Glossary
Earnout Structure
An earnout structure is the mechanism that pays part of a purchase price later, only if the business hits agreed targets after close. It exists to bridge a gap the two sides cannot close on price: the seller believes the business will perform, the buyer is not willing to pay for that belief up front. At Treewalk we do not draft the legal terms, but we do the work the terms depend on, which is defining the metric so it can actually be measured when the time comes.
What an earnout is trying to solve
An earnout is a disagreement about the future, converted into a payment schedule. The seller says revenue is about to grow, or that a major customer is secure, or that a new contract will land. The buyer will not fund that on day one. So a portion of the price is deferred and made conditional.
That makes it a bridging tool, not a discount. Used well it gets a deal done that would otherwise die on valuation. Used carelessly it converts a clean disagreement about price into a messy dispute about accounting, eighteen months after everyone has moved on.
The part that decides whether it works: the metric
Almost every earnout dispute traces back to a metric that was easy to agree on and hard to measure.
Revenue is the simplest and the least contentious, because it is harder to manipulate and easier to verify. Gross profit is workable. EBITDA is the most common and the most dangerous, because post-close EBITDA depends on decisions the buyer now controls: how much overhead gets allocated, what the new owner pays themselves, what gets invested in growth. A seller whose earnout rides on EBITDA has handed the buyer meaningful influence over their own payout.
Customer-specific triggers are increasingly common in lower-middle-market deals, and they work well where concentration is the actual risk being priced.
The calls we get tend to arrive at the same moment: the parties cannot bridge on price, and someone wants to know whether an earnout tied to a particular metric would work, or whether a seller note that becomes forgivable once three named customers reach an agreed level would be cleaner. Those are financial questions, so we can answer them. Whether the resulting clause is enforceable is not ours to answer.
Where we fit, and where we do not
This distinction matters, because it determines who you should be asking what.
| Question | Who answers it |
|---|---|
| Is this metric measurable from the books as they exist? | Us |
| What is the defensible baseline to measure against? | Us |
| Should working capital or debt-like items sit in the structure? | Us |
| How is the clause drafted and enforced? | Your lawyer |
| What happens on a dispute, or a resale during the period? | Your lawyer |
| Is the overall valuation sensible? | A valuation firm, though we will say if a number looks wrong |
We give input on structure when it is a financial question. De-risking, drafting and enforceability run through counsel, and we work alongside them rather than in place of them.
Sometimes the diligence itself is what points to a structure. On one deal we found W2 and 1099 workers had been misclassified, which raises the question of whether a buyer wants to assume that unrecorded liability at all, or take the assets instead. On another, a union arrangement was being worked around by routing the work through contractors. Findings like those change the shape of the deal, not just the price.
Practical terms worth settling before signing
- The baseline. Measured against what, exactly? A restated historical figure, using the same normalization adjustments the diligence applied, not the seller’s original presentation.
- The accounting basis. Lock the policies for the earnout period so a change in method cannot move the target.
- The period. One to three years is typical. Longer periods dilute the seller’s influence over the outcome and raise dispute risk.
- Cliff or sliding scale. All-or-nothing at a threshold creates a strong incentive to game the final quarter. A sliding scale usually behaves better.
- Buyer conduct. Some commitment to operate the business normally during the period, so the target is not undermined by decisions the seller cannot control.
- Dispute mechanism. Who computes the figure, what the seller gets to see, and who breaks a tie.
Frequently asked questions
How is an earnout different from a seller note?
A seller note is deferred payment the seller is owed regardless, unless something specific goes wrong. An earnout is contingent from the start and only becomes payable if the business performs. A forgivable seller note sits between the two, and is sometimes the cleaner instrument when the parties want simpler mechanics.
What metric should an earnout be based on?
Whichever one is hardest to manipulate and easiest to verify from the books that will actually exist post-close. Revenue and customer-specific triggers usually beat EBITDA on both counts, even though EBITDA is more common.
Do earnouts usually get paid?
It varies enormously with how the metric was defined. Where the baseline was set from tested figures and the target sits on something objective, they generally pay. Where the target rides on post-close EBITDA with no conduct commitments, disputes are far more likely.
Should the earnout be agreed before or after diligence?
The concept can be agreed in the letter of intent, but the numbers should not be finalized until diligence establishes the real baseline. Setting a target against a presented figure that later drops is how earnouts become unreachable on the day they are signed.
Do you help negotiate the earnout?
We advise on the financial substance: whether the metric is measurable, what baseline is defensible, and how it interacts with working capital and debt-like items. The drafting and negotiation of the clause itself belongs with your lawyer.
Where to next
If price is the thing standing between you and a signed deal, the structure conversation is worth having before you concede on value. Our transaction advisory services team sets the baselines these structures depend on. Read earnout for the concept and buy-side due diligence for how the underlying numbers get tested. To talk through a specific structure, email Avnit Sekhon at avnit.sekhon@treewalk.com.
