Posted by Jennifer M. Settles, Esq. | June 24, 2026

 

Earnouts Explained: How to Bridge a Valuation Gap Without Getting Burned

In many business sales, the buyer and seller agree on almost everything – except the price. The seller is confident the business will keep growing and wants to be paid for that potential; the buyer is wary of paying today for performance that hasn’t happened yet. When that gap can’t be closed through negotiation alone, an earnout is often the tool that bridges it. Used well, an earnout can get a deal done that would otherwise fall apart. Used carelessly, it can leave a seller waiting for money that never arrives.

Here’s how earnouts work, where they go wrong, and how to protect yourself on either side of the deal.

What an Earnout Is

An earnout is a portion of the purchase price that isn’t paid at closing but instead becomes payable later, if the business hits agreed targets after the sale. Rather than paying the full price up front, the buyer pays a base amount at closing and additional amounts over a defined period—typically one to three years—depending on how the business performs. In effect, it shifts some of the risk of future performance from the buyer onto the seller, who only collects the full price if the business delivers.

Why Earnouts Exist: Bridging the Valuation Gap

The core purpose of an earnout is to resolve a disagreement about what the business is worth. The seller believes in a higher number based on growth they see coming; the buyer isn’t willing to pay for projections. An earnout lets both sides have their position: if the seller is right and the business performs, they earn the higher price; if they’re wrong, the buyer hasn’t overpaid. It turns an argument about the future into a structure that rewards whoever turns out to be correct.

How Performance Gets Measured

The single most important – and most contested – part of any earnout is the metric used to measure performance. Earnouts can be tied to revenue, gross profit, EBITDA, customer retention, or specific milestones. Each choice carries tradeoffs. Revenue is simple to track but ignores profitability; EBITDA reflects the bottom line but can be influenced by how the buyer runs and accounts for the business after closing. The metric you choose shapes everything about whether the earnout pays out, so it deserves careful attention rather than a quick agreement.

The Central Risk: You No Longer Control the Business

Here is the trap that burns sellers most often. After closing, the buyer controls the business  . . . and the buyer’s decisions can directly affect whether the earnout targets are met. A buyer might cut spending in ways that depress short-term profit, shift the business’s focus, fold it into a larger operation, drastically increase ad-spend, or make accounting choices that move the numbers. Whether or not any of this is intentional, the seller’s payout now depends on a company they don’t run. Recognizing this dynamic is the first step to protecting against it.

Protecting the Seller: Operating Covenants

Because the seller is exposed to the buyer’s post-closing conduct, a well-drafted earnout includes protections (often called operating covenants) that constrain what the buyer can do during the earnout period. These might require the buyer to run the business consistently with past practice, maintain certain spending or staffing levels, refrain from moving revenue to affiliated entities, or operate the business in good faith to give the targets a fair chance of being met. Without these guardrails, a seller is trusting the buyer’s goodwill alone – which is a risky proposition when real money is on the line.

Define the Accounting and the Calculation

Many earnout disputes are really accounting disputes. The agreement should specify exactly how the relevant financial metrics will be calculated, which accounting methods apply, and how shared or allocated costs are handled. If “profit” can be computed several ways, you can be sure the buyer and seller will favor different ones. Pinning down the methodology in the contract – ideally with a worked example – removes much of the ambiguity that can later turn into litigation.

Build In Transparency and Dispute Resolution

A seller relying on an earnout needs visibility into the numbers behind it. Good agreements give the seller rights to receive regular financial reporting, and sometimes to audit the relevant figures, so they can verify the calculation rather than simply accept the buyer’s word. It’s also wise to agree in advance on how earnout disputes will be resolved – often through a designated independent accountant – so a disagreement over the numbers has a defined resolution path rather than heading straight to court.

Consider Acceleration and Change-of-Control Provisions

An earnout can stretch over several years, and a lot can change in that time. What happens if the buyer sells the business again, or if the seller is supposed to stay on but is terminated, before the earnout period ends? Thoughtful agreements address these scenarios, for example, by accelerating the earnout payment if the buyer resells the company or undergoes a change of control. Anticipating these possibilities keeps a later event from suddenly wiping out money the seller was counting on.

The Bottom Line

An earnout is a powerful way to bridge a valuation gap and get a deal across the finish line, but it shifts real risk onto the seller – who collects only if a business they no longer control performs. The difference between an earnout that pays and one that disappoints almost always comes down to the details: the metric, the accounting, the operating covenants, the transparency, and the protections built into the contract. This is not a place to rely on a handshake or a simple formula.

If an earnout is part of your deal, whether you’re buying or selling, the structure and the fine print are what determine how it turns out. Schedule a free consultation to talk through how to structure an earnout that actually protects you.   Contact us as www.jsettleslaw.com or (602) 617-3938.

About the Author Jennifer M. Settles makes business owners’ lives easier. With 25+ years structuring M&A deals, commercial contracts, corporate governance, and complex real estate transactions, including over two decades as lead in-house transactions counsel for major corporations, she brings big-firm firepower to the founders, dealmakers, and growing companies who need it most. Clients describe her as knowledgeable, refreshingly direct, and relentlessly focused on their best interests. Jennifer offers white-glove, direct-access service and transparent, predictable fees. Learn more or schedule a consultation.