5 Smart Tips for Structuring Earn-Outs That Create Win-Win M&A Deals

When buyer and seller can’t fully agree on valuation at the time of acquisition, earn-outs become the bridge. Structured properly, they align interests, reduce risk, and help close deals that might otherwise fall apart.

But if mishandled, earn-outs can breed resentment, disputes, and post-close misalignment.

In this post, we’ll walk through best practices for structuring earn-outs so you can protect your investment while keeping sellers motivated to drive performance after the deal.

What Is an Earn-Out in M&A and Why Structuring Earn-Outs Matters

An earn-out is a deferred payment structure where part of the purchase price is contingent on the business hitting specific performance targets after closing.

Rather than paying the entire price up front, the buyer agrees to pay additional amounts over time if agreed-upon metrics are met.

For example:

• Deal Price: $5 million
• Upfront: $3.5 million
• Earn-Out: $1.5 million paid over 2 years if EBITDA hits $1M/year

This allows buyers to hedge risk while sellers get upside for continued business success.

When Structuring Earn-Outs Makes Sense in Small Business Acquisitions

Earn-outs are especially common when:

• The business is highly reliant on the owner’s relationships
• Forecasted growth is aggressive or uncertain
• There are major customer contracts in the pipeline
• Revenue is seasonal or variable
• The parties have differing views on valuation

Instead of walking away from the table, a well-structured earn-out gives sellers “skin in the game” while providing buyers with risk protection.

 

Types of Metrics Used When Structuring Earn-Outs

The structure of an earn-out depends on which metric is used as the performance benchmark. Common types include:

Revenue-Based Earn-Outs

These are tied to gross revenue, often over 1–3 years. Easier to track but can be manipulated through pricing strategies or channel shifts.

Pros:

• Simple to measure
• Less susceptible to accounting changes

Cons:

• Doesn’t account for profitability
• Could incentivize unprofitable growth

EBITDA or Net Income-Based Earn-Outs

These are based on adjusted EBITDA or net profits, reflecting actual earnings.

Pros:

• Tied to business value
• Encourages profitable growth

Cons:

• More complex to measure
• Can be influenced by discretionary expenses

Milestone-Based Earn-Outs

Earn-outs tied to key events like new customer wins, product launches, or team retention.

Pros:

• Useful when financial metrics are hard to predict
• Good for early-stage or R&D-driven businesses

Cons:

• Hard to define clearly
• Risk of subjectivity

5 Tips for Structuring Earn-Outs That Actually Work

1. Keep the Metrics Simple and Auditable

The most common source of post-close conflict is vague or complex measurement criteria. Your QofE or diligence team should validate whether the metric is:

• Easy to measure using standard reports
• Not easily manipulated by accounting decisions
• Clearly defined in the purchase agreement

For example, use “Adjusted EBITDA per GAAP, normalized for seller addbacks” and reference a template calculation in the annex.

2. Cap the Earn-Out Value and Duration

Avoid open-ended deals. Most earn-outs in lower middle market M&A:

• Last 1 to 3 years
• Account for 20% to 40% of the total deal value
• Pay out quarterly or annually

Capping duration and total earn-out gives both sides a clear timeline and expectations.

3. Align Control and Incentives

Earn-outs fail when the seller no longer has control but is still being measured on outcomes. Align operational control with the earn-out structure:

• Will the seller stay on as a manager or advisor?
• Can they control pricing, hiring, or ad spend?
• Is there a defined handover of duties?

If the seller isn’t involved post-close, avoid earnings-based structures they can’t influence.

4. Define What Happens If the Buyer Sells or Merges

What happens to the earn-out if the buyer flips the company or merges with another firm? Smart sellers include clauses that trigger:

• Full acceleration of unpaid earn-out
• Protection of payout if performance was on track

Buyers should negotiate reasonable limits while ensuring alignment.

5. Consider Escrow or Holdback Mechanisms

To protect buyers from overpayment, some deals hold a portion of the earn-out in escrow—released once targets are verified.

This is useful when:

• Financials are compiled by the seller
• There’s uncertainty in revenue sources
• Large customer contracts are in play

It also prevents disputes over whether targets were truly achieved.

Red Flags to Avoid When Structuring Earn-Outs

Poorly structured earn-outs lead to mistrust and even litigation. Watch out for:

• Vague definitions of metrics (e.g., “net profit after expenses”)
• Undefined addbacks or adjustments
• No dispute resolution mechanism
• Earn-out tied to consolidated buyer performance, not the acquired business
• No clarity on seller’s role post-close

Always define dispute processes typically using an independent accountant or advisor for arbitration.

Tax and Legal Considerations

Earn-outs are typically taxed as capital gains, but structure matters:

• Ensure the earn-out is tied to equity, not continued employment, or it may be taxed as ordinary income
• Discuss allocation of purchase price between goodwill, assets, and earn-out components
• Consult M&A-focused tax advisors before finalizing terms

How Structuring Earn-Outs Impacts Valuation and Deal Terms

While not counted in the upfront valuation, Structuring Earn-Outs influence:

• Perceived total deal value
• Financing structure (e.g., SBA loan limits may exclude earn-outs)
• Seller’s willingness to close at a lower initial price
• Buyer’s confidence in covering contingencies

Some buyers even use earn-outs to test-drive the business performance before finalizing a larger payout.

Final Thoughts on Structuring Earn-Outs for M&A Success

Earn-outs can be a powerful way to close the valuation gap but only if structured carefully. The goal is to create alignment, not friction.

With clear metrics, defined roles, capped payouts, and dispute protections, you can turn a deal risk into a deal closer.

Want help drafting or reviewing your earn-out structure?

Our M&A team at VASL can help you model performance metrics, assess legal risks, and support negotiation strategies.

Book a 30-minute consult: Here
Learn more at: VASL Inc