Earnouts in Business Sales: Maximizing Value While Managing Risk

Earnouts help bridge valuation gaps by tying part of the sale price to future business performance, offering sellers higher potential payouts while protecting buyers from overpaying. They are useful in negotiations, particularly when buyer and seller valuations differ, and can ensure a smooth transition by retaining the seller’s involvement. However, risks such as market shifts, buyer mismanagement, and misaligned incentives must be carefully managed. Proper structuring, clear terms, and strategic planning are essential for maximizing value and ensuring a successful transaction.

Homer Smith emphasizes the importance of considering earnouts as part of a broader strategy for business transitions. Understanding how they work, and their potential risks can help sellers maximize value while ensuring a smoother sale process.

Key Factors to Consider in an Earnout Agreement

When evaluating whether an earnout is the right fit, several major factors come into play. First, the specific variables tied to the earnout structure will vary based on the industry, business type, and deal specifics. Common earnout metrics include top-line revenue, profitability, and key employee retention. For example, an agreement might require revenue to reach at least 90% of the previous year's total or mandate that 85% of key employees remain with the company post-sale.

Another critical factor is the seller’s level of control after the transaction. If the seller has no say in hiring, firing, or managing business expenses, the buyer could make operational changes that impact financial performance, potentially reducing or eliminating the earnout payout. Negotiating clear terms around post-sale decision-making authority can help mitigate these risks. Understanding these key elements ensures that the earnout is structured fairly, reducing potential disputes and increasing the likelihood of a successful transaction.

Typical Earnout Timeframes

Earnout periods typically range from one to three years, though the structure varies by deal and industry. Rather than a single payout at the end, many agreements include annual milestones that trigger partial payments. The seller’s post-sale involvement also plays a key role—longer commitments may lead to higher potential payouts, while shorter earnouts may limit the total value buyers are willing to offer. Ultimately, the duration and terms should align with both parties’ goals and expectations.

Overlooked Aspects and Misconceptions of Earnouts

One of the most overlooked aspects of an earnout is the legal structure surrounding it. While sellers may retain some managerial influence post-sale, they often have little to no legal control over the business. Without strong contractual protections, disputes over payout terms can arise, leaving sellers vulnerable. Key safeguards include structuring earnouts with milestone-based payouts rather than waiting for a full term, restricting the buyer’s ability to manipulate expenses or take out loans that could impact profitability, and ensuring funds are placed in escrow to guarantee availability. Additionally, buyers with multiple affiliated entities may engage in internal transactions that artificially reduce profitability, making it harder for the seller to meet earnout targets. A recent case highlighted the importance of defining how general administrative expenses are handled post-sale, as a disagreement on this point nearly led to costly legal battles. Since buyers often have deeper pockets for litigation, proactive planning and clear legal terms are critical to protecting the seller’s interests and avoiding future conflicts.

Tax Implications of Earnouts

Taxes play a significant role in structuring earnouts, offering both advantages and potential drawbacks. One key consideration is imputed interest, which applies to deferred payments and is taxed at a higher rate than capital gains. This means that while the total sale price may remain the same, an earnout structure can result in a higher tax burden compared to an all-cash sale.

However, earnouts also provide a strategic tax planning opportunity. Since payments are spread over multiple years, sellers have more time to implement tax mitigation strategies, potentially reducing or even eliminating certain liabilities through proper structuring. The key is understanding these implications in advance, ensuring that tax considerations are factored into negotiations, and working with a knowledgeable team to optimize the financial outcome.

Surround Yourself with the Right Team

Navigating an earnout—and a business sale in general—can be highly complex, involving factors like working capital adjustments, reps and warranties, and legal provisions that impact the final outcome. One of the biggest mistakes sellers make is underestimating these complexities, especially when dealing with a known buyer or unsolicited offer. While skipping an investment bank or broker may seem like a cost-saving move, it can lead to significantly higher legal expenses and unfavorable deal terms later.

The key to successfully managing an earnout is having an experienced team of professionals who specialize in deal structuring. They can help sellers fully understand contractual provisions, ensure fair terms, and protect against scenarios where a buyer shifts too much value into an earnout with the intent to minimize payouts. For most business owners, selling their company is a once-in-a-lifetime event—having the right guidance ensures they achieve the best possible outcome.

Final Thoughts

Earnouts can enhance business sales by bridging valuation gaps and maximizing seller payouts, but they come with risks. Clear performance metrics, legal protections, and tax planning are essential to avoid disputes and ensure a fair outcome. Having the right team of advisors is key to navigating complexities and securing the best possible deal.

The information in this material is for general information only and is not intended to provide specific advice or recommendations for any individual. Integrated Financial Partners does not provide legal/tax/mortgage advice or services. Please consult your legal/tax advisor regarding your specific situation. This report is intended to be used for educational purposes only and does not constitute a solicitation to purchase any security or advisory service. Past performance is no guarantee of future results. An investment in any security involves significant risks and any investment may lose value. Refer to all risk disclosures related to each security product carefully before investing. Investment advice offered through Integrated Financial Partners, doing business as Konvergent Wealth Partners, a registered investment advisor.