Key points
- An earnout is additional compensation a seller receives after closing, tied to the acquired company hitting agreed future performance targets.
- Buyers use earnouts to bridge a price gap, reduce risk on uncertain future performance, service acquisition debt, and keep a departing founder motivated.
- The main building blocks are cash upfront versus deferred, the KPIs (revenue, EBITDA, or ARR), the timeline (typically one to three years in micro-SaaS), and how payment and partial or missed targets are handled.
- Floor-and-ceiling KPIs and catch-up provisions make an earnout fairer than an all-or-nothing structure.
- For recurring-revenue SaaS, an ARR-based earnout is usually cleanest, especially if the seller is not staying on post-acquisition.
As a founder looking to exit your startup, you will inevitably see earnouts as part of the structured offers you receive. Earnouts are very common when structuring a SaaS M&A deal, and knowing how to structure a deal effectively is the best way to optimize your exit and proceeds from the sale. This guide is part of thinking through your broader exit strategy.
So let’s get inside the buyer’s head, break down what earnouts are, and learn how they can improve your upcoming deal structure.
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What Is an Earnout?
In an M&A deal like those Acquire.com facilitates daily, it’s common in larger-sized transactions for the seller to receive only a partial amount of cash on the day the transaction closes, plus deferred compensation in the future.
That deferred compensation can take different forms:
- A seller note: you finance part of the purchase price for the buyer and accrue interest until they repay the outstanding amount.
- A seller holdback: a third party holds part of the purchase price in escrow to cover potential warranty claims, post-closing liabilities, or other agreed risks.
- An earnout: additional compensation tied to future performance milestones of the company, post-transaction.
In short, an earnout ties part of your payout to how the business performs after the deal closes.
Why Do Buyers Use Earnouts?
The concept is simple: instead of paying the full price upfront, the buyer pays a lump sum and then the remainder when your startup meets certain targets. But buyers use earnouts for different reasons, so it’s key to understand the buyer’s motivations. It helps you design a better deal structure and counter-offer effectively.
To bridge a gap in price expectations
This happens all the time: you expect a higher price than the buyer is comfortable paying. If the gap between bid and ask isn’t unbridgeable, an earnout can be the solution.
For example, say the buyer of your SaaS company is willing to pay up to 4x Seller Discretionary Earnings (SDE), but you won’t sell for less than 5x SDE. If the buyer wants to close, they can agree to a 5x SDE valuation only if the company hits certain milestones post-acquisition, like 30% ARR growth next year.
From the buyer’s perspective, this says: “If your business delivers the 30% ARR growth you promised, I’m happy to pay the 5x multiple you asked for.”
Remember, a company’s value is based on its future expected cash flow, not simply its past. An earnout is especially suitable after a recent strategic shift, pricing change, or product launch- changes you believe will pay off long-term but which represent uncertainty, and therefore risk, to the buyer. Earnouts let you justify a higher valuation by underwriting some of that risk.
To gain confidence to offer your ideal price
Due diligence reduces a buyer’s risk but can’t eliminate it. Maybe your company has a few important clients, perhaps even relatives, who might cancel if you leave and a new CEO takes over. Maybe the buyer is less familiar with your market and fears changes to the top line, such as a new federal bill or a shift in strategy from a major enterprise customer.
Such events are outside everyone’s control, but the buyer may expect you to share that systemic risk. Here, the buyer seeks protection against downside risk rather than a guarantee of future performance. For example, you might define an earnout as 30% of the total purchase price, 15% after one year, and 15% after two years, on the condition that ARR doesn’t fall below its current level.
In one deal I structured where we’d take over management, the seller was reluctant to tie the earnout to performance he couldn’t control. So we took current ARR and historical average churn, listed all existing clients, and agreed to pay the full earnout as long as those existing clients still generated at least (1 minus churn rate) times current ARR. In other words: “We’ll pay full price as long as your current customers do not churn faster once we take over.”
Protecting the buyer’s downside can matter even more than delivering outstanding growth, especially when they’re financing the deal with debt. Being transparent, building trust, and keeping clean reporting all help you here.
To protect against defaulting on acquisition debt
Some buyers, many more in the US thanks to SBA loans, use debt to acquire a micro-SaaS company. If debt is 60% to 80% of the purchase price, the buyer must service the loan from the business’s cash flow or risk defaulting, and legal pursuit or seizure of personal assets. If the business underperforms, the buyer’s risk is significant, so an earnout may be necessary.
In a recent deal, we used leverage to meet the seller’s asking price. To service both the loan and the earnout, the business needed to generate at least $3M per year for two years. It was generating $4M at the time, but cash flow had doubled due to COVID and looked likely to revert to about $2M. The owner still wanted to value on $3M cash flow, so we made the earnout conditional on meeting our debt obligations, paying it only if the business generated at least $3M going forward.
If you’re in that scenario, some ways to negotiate:
- Agree to the earnout, but with faster payment if the business overperforms. For a $2M earnout over two years, argue that if year one generates $3.5M, you get $1.5M of the $2M.
- If the issue is only the company’s capacity to service debt, offer a seller note instead of an earnout, and agree to postpone repayment if the buyer is tight on cash. A seller note is a debt instrument repaid regardless of performance, giving you greater certainty of being paid in full.
To incentivize you to deliver outstanding performance
This applies when you stay operationally involved post-acquisition. When you exit a business worth a few million, you may not be as motivated to keep growing it as when you owned it. The new owner can use an earnout to keep you motivated: “If you deliver outstanding performance under my ownership, you get your extra share of the pie.”
It doesn’t always work out as planned (see WhatsApp’s founders walking away from $850M), but in SaaS this is generally a great way to stay excited, and it can be very rewarding financially.
The new owner could use an earnout to keep you motivated. It’s also another way of saying: “If you deliver outstanding performance under my ownership, you’ll get your extra share of the pie.”
History tells us it does not always work out as planned (like WhatsApp’s founders casually walking away from $850 million), but overall, in the world of SaaS, this is a great way to keep you excited and can be very rewarding, financially.
How to Structure an Earnout
Let’s break an earnout into its main components, with examples.
Cash upfront versus deferred
How much does the buyer pay in cash upfront, and how much is deferred?
Every situation differs, but the rule of thumb is: the bigger the gap between bid and ask, the less cash upfront the buyer will pay. It’s all about risk and reward. Buyers pay more to protect against future uncertainty; you can take more risk for a greater payout.
The split varies. A 10-30% earnout can be common on Acquire.com, but it all depends on the level of risk with the deal.
Earnout KPIs
Which metrics is the earnout based on?
This is the trickiest part. Like designing a management incentive scheme, there are many ways to game the numbers. There’s no single right answer; it relies heavily on trust between you and the buyer. The most common metrics are financial (revenue, EBITDA) or operational (new customers, website traffic, ARR, average revenue per user).
A simple example, where the buyer is a financial investor, and you remain in charge of operations:
- A revenue-based earnout incentivizes you to drive revenue up, which can lower margins through discounts or aggressive marketing.
- An EBITDA-based earnout incentivizes you to cut costs near year-end to hit the target, which may hurt long-term development.
- A better structure combines revenue growth plus a minimum EBITDA margin.
If you’re not involved post-transaction, defining KPIs gets trickier since the buyer controls operations. I generally advise against a pure EBITDA earnout: EBITDA can miss target through legitimate strategic decisions, for instance if the new owner increases marketing spend to drive growth. For SaaS and recurring-revenue businesses, growing ARR is in the new owner’s best interest anyway, so if you’re not involved, I’d structure the earnout around ARR. It’s also easier to monitor and verify than EBITDA. Whatever you choose, state clearly in the contract how each KPI is defined and calculated. When the buyer is strategic and intends to merge your company into their own, earnout design gets trickier still.
Earnout timeline
What period is the earnout spread over?
General market practice is one to five years. In micro-SaaS, one to three years is more typical. If you’re not involved operationally, a one-year earnout is usually negotiable without much friction; two years becomes more complicated.
Payment and Missed KPIs
When is the earnout paid, and how are partial payments calculated?
Take a $3M earnout paid over three years on the condition that ARR stays at least $5M each year. If you hit target every year, you can structure the payout creatively:
- $1M each year, or
- $3M after three years, or
- a progressive payout, such as 20% in year one, 30% in year two, and 50% in year three.
Now the case where you do not hit the $5M ARR target. An all-or-nothing structure, where you miss the target and get nothing, is very rare. But a pure linear payout, where hitting $2.5M of $5M pays 50%, isn’t sensible either.
Floor and Ceiling KPIs
To keep it fair without over-complicating, use a floor and ceiling. In our example, the ceiling is $5M ARR; set the floor at $4.5M. If ARR lands between them, you get a proportionate amount, with the floor equal to 0% of the earnout and the ceiling equal to 100%. So $4.75M ARR would pay 50% of that year’s earnout.
Catch-up Provision
If you miss the KPI one year, is there a catch-up? Say you’re eligible for $1M per year: if ARR is $4.5M in year one (0% paid) but hits $6M in year two, you can negotiate to receive $2M at the end of year two.
Worried about the technical details and leaving value on the table? Earnouts get complex fast on a $500k+ deal. Get a second opinion from an M&A expert, or list your startup on Acquire.com to get matched with the right advisor.
Worried about all the technical details and missing out on value?
Earnouts may not be as straightforward as you think when you're a $500k+ deal. Get a second opinion from an M&A Expert.
When Is the Earnout Paid?
When you earn the payout and when it’s actually paid are both negotiation points. You might hit the $1M target but get paid six months later, effectively a 0%-interest credit line to the buyer that gives them six extra months of business cash flow to fund the payment.
Other Risks and Factors to Consider
When you structure a deferred payout, include clauses in the purchase agreement for exceptional situations:
- What happens if the buyer sells the company, divests part of the business, or discontinues a product before the earnout period ends?
- A clause letting you regain control of operations, at least through the earnout period, if the new owner runs the business into the ground.
- An information-access clause, for example full access to accounting or bank statements on demand, so you can verify you’re paid what you’re owed.
- Consider pairing the earnout with a non-competition clause and, where funds are held back, understanding how escrow protects your acquisition.
As a rule, it’s best to be assisted by a good SaaS M&A advisor and a good lawyer in these negotiations.
The Bottom Line
Earnouts can be a powerful, creative strategy when selling and negotiating the acquisition of your startup. Use everything above to respond effectively to the letter of intent (LOI) you receive. Understood well, an earnout lets any SaaS owner control the conversation, potentially increase their payout, and reach a mutually satisfying agreement.
Frequently Asked Questions
What is an earnout in an acquisition?
An earnout is additional compensation a seller receives after the deal closes, tied to the acquired company hitting agreed future performance targets such as revenue, EBITDA, or ARR. Instead of paying the full price upfront, the buyer pays a lump sum plus a deferred amount contingent on performance.
Why do buyers use earnouts?
To bridge a gap between the seller’s asking price and what they’ll pay upfront, to reduce risk on uncertain future performance, to help service acquisition debt, and to keep a departing founder motivated to grow the business post-sale.
How long does an earnout last?
General market practice is one to five years. In the micro-SaaS space, one to three years is more typical. Shorter earnouts of around one year are easier to negotiate when the seller isn’t staying on operationally.
What KPIs are earnouts based on?
Most commonly financial metrics like revenue and EBITDA, or operational ones like ARR, new customers, and ARPU. For recurring-revenue SaaS, an ARR-based earnout is usually cleanest and easiest to verify, especially if the seller isn’t involved after closing.
What is the difference between an earnout and a seller note?
An earnout pays out only if the business hits future performance targets, so payment isn’t guaranteed. A seller note is a debt instrument the buyer must repay regardless of performance, giving the seller greater certainty of being paid in full.
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