Understanding Earnouts and Deal Structures in Business Sales

Selling a business is rarely as simple as agreeing on a price and handing over the keys. Most transactions involve complex deal structures designed to align the interests of buyers and sellers while addressing risks and uncertainties. One common component of these structures is an earnout, which ties part of the purchase price to the business’s future performance.

This white paper explains earnouts and other deal structures, highlighting their purpose, how they work, and key considerations for sellers navigating the complexities of business sales.

1. Why Deal Structures Matter in Business Sales

The structure of a business sale determines how and when the purchase price is paid, how risks are distributed between the buyer and seller, and how the transaction addresses factors like future growth or uncertainties.

Key Objectives of Deal Structures:

• Risk Mitigation: Protect buyers from overpaying if the business underperforms after the sale.

• Alignment of Interests: Encourage sellers to help transition the business successfully.

• Flexibility: Allow buyers to make acquisitions without excessive upfront costs.

By understanding these structures, sellers can better negotiate terms that balance their need for financial security with buyer expectations.

2. What Is an Earnout?

An earnout is a contingent payment structure in which a portion of the purchase price is tied to the business’s performance after the sale.

How Earnouts Work:

• Buyers and sellers agree on performance metrics, such as revenue, EBITDA, or customer retention, that the business must achieve post-sale.

• If the business meets or exceeds these targets, the seller receives additional payments over a specified period (e.g., 1–3 years).

• Earnouts typically bridge the gap between the seller’s valuation expectations and the buyer’s willingness to pay upfront.

Advantages of Earnouts for Sellers:

• Higher Total Value: Earnouts allow sellers to capture upside if the business performs well after the sale.

• Deal Closure: Helps overcome valuation disputes and ensures the deal moves forward.

Advantages of Earnouts for Buyers:

• Risk Reduction: Protects the buyer from paying for projected growth that doesn’t materialize.

• Smooth Transition: Sellers are incentivized to assist with the transition to ensure the business meets performance targets​​.

3. Common Deal Structures in Business Sales

In addition to earnouts, there are several other deal structures that can impact how proceeds are distributed:

A. All-Cash Deals

• What It Is: The buyer pays the entire purchase price upfront in cash.

• Advantages:

• Simple and straightforward.

• Provides immediate liquidity for the seller.

• Disadvantages:

• Rare for larger deals, as buyers often prefer to spread out payments.

B. Seller Financing

• What It Is: The seller agrees to finance part of the purchase price, effectively acting as a lender to the buyer.

• How It Works:

• The buyer makes installment payments to the seller over time, often with interest.

• Advantages:

• Broadens the pool of potential buyers by lowering their upfront capital requirements.

• Provides the seller with ongoing income post-sale.

• Disadvantages:

• Involves risk for the seller if the buyer defaults on payments​​.

C. Equity Rollovers

• What It Is: The seller retains partial ownership in the business, typically as part of a private equity acquisition.

• How It Works:

• The seller rolls a portion of their equity into the buyer’s ownership structure, allowing them to participate in future growth.

• Advantages:

• Offers the potential for higher long-term returns.

• Keeps the seller involved in the business’s success.

• Disadvantages:

• Delays full liquidity for the seller and involves future risks​​.

D. Deferred Payments

• What It Is: The buyer agrees to pay a portion of the purchase price at a later date, often tied to specific milestones.

• Advantages:

• Reduces immediate capital burden on the buyer.

• Ensures seller participation in achieving post-sale goals.

• Disadvantages:

• Delays full payment for the seller and involves trust in the buyer’s ability to pay.

4. Key Considerations When Negotiating Earnouts

Earnouts can be beneficial for both parties but require careful negotiation to avoid disputes.

A. Choosing the Right Metrics

• Common Metrics: Revenue, EBITDA, gross margins, or customer retention rates.

• Ensure the metrics are clear, measurable, and directly influenced by the seller’s involvement post-sale.

B. Defining the Earnout Period

• Most earnout periods range from 1–3 years. Shorter periods are preferred by sellers to reduce risk.

C. Ensuring Transparency

• Require the buyer to provide regular reports on the business’s performance.

• Negotiate rights to audit the buyer’s financial records to verify earnout calculations.

D. Mitigating Risks for Sellers

• Control Over Operations: Sellers should negotiate provisions ensuring they retain some influence over operations affecting the earnout metrics.

• Caps and Floors: Establish minimum and maximum earnout thresholds to reduce uncertainty.

• Escrow Accounts: Request a portion of the earnout funds be held in escrow to guarantee payment​​.

5. Legal and Tax Implications of Deal Structures

A. Tax Considerations

• Earnouts and deferred payments are often taxed differently from upfront cash payments.

• Sellers may face ordinary income tax on earnouts, rather than the more favorable capital gains tax rate.

Actionable Tip: Consult a tax advisor to structure payments in a tax-efficient manner​​.

B. Legal Protections

• Engage legal counsel to draft clear terms for earnouts, seller financing agreements, and equity rollovers.

• Include dispute resolution clauses to address disagreements over performance metrics or payment timelines.

6. Common Pitfalls and How to Avoid Them

A. Misaligned Expectations

• Earnouts can lead to disputes if the seller and buyer have different expectations about performance metrics.
  Solution: Clearly define all terms and include scenarios for unexpected market conditions.

B. Buyer Interference

• Buyers may alter operations in ways that negatively impact earnout metrics.
  Solution: Negotiate operational oversight or include covenants protecting the seller’s interests.

C. Over-Reliance on Contingent Payments

• Sellers risk losing a significant portion of the sale price if performance targets aren’t met.
  Solution: Balance earnouts with other upfront payment structures to reduce risk.

Conclusion: Navigating Complex Deal Structures

Earnouts and other deal structures are essential tools in the M&A process, offering flexibility and risk-sharing opportunities for buyers and sellers. However, they require careful planning, negotiation, and legal protection to ensure fairness and alignment of interests.

Take Action Today: Consult with an experienced M&A advisor and legal counsel to understand how different deal structures can work for you. With the right preparation, you can achieve a successful sale while protecting your financial interests.