Earnouts: how buyers use them, how sellers get caught out, and what to watch before you sign

Selling your business will probably be the biggest financial event of your life. And yet most founders wander into it half-educated, half-hopeful, and fully exposed. Nodding along in meetings they don’t fully understand, signing documents they haven’t properly interrogated, and discovering the problems six months after the ink is dry and the lawyer has gone on holiday.

It’s the perfect storm for being royally stitched up.

That’s because founders often think that selling their company will look like it does in the movies. The buyer wires the money over in full, everyone shakes hands, champagne corks pop, owner swans off into the sunset, new life starts Monday.

Wonderful. But also total bollocks (in 99.99% of cases).

In most deals, some of the price is paid at closing and the rest is paid later, if certain things happen. That deferred element is the earnout. The mechanism that decides how and when you receive the portion of the price that wasn’t in your account on day one. Usually it’s tied to performance, milestones, or specific conditions, and understanding the details of it is the difference between a good deal and a very expensive lesson.

Where earnouts make sense

There are situations where no earnout makes sense. If your business is being absorbed so completely that its future performance can’t be measured separately, fair enough. If you’re selling to someone who assumes your clients will scatter and has no interest in you sticking around courting competitors, fair enough. I’ve even seen a deal where the seller was heading into public office and couldn’t legally retain a contingent financial interest.

Of course, sometimes the seller just wants out. Health, exhaustion, divorce, a new chapter. And a clean break is the whole point. But most deals are a split: cash at closing, the rest earned over time.

That’s not some modern financial trick either. Earnouts have been around for decades, becoming more common as acquisitions turned into standard growth strategy. Buyers didn’t want to swallow all the risk upfront, so they found a way to say yes while still protecting themselves. “We’ll pay your number. If it holds up.”

The simple rule is this: the more uncertainty the buyer feels about post-deal performance, the more complex and protective the earnout will be. An earnout typically covers three things:

• The formula for calculating payments
• The time period involved
• The conditions attached to those payments.

The formula is negotiated, yes, but don’t kid yourself about whose tool this fundamentally is. Cash at closing is gone forever. The earnout is how the buyer de-risks what’s left and steers your behaviour after the deal.

Most modern earnouts are tied to one or two core metrics, usually revenue or EBITDA. And the standard timeframe is usually a year. Five-year earnouts used to show up more often but in today’s market that feels more like a prison sentence.

Incentives drive behaviour

Here’s where it gets interesting, and by interesting I mean dangerous. Charlie Munger once said “show me the incentives and I’ll show you the outcome.” He wasn’t f*cking around.

Imagine the buyer tells you they’re acquiring your firm to build out their HR consulting capability. It’s the kind of strategic deal that makes you feel flattered, a story you can drop into future conversations and feel smug about.

Then you read the earnout and discover it’s tied only to the performance of your department, measured in isolation. Now suppose you spot a big cross-sell opportunity with another division. Helping them would be great for the overall business but would do nothing for your own payout. You might even identify that some of the work done by your section would make MORE sense in another part of the business, even if doing so would impact the bottom line of the department you’re being judged on.

What would you do?

If your answer is that you’re a team player who would always put the good of the company ahead of yourself then I say that answer lasts only as long as the situation is hypothetical.

Human nature dictates that if your earnout is siloed, your attention will be siloed. Flip it the other way and tie the earnout to total company performance, and now you’re being paid for market conditions, someone else’s mess, or a board decision made three levels above your head. There’s no perfect answer, but there is a real danger in pretending incentives are neutral. They’re not. They shape behaviour.

Simple earnouts are better for everyone

The more complex the earnout, the less motivating it becomes. And this is a point buyers either don’t understand or quietly exploit. If I want my dog Monty to drop the ball, I give him a treat. I don’t build a spreadsheet. Hit target, get reward: that’s how incentives work.

Once you start layering in threshold effects, micro-adjustments, accounting tweaks, exclusions, exceptions, and definitions that require a forensic accountant and a strong drink to decode, you’re creating confusion, argument, and the occasional small civil war.

Clarity matters more than cleverness, and any buyer who pushes back on that principle deserves a raised eyebrow and a very direct question about why they need it complicated.

A warning

Be extremely careful what you promise in early conversations. A buyer says “last year was strong, EBITDA jumped eight points, we need confidence this is sustainable,” and because you’re trying to sell, you say “absolutely, here’s why it’s the new normal.” Congratulations, you have just turned your optimism into a contractual obligation.

I’ve seen this happen too often. Founders oversell the future in management meetings, heads of terms discussions, and due diligence calls, and the buyer bakes that confidence straight into the earnout structure. Your pitch is no longer a pitch; it’s the hurdle. Project responsibly. Explain the upside, of course, but leave room for uncertainty, because once your narrative hardens into earnout maths, it stops being a conversation and starts becoming a loaded gun pointed at you.

Know your numbers

Whatever the metric, model it backwards before you agree to anything. Run historical scenarios, test best case and worst case, and make sure you understand exactly how the numbers are being calculated. Get the buyer’s finance team to walk you through it line by line, and never assume you and they mean the same thing until you’ve seen the definition in black and white.

On the question of cliffs versus slopes: if the deal says “hit 18% net profit and receive £160,000,” your first question should be what happens at 17.9%. If the answer is nothing, that’s a cliff, and cliffs are bloody stupid. A well-structured earnout should have a slope. Miss by a bit, still get something; overperform, get paid properly; ideally carry forward a shortfall if you smash the following year’s target.

Otherwise you create all sorts of distorted behaviour near the line: revenue gets dragged forward, costs get delayed, decisions get warped. Nobody acts rationally when one percentage point separates a healthy payout from absolutely nothing. Watch for ceilings too. If the earnout caps out too early, extra effort stops paying, which is a recipe for cynical timing games and half-hearted decisions from the person the buyer supposedly just paid a premium for.

Match the earnout to the employment agreement

Employment agreements are where a lot of founders become strangely relaxed, and they shouldn’t be. If your earnout runs for two years, your employment agreement should run for two years as well. If you get pushed out after nine months, your earnout is suddenly sitting in the hands of people you no longer control. You’ve lost your salary, your authority, your day-to-day visibility, and your ability to influence the very thing that determines whether you get paid. You’re watching someone else drive your car into a wall.

A matching employment agreement gives you protection around compensation, title, responsibilities, and process. In a healthy relationship you may never need to rely on it. In a bad one you’ll be very grateful it exists, so get proper legal advice, because this is jurisdiction-specific and improvising is stupid.

Think through non-compete options

While you’re at it, think carefully about non-compete carve-outs. What are you already doing that could accidentally get caught? Advisory roles, board seats, angel investments, industry mentoring. Spell it out explicitly.

And if the relationship eventually turns sour, what freedom do you actually want? Maybe you can’t start a direct competitor, fine, but perhaps you want the right to join a client in an operating role, sit on certain boards, or invest in adjacent businesses.

Those options are far easier to protect before you sign than after the relationship has gone sideways and everyone’s talking through lawyers.

If the buyer defaults

The nightmare scenario is what happens if the buyer defaults on earnout payments. Normally the documents require written notice and then a cure period. If they still fail to pay after that, you have a serious problem.

The right position is straightforward: if the buyer materially defaults on the earnout, you keep what you’ve already received and you’re released from the non-compete. You may still have to rebuild from scratch, but at least you’re free to do it.

You shouldn’t be handing back the completion money while simultaneously being told you can’t work in your own industry. That would be an absolute piss-take, and one that’s worth fighting hard to prevent in the drafting stage rather than the courtroom.

What you should be asking yourself

The questions worth pondering before you sign anything:

• Does this earnout incentivise the right behaviour?
• Is it simple enough to calculate without monthly trench warfare?
• What happens if I just miss the target?
• Does this structure actually reduce my risk or just redistribute it?

That last one matters most. If the earnout leaves you carrying most of the entrepreneurial risk but now with a boss, a narrower role, and less upside, you have to ask yourself what exactly you’re selling for. Most founders started their businesses because, in one way or another, they’re unemployable. An earnout is not just deferred money, it’s the price of voluntarily stepping back into employment. Make absolutely sure that price is worth paying. If you haven’t yet mapped out your business exit strategy, that’s the place to start.

And if you want help thinking through valuation, deal structure, or the traps on either side of a transaction, you know where to find me.

Book a free discovery call with Dominic.

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Written by business coach and leadership coaching expert Dominic Monkhouse. You can order your free copy of his new book, Mind Your F**king Business here.