Earn-outs are one of the most powerful tools in M&A to bridge a valuation gap. They can also move the negotiation from before closing to after closing — where it is far more dangerous. Here is how to tell the difference.
Key takeaways
- An earn-out does not solve disagreement about the future. It postpones it.
- Earn-outs work when the founder still controls the outcome and performance can be measured objectively. They become a trap when the buyer controls the variables.
- The structure matters more than the amount: who controls what, how performance is measured, and what happens if the business changes.
This week, I find myself negotiating the final stages of an acquisition. The due diligence has been completed. Most of the legal documentation is already on the table. The terms of the transaction have largely been agreed.
And, as so often happens at this stage, the conversation has shifted towards one word: earn-out.
For many M&A advisors, earn-outs are one of the most powerful tools available to bridge valuation gaps and bring buyers and sellers together. And in many situations, they are exactly that. They unlock transactions that would otherwise never happen.
But after more than 25 years in M&A, I have also learned something else.
An earn-out does not solve disagreement. It postpones it.
Sometimes that is exactly what both parties need. Sometimes it simply moves the negotiation from before closing to after closing. And that can be far more dangerous.
Why earn-outs exist
At their core, earn-outs exist because buyers and sellers disagree about the future. The seller believes the business will continue to perform strongly. The buyer is less certain.
Rather than arguing about who is right, they agree on a mechanism: "If the business performs as expected, the seller receives additional consideration."
Simple. Elegant. Perfectly logical. At least on paper.
When earn-outs create value
The best earn-outs genuinely align interests. They work particularly well when:
- The founder remains actively involved after closing.
- Future performance depends largely on the existing management team.
- Both parties share the same strategic objectives.
- Performance can be measured objectively.
In these situations, an earn-out allows both sides to share risk. The seller participates in future upside. The buyer avoids paying today for performance that has not yet been delivered. Everybody wins.
When earn-outs become a trap
The problems begin when the seller no longer controls the outcome.
Imagine selling your company. You no longer own it. The buyer now decides:
- Investment levels
- Pricing strategy
- Recruitment
- Marketing spend
- Product development
- Integration priorities
Yet your earn-out depends on EBITDA. You are now being measured against results that are no longer entirely under your control.
That is where alignment disappears. And conflict begins.
The illusion of objectivity
One of the biggest mistakes sellers make is believing that financial metrics are objective. They are not.
EBITDA may seem straightforward. Until questions arise such as:
- Which costs belong to the acquired business?
- How are corporate overheads allocated?
- What happens if the buyer restructures operations?
- What if customers are transferred to another division?
- What if investment decisions reduce short-term profits to create long-term value?
Suddenly, the metric that looked perfectly objective becomes open to interpretation. And interpretation often becomes negotiation.
The most common mistake sellers make
In my experience, sellers often negotiate the price far more carefully than they negotiate the earn-out itself.
Ironically, the earn-out may represent 20%, 25% or even more of the total consideration. Yet discussions around its mechanics are frequently rushed.
The key question is rarely "What is the percentage?" The real questions are:
- Who controls the variables?
- How will performance be measured?
- What happens if the business changes?
- What decisions require mutual agreement?
- What happens if the founder leaves earlier than expected?
The structure often matters more than the amount.
A good earn-out is boring
This may sound counterintuitive. But the best earn-outs are the ones that nobody needs to discuss after closing.
They are simple. Transparent. Easy to calculate. Easy to verify. And they leave as little room as possible for interpretation.
Complex earn-outs rarely become sophisticated. They become litigated.
Sometimes the best earn-out is no earn-out
Not every valuation gap should be solved through an earn-out. Sometimes the disagreement simply reflects fundamentally different views of the business. And that is perfectly acceptable.
Forcing an earn-out into a transaction does not eliminate the disagreement. It simply delays the moment when it resurfaces.
Occasionally, accepting a lower upfront price with complete certainty is preferable to chasing a larger number that depends on years of uncertainty.
As I wrote in an earlier newsletter, price and value are not always the same thing. Neither are price and certainty.
A final thought
One of the most valuable lessons I have learned is that successful M&A transactions are not built on optimistic assumptions. They are built on well-designed incentives.
An earn-out should align interests. Not create future disputes.
If both parties leave the negotiation believing they have created a mechanism that is perfectly fair, they should ask themselves one final question: "Will this still feel fair two years after closing?" Because that is when the earn-out is truly tested. (What happens in those years after closing is the subject of The Day After.)
As Charlie Munger once said: "It's not supposed to be easy. Anyone who finds it easy is stupid."
Earn-outs are rarely easy. The objective is not to make them perfect. The objective is to make them workable.
Frequently asked questions
What is an earn-out in M&A?
An earn-out is a deferred, contingent part of the purchase price: the seller receives additional payment after closing if the business reaches agreed targets, usually revenue or EBITDA, over a set period. It is used to bridge a gap between what the seller expects and what the buyer is willing to pay upfront.
When is an earn-out a good idea?
When the founder stays involved after closing, future results depend mainly on the existing team, both parties share the same strategy, and performance can be measured objectively. In those cases an earn-out shares risk fairly.
Why do earn-outs lead to disputes?
Because after closing the buyer controls investment, pricing, costs and integration, while the seller is paid on results. Metrics like EBITDA become open to interpretation — overhead allocation, restructuring, transferred customers — and interpretation turns into negotiation.
Earn-outs, deferred payments and how to bridge a price gap are covered in the negotiation sessions of the M&A Training Program and in my book Mergers & Acquisitions: Strategy, Execution, and Decision-Making.
First published in Inside Corporate Finance, my LinkedIn newsletter. Subscribe here.
