What You’ll Learn
- What an earnout is, and why it shows up in deals where the buyer and seller can’t agree on a single number for the business
- How an earnout protects a buyer’s cash and a seller’s upside at the same time, and why that built-in tension is what makes the clause work
- Why the metric you pick to measure performance, revenue, EBITDA, or something else, decides more fights than any other clause in the agreement
- The specific covenants that keep a buyer from quietly starving an earnout after closing
- What happens when an earnout dispute can’t be settled by an accountant and ends up in front of a judge instead
Two people can look at the same business and land on two honest, defensible numbers. The seller sees thirty years of relationships, a pipeline that’s about to convert, and a growth story the financials haven’t caught up to yet. The buyer sees trailing revenue, a customer base that’s never been tested under new ownership, and a healthy discount for everything that could go wrong. Neither one is lying. They’re just valuing different futures.
An earnout agreement helps to bridge that gap. Instead of forcing both sides to agree on one price today, the purchase agreement splits the payment: a fixed amount at closing, plus additional payments later if the business hits agreed targets. The seller gets a shot at the higher number they believe in. The buyer doesn’t have to pay for a future that might not show up. Done well, an earnout turns a stalled negotiation into a signed deal. Done carelessly, it turns a signed deal into a lawsuit eighteen months after closing, which is the outcome every clause below is written to prevent.
What Is an Earnout?
Strip away the deal jargon and an earnout is a contingent payment obligation. The buyer owes the seller more money, but only if the business performs at or above a threshold defined in the purchase agreement, measured over a set period after closing, usually one to three years. If the target isn’t met, the buyer owes nothing further. If it’s met or exceeded, a formula in the agreement determines how much gets paid, sometimes all at once at a single trigger, more often on a sliding scale tied to how far above or below target the business landed.
That structure is why earnouts get called a bridge. They don’t resolve the valuation disagreement. They defer it, and let real performance settle the argument that projections couldn’t.
The Protection an Earnout Gives the Buyer
A buyer paying full price at closing for a business that might not perform is taking on someone else’s optimism at their own risk. An earnout shifts part of that risk back where it belongs. The buyer keeps more cash in hand at closing, which matters enormously if the deal is financed. And the seller, instead of walking away the day the wire clears, stays financially tied to the outcome. If they’re staying on to run the division or advise through the transition, their paycheck depends on the same numbers the buyer cares about. That alignment is worth more to a buyer than almost any warranty in the agreement, because it turns a seller who could otherwise coast into one who’s still pulling in the same direction.
The Protection an Earnout Gives the Seller
For the seller, the earnout is the difference between accepting a buyer’s conservative number and getting paid for the number they believe the business will hit. If the buyer’s valuation reflects skepticism about growth that hasn’t materialized yet, an earnout lets the seller say, in effect, pay me the discounted price now, and pay me the rest when I’m proven right. It’s also frequently the only way a deal closes at all. Buyers who won’t move off a lowball cash number will often move considerably on a number that only costs them anything if the business delivers. The earnout isn’t a consolation prize. For a seller confident in the business, it’s frequently where the real money is.
The Metric You Choose Decides the Fight You’ll Have
Every earnout dispute traces back to one decision made months before the trigger date: what, exactly, gets measured. Revenue is the simplest metric and the hardest for a buyer to manipulate after closing, but it says nothing about whether the business was profitable while hitting that number. EBITDA and net income get closer to real performance, but they open the door to a much messier argument, because a buyer who now controls the business also controls a long list of decisions that affect the bottom line: how overhead gets allocated, which costs get shifted onto the acquired unit, how aggressively the sales team gets staffed. None of those decisions have to be made in bad faith to still tank a seller’s earnout.
No metric is immune to this problem. What protects both sides is precision in how the metric is defined, down to the accounting policies that apply, the expenses that are excluded, and who has the final say when a judgment call must be made.
The Covenants That Do the Real Protecting
The performance metric gets the attention, but the covenants around it usually determine whether an earnout gets paid fairly. A well-drafted agreement requires the buyer to run the business in the ordinary course, consistent with how it operated before the sale, for the earnout period. It restricts the buyer’s ability to change accounting methods, reallocate overhead onto the acquired business, or make staffing and budget decisions specifically designed to suppress the numbers. It typically requires separate books and records for the acquired business, so performance can be measured cleanly instead of estimated out of a combined set of financials. And it often includes an acceleration clause, so that if the buyer sells the business or materially breaches these covenants before the earnout period ends, the full remaining payment becomes due immediately rather than disappearing into a technicality.
None of these provisions are optional extras. They’re the mechanism that keeps an earnout a genuine opportunity, not a number the buyer controls from day one.
When Earnouts Break Down
Most jurisdictions read an implied covenant of good faith and fair dealing into every contract, earnouts included, which means a buyer generally can’t run the business specifically to avoid paying what was promised. But “generally can’t” is not the same as “never does,” and proving bad faith after the fact is a harder fight than avoiding the dispute in the first place through clear drafting. When a disagreement does surface, better-drafted agreements route it to a neutral accountant or arbitrator rather than straight to court: the buyer delivers a calculation within a set window, the seller has a defined period to object, the parties negotiate, and an independent accounting firm resolves what remains unsettled. That process is faster and cheaper than litigation, and it’s only available if the agreement built it in ahead of time.
Getting the Earnout Right Before You Sign
An earnout can make an otherwise impossible negotiation work. It can also become the most contested part of a deal that looked simple on the closing date. The difference almost never comes down to the headline number. It comes down to how the metric is defined, what the buyer is and isn’t allowed to do while the clock is running, and what happens the day the two sides read the same numbers differently.
This article reflects general principles of M&A practice as commonly applied across jurisdictions, including Rhode Island, particularly the implied covenant of good faith and fair dealing that most states read into commercial contracts. Earnout terms are negotiated deal by deal, and the specific protections available depend on the language of your purchase agreement. Have any proposed earnout provision reviewed before you sign.
Sayer, Regan & Thayer works with business owners on both sides of Rhode Island sale transactions, structuring the terms that protect a deal long after the closing dinner is over. If you’re negotiating a sale with an earnout on the table, or reviewing one a buyer has already proposed, talk to us first.
Contact Sayer, Regan & Thayer for more information.
Sayer, Regan & Thayer is a law firm serving clients throughout Rhode Island, Massachusetts, and Connecticut.
This article is intended for general informational purposes and does not constitute legal advice. Boundary disputes involve specific facts and legal questions that require the advice of a licensed attorney in your state. Consult a qualified business attorney before taking action.
Frequently Asked Questions
How long does a typical earnout period last?
Most run one to three years, though some extend longer for businesses where performance takes time to prove out, like a product launch or a slow-building book of recurring revenue. Longer periods generally favor sellers with real confidence in growth and favor buyers who want more time to see if that confidence was justified.
What if the buyer cuts my budget or changes how the business is run during the earnout period?
This is the most common source of earnout disputes, and operating covenants are written to prevent it. A seller should insist on specific language requiring the buyer to run the business consistent with past practice, restricting changes to accounting methods and overhead allocation, and ideally including an acceleration clause if those restrictions are breached.
Does an earnout have to be paid in cash?
No. Earnout payments can be structured as cash, stock in the acquiring company, a promissory note, or some combination. Non-cash consideration usually comes with its own set of risks worth negotiating separately, particularly if the payment is stock in a company that isn’t publicly traded.
Who decides if there’s a dispute over whether the target was met?
A well-drafted agreement answers this before it becomes a problem, typically routing unresolved disagreements to a neutral accounting firm rather than a courtroom. Without that provision, a dispute defaults to litigation, which is slower and more expensive for everyone involved.
Should a seller always push for the highest possible earnout target?
Not necessarily. A target set too high can end up functionally unreachable, which helps the buyer more than the seller. The more useful negotiation usually isn’t about the size of the number; it’s about how clearly that number is defined and how tightly the buyer’s conduct is restricted while the seller’s payout depends on it.