In the acquisition of a SaaS or software company, earnouts are common to address valuation gaps, align post-close incentives, and balance risk between the buyer and the seller.
Even in businesses with recurring revenue, where baseline performance is more predictable, earnouts may be used when there’s disagreement around future growth, reliance on a few key accounts, or uncertainty tied to the founder’s continued involvement.
Structuring an earnout agreement correctly is crucial: the terms surrounding timing, performance metrics, and control rights can significantly impact outcomes for both parties.
In this article, we break down how earnouts work, when they make sense, what risks to anticipate, and how to structure them effectively.
What is an earnout in M&A?
An earnout is a contractual provision that defers part of the purchase price in an M&A transaction, contingent on the acquired company achieving specific post-close performance targets. These targets can be financial, such as annual recurring revenue (ARR), EBITDA, or net revenue retention, as well as operational, such as completing a product roadmap or retaining key customers.
Earnouts are often used to bridge the gap between valuation expectations. Sellers usually have a confident view of future growth, while buyers approach those projections with caution, factoring in execution risk and market variability. An earnout agreement allows both parties to move forward: it enables the seller to benefit if future goals are met, while the buyer avoids overpaying upfront.
Why earnouts matter in M&A
For founder-led, growth-stage businesses, especially in fast-evolving tech sectors, earnouts can support deal alignment in several ways:
1. Bridge valuation gaps
When a seller values the company based on future potential and the buyer values it based on trailing performance, an earnout provides a compromise structure. It ties part of the purchase price to forward-looking outcomes without requiring the buyer to price in the whole upside on day one.
Read: SaaS Multiples: Valuation Benchmarks for 2025
2. Align incentives in post-close transitions
Earnouts often require that the founder or management team remain involved for a period after the close. By tying future compensation to company performance, earnouts also reinforce alignment during the integration period.
3. Reduces risk from the buyer's perspective
An earnout deal defers a portion of the total consideration, reducing immediate capital outlay and preserving flexibility in case the acquired company underperforms.
For example, a private equity buyer may agree to acquire a SaaS business for $20 million, structured as $15 million upfront with a $5 million earnout tied to achieving $10 million ARR within 24 months. If performance goals are met, the seller realizes their full valuation; if not, the buyer’s exposure is capped.
Structuring an earnout agreement: Terms, metrics, and timing
Earnouts must be designed with clarity and enforceability. Key variables include:
1. Performance metrics
Metrics should be:
- Specific and objective – e.g., audited EBITDA, recognized revenue, customer retention rates.
- Aligned with buyer priorities – particularly relevant in strategic acquisitions.
- Realistic and achievable – based on historical performance and defensible assumptions.
2. Timeline and duration
Earnouts typically span 1 to 3 years post-close. Longer periods increase uncertainty and can exacerbate the risks associated with integration, control, or unexpected events, such as macroeconomic downturns or regulatory changes.
3. Payout mechanics
The terms of the agreement should define:
- How and when earnouts are measured (quarterly vs. annually)
- When payments are triggered (e.g., after audited financials)
- Whether there is a cap on total potential payout
Legal and strategic risks
While earnouts can unlock stalled negotiations, they also introduce complexity. The most common challenges include:
Ambiguity in definitions
If terms like “net revenue” or “customer retention” aren’t precisely defined, disputes can arise over how performance is measured.
Control and operational changes
Buyers typically assume operational control post-close. If strategic shifts deprioritize earnout-aligned goals, sellers may find themselves unable to meet targets through no fault of their own.
Enforcement
Earnouts can lead to protracted disputes, especially if there’s no agreed-upon arbitration or dispute resolution framework in place.
Recommended: The M&A Letter of Intent Explained for Founders
How earnout disputes can be prevented
Founders and their advisors should ensure the earnout agreement reflects both legal safeguards and commercial reality.
Key structural protections
- Detailed performance definitions: Use precise and objective language.
- Seller information rights: Secure access to performance reports and financial data.
- Dispute resolution clauses: Include neutral third-party mechanisms for arbitration.
- Operating covenants: In some cases, founders may negotiate limitations on material changes that could adversely affect earnout metrics.
Consider escrow or guarantees
To ensure funds are available for payout, buyers and sellers may agree to holdback structures, escrow accounts, or personal guarantees for larger earnout tranches.
Real-world example: Closing the gap with a performance-based earnout
In high-growth, early-stage businesses, valuation gaps are common, particularly when historical metrics don’t fully support future projections. In one such case, the L40° team structured an earnout tied to revenue milestones aligned with the company’s growth trajectory. The milestones reflected targets the seller believed were achievable, while offering the buyer protection if performance fell short.
This approach is typical in fast-scaling companies where a larger portion of the deal consideration is contingent on future performance. By aligning incentives and deferring part of the payout to proven results, the earnout helped both sides reach an agreement and close with confidence.
Earnouts in M&A: A tool, not a shortcut
Earnouts are not a substitute for agreement on enterprise value, but when thoughtfully structured, they can provide flexibility and unlock deals that might otherwise stall. They work best when both parties share transparency, align incentives, and anticipate post-close realities.
At L40°, we support founders with deep experience in earnout structuring, balancing valuation strategy, financial mechanics, and negotiation dynamics with discretion and resolve. From first offer to close, we help tech leaders navigate complex exits with precision.
FAQs: Common founder questions about earnouts
What if the company doesn’t meet the earnout targets?
If the business fails to meet the performance targets in the agreement, the payments are typically not made. However, this outcome is usually outlined clearly in the earnout agreement, so both parties understand the consequences in advance. Sellers should negotiate realistic targets to avoid this situation.
Can earnouts be renegotiated after closing?
Earnouts are legally binding agreements, so renegotiation after closing is uncommon and often challenging. However, in exceptional cases, both parties may agree to adjust terms if circumstances change significantly, such as unforeseen market conditions or operational disruptions. Sellers and buyers should anticipate potential scenarios during negotiations to minimize the need for renegotiation.
What’s the typical length of an earnout period?
Earnouts generally last between 1 to 3 years. The duration depends on the complexity of the business and the time needed to achieve the agreed performance metrics. Longer earnouts may carry additional risks for both parties, so the timeline should be carefully considered during negotiations.
Who controls the business during the earnout period?
Control of the business typically shifts to the buyer after the sale closes, but the seller may remain involved in day-to-day operations, especially if their expertise is crucial to meeting earnout targets. The earnout agreement should clarify the seller’s role and responsibilities to avoid conflicts over business decisions.
Are earnout payments taxed?
Yes, earnout payments are usually subject to taxes, but the specifics depend on the tax laws in the relevant jurisdiction. Sellers should consult a tax advisor to understand their obligations and plan for tax-efficient earnout structures.
