How do I structure an earnout in an acquisition?
Short answer
Tie part of the purchase price to how the business performs after closing. Pick one clear metric, such as revenue or profit. Set a fixed period, a payout formula and a cap. I like to weight payments toward the early years, when the risk of a drop is highest. Many people talk to a securities attorney about how to draft it. This is education, not legal advice.
Start with the worry that makes you want an earnout at all. In most deals I see, the buyer is afraid the business will slow down once the owner steps back. An earnout lets you pay part of the price only if the business holds up. The seller still gets a fair price if it does.
Pick what the payout is tied to
Choose one number both sides can measure the same way. Revenue is the simplest. Profit is more exact but easier to argue about, because costs can move after closing. Whatever you choose, write down how it is calculated so nobody debates it in year two.
In a demo I ran, I described buying an insurance business with $1.2 million a year in revenue and $300k a year in profit. It had been operating for 7 years. The seller was 70 and a bit burnt out. My biggest worry was a revenue drop after closing. That worry should drive the structure.
Here I walk through how I described that insurance purchase, with seller financing and a revenue royalty, to an AI deal structuring tool.
Set the period and the shape of the payments
In that example I offered a gross revenue royalty going forward for seven years, with the most paid during the first three years. That shape matters. The early years are when a lost customer relationship hurts most, so that is where the seller has the most reason to help. Later payments can taper off.
A royalty is one tool and a classic earnout is another. The tool also suggested ideas like phantom equity and a step down ownership model. Each one ties the seller's pay to results in a slightly different way. Compare a few before you pick one.
Keep the seller on your side
An earnout is not a way to avoid paying. I made this point in the same session.
"You want the counterparty to be supportive, to spread good word about you and to want you to win."
If the seller feels tricked, they may not help with handoffs, introductions or staff. Then the metric you tied the payout to can get worse, and both sides can lose. So make the terms fair and easy to follow.
It also helps to link what people get paid to results. I make a similar point about sponsors who take their fees at closing. When pay does not depend on how the investor does, the two sides are not really aligned.
In this webinar I explain why I want the people running a deal to be paid based on how the deal performs.
Summary and key takeaways from this video
Items to settle in writing
- The exact metric and how it is calculated
- The length of the earnout period
- The payout formula, any floor and any cap
- What the seller can see, such as monthly reports
- What the buyer can and cannot change during the period
Those last two points are where disputes start. A seller will want to know you will not cut the business off at the knees. A buyer will want room to run the company. Many buyers and sellers talk to a securities attorney about the final language. I am not giving legal advice here.
From my books and event talks
One more thing about earnouts. Deal structure often matters as much as the strategy, and a good deal can be ruined by a bad structure. I have also seen deals declared dead until someone asked, what if we structure it this way? If the seller wants cash now and you worry about a drop later, do not walk away. Ask whether a different payment shape solves both concerns. An earnout, a royalty or a step down in ownership might be the version that gets both sides to yes.
"Many times, deal structure matters just as much as the strategy in the deal. Usually the team matters even more, but the deal structure matters a ton. You can make a good deal and ruin it with a bad structure."
"The importance of structuring deals, I don't think, can be stressed enough. Structure can completely change the conversation. Many times people told me, "This deal's dead, go away, you're wasting your time," and we say, "What if you structure it this way?"."
On the record
- In the demo, the buyer was purchasing an insurance business with $1.2 million a year in revenue, $300k a year in profit and 7 years in business.
- The example offered a gross revenue royalty for seven years, with the most paid during the first three years.
- The Deal Structure Ninja tool has produced over 8,000 deal structure possibilities for Family Office Club clients.
Sources
From Richard C. Wilson's Centimillionaire Strategies YouTube channel: Artificial Intelligence for Capital Raising | Top 7 AI Tools Live Demo + Q&A, Capital Raising Frequently Asked Questions Webinar. Quotes come from the video captions, lightly edited for readability. Figures are the speakers' own estimates and experience.
General education only. Not legal, tax or investment advice.
Talk to a securities attorney to explore options around earnout agreement drafting, purchase price terms and seller financing documents. Do not use AI to write your own legal agreements.
Where to start
- Write down your main post-close worry, such as a revenue drop.
- Choose one metric and define exactly how it is measured.
- Decide the period and whether payments are heavier early.
- Compare two or three structures before settling on one.
- Consider talking to a securities attorney about the draft terms.
People also ask
Should an earnout be based on revenue or profit?
Revenue is simpler to measure and harder to dispute. Profit tracks real results but depends on costs the buyer controls. I picked revenue in my insurance example.
Can a buyer with little cash use an earnout?
Yes, it can reduce the cash needed at closing. In my experience, deal structure can help buyers with limited capital, though results vary by deal. Many buyers talk to a securities attorney about any structure first.
Does an earnout replace seller financing?
No, they can work together. In my example I wanted some seller financing and a revenue royalty in the same deal.
Related questions
- What is a most favored nation clause for investors?A most favored nation clause, or MFN, says that if the sponsor gives another investor better terms, you can ask for those terms too.
- What is a promote and how is it calculated?A promote is the back end profit that goes to the sponsor or operating partner after the investors who put in the money have received their preferred return.
- What is the difference between a convertible note and a SAFE?A convertible note is commonly described as a loan that later converts into equity, often with interest and a maturity date.
- How does a distribution waterfall work?A distribution waterfall is the order in which a deal pays out cash.
Work through it with the investor meeting follow-up checklist. See all deal structuring resources.