Blog · Published 2026-11-04
Earnout structures in a small acquisition: how they work and what a buyer should diligence first.
An earnout pays part of the purchase price later, only if the business reaches an agreed target after closing. It bridges a gap between what the seller believes the business will earn and what the documents prove today. The diligence that matters is making the target measurable: a metric defined in writing, a baseline that ties to the documents, and accounting rules both sides can apply the same way. Have a lawyer draft and review the terms.
Why earnouts appear in small deals
Earnouts usually show up when the seller's view of the future is stronger than the record. A forecast that assumes growth the statements do not yet show, a large contract not yet signed, or add-backs the buyer will not accept are typical triggers. Instead of paying for the forecast at closing, the buyer offers to pay for it when it happens.
That makes the earnout a direct consequence of diligence. The gap it bridges is the gap between the CIM and the documents, the same gap a quality of earnings review measures. If you are financing the deal with a lender, ask early whether and how it allows an earnout; for SBA deals see the SBA quality of earnings requirements and confirm the current earnout rules with your lender.
Common structures, and what each needs from diligence
| Metric | Why parties choose it | What diligence has to settle first |
|---|---|---|
| Revenue | Simple to measure and hard for the buyer to reduce through cost decisions. | Which revenue counts: recurring only, one product line, net of refunds and credits. Tie the baseline to the statements and the tax return. |
| Gross profit | Rewards profitable revenue, not any revenue. | Which costs sit above the line, and whether that may change after closing. |
| EBITDA | Closest to what the buyer values. | The add-back rules, treatment of owner pay, integration costs and buyer overheads. Most exposed to dispute because so many choices move it. |
| Customer or contract milestone | Ties payment to a specific event, such as a renewal or a named contract. | Exactly what counts as the event, and what happens if the customer renews on different terms. |
| Product or technical milestone | Common for software, where a release or certification drives value. | An objective test of completion and who decides it. |
Where earnout disputes start
- An undefined metric. Terms like revenue or EBITDA without a written definition and an example calculation.
- A baseline that does not tie. A target set off a CIM figure that differs from the statements or the return. The worked example below shows such a gap.
- Changes in accounting. A new owner changes revenue recognition, cost allocation or the accounting system, and the metric moves for reasons unrelated to performance.
- Control after closing. The seller argues that the buyer's decisions on pricing, staff or investment kept the target out of reach.
- Information rights. The seller cannot see the numbers needed to check the calculation.
- Integration. The business is merged into another and the metric can no longer be measured on its own.
Earnouts when buying a software company
Software deals add their own earnout questions. If the target is recurring revenue, the definition of recurring revenue decides the payment, so it should be the same definition you tested in diligence; see key metrics for a SaaS acquisition. If customers will be moved onto the buyer's own product, or the product is bundled with others, agree in advance how the acquired product's revenue will still be measured. And if a milestone depends on a release or a security report, write down who decides that it has been reached, because "done" means different things to a founder and to a buyer.
The wider software checklist is in software company acquisition due diligence.
A diligence checklist before agreeing an earnout
- Write the metric's definition, then compute it yourself for the last periods from the documents. If you cannot, the definition is not ready.
- Tie the baseline figure to the financial statements and tax returns, not to the CIM alone.
- List every add-back the seller relies on and decide which ones the earnout calculation will accept. See QoE testing for how add-backs are tested.
- Name the accounting policies the calculation will use, and freeze them for the earnout period.
- Agree what information the seller receives and when, and how a disagreement is resolved.
- Check the forecast behind the earnout against the contracts: is the large customer actually signed, and can its contract be assigned to a new owner?
- Ask your lawyer to draft the terms and your accountant to test the calculation on real figures before signing.
Where Deal OS fits
Deal OS does not draft or advise on earnout terms. What it does is the step before: it reads the CIM, the statements, the tax return and the add-back schedule, and reports where the figures differ and which add-backs look weak, each with its page. Those are the numbers an earnout is built on. See the sample brief, the quality of earnings software page and pricing.
Worked example from the sample brief
The numbers an earnout would be built on, from the sample brief (a synthetic deal), quoted from it:
- Two baselines for the same revenue. Trailing twelve month revenue is $6.21M on page 6 of the CIM and $5.95M as gross receipts on the tax return. The brief shows the $260K gap side by side and says to reconcile it before applying any multiple.
- Add-backs that may not hold. The seller presents adjusted EBITDA of $1.42M. The brief itemizes the add-backs and rates each one; $90K of them are rated questionable or unlikely, which gives $1.33M that holds up on the documents.
- A recurring revenue definition to pin down. Page 7 says about 78% of revenue is recurring. Page 22 defines recurring as all revenue from accounts with an active inspection agreement, including repair and call-out work. The brief flags the two passages as inconsistent.
The example is Sentinel Fire & Safety, Inc., a synthetic company built to show the product. Nothing in it describes a real business, and the same output shape applies to a real data room. See the whole thing at /sample-brief.
Questions
Frequently asked questions.
What is an earnout in an acquisition?
A part of the purchase price paid after closing, only if the business reaches an agreed target, such as revenue, gross profit, EBITDA or a milestone, within an agreed period.
What are the most common earnout structures?
Targets based on revenue, gross profit or EBITDA, and milestones such as a contract renewal or a product release. Revenue is simplest to measure; EBITDA is closest to value but most open to dispute.
Why do earnouts lead to disputes?
Usually because the metric was not defined precisely, the baseline did not tie to the documents, accounting changed after closing, or the seller could not see or influence the figures.
What should a buyer check before agreeing to an earnout?
That the metric can be computed from the documents for past periods, that the baseline ties to the statements and tax returns, which add-backs count, which accounting policies apply, and what information the seller will receive.
Can I use an earnout in an SBA-financed acquisition?
Ask your lender. SBA rules on seller financing and contingent payments are set in the SBA's standard operating procedure and change over time, so confirm the current position for your deal.
See it on a deal.
Open a real brief on a synthetic deal without an account, or check how a single deal is priced.
