could not otherwise close, the earnout usually becomes the dispute that ends the relationship.

Frequently Asked Questions

What is an earnout in an M&A transaction?

An earnout is a portion of the purchase price that is paid to the seller after closing, contingent on the business hitting agreed performance targets — usually revenue, EBITDA, or specific operational milestones — over a defined period, typically one to three years.

Why do buyers and sellers use earnouts?

Earnouts let buyers and sellers close a deal even when they disagree on what the business is worth. The seller believes future performance will justify a higher price; the buyer is not willing to pay for performance that has not yet happened. The earnout shifts that risk to the seller in exchange for the chance to capture the upside.

What is the biggest risk with an earnout?

Loss of control. Once the deal closes, the buyer runs the business. The seller’s earnout depends on decisions made by people who have an economic incentive to defer or reduce earnout payments. Without carefully drafted protections, the seller can watch the earnout disappear through operational choices they cannot influence.

How long should an earnout period be?

Most earnouts run twelve to thirty-six months. Shorter periods are easier to measure and less prone to dispute. Longer periods raise the risk that the seller’s involvement in the business is no longer meaningful and that the operational landscape will change in ways that disconnect performance from anything the seller did.

Can earnout disputes be avoided?

Fully avoided, no. Minimized, yes — through clearly defined metrics, agreed accounting methodology, operational covenants protecting the earnout business, and a defined dispute resolution path. Earnouts drafted in detail tend to settle; earnouts drafted loosely tend to litigate.

About the Author

Scott Levine is the Founder and Managing Partner of AEGIS Law, a national law firm built on a fundamentally different model: lawyers focus exclusively on practicing law while a dedicated management team runs the business. Scott has spent nearly thirty years guiding entrepreneurs, founders, and closely held companies through mergers, acquisitions, growth transactions, and exits. He works alongside the firm’s M&A team — including Rochelle Walk, Robert Gold, and others — across AEGIS offices in St. Louis, Chicago, Denver, Tampa Bay, and Southern Illinois. He can be reached through aegislaw.com.