Earnout structure in lower middle market M&A

Earnouts are the most misunderstood deal term in lower middle market M&A.

A founder sees the headline number ("$15M deal: $10M base + $5M earnout") and assumes the math is simple. The buyer sees the same number and treats the earnout as optionality, contingent on targets they control after close. Most LMM earnouts pay materially less than the headline suggests.

This piece walks through what determines whether an earnout actually pays, the structures that protect sellers, and the structures that hand control to the buyer.

What an earnout is

An earnout is contingent consideration paid to the seller after close, based on the post close performance of the business. The buyer pays at close (the base), and if the business hits agreed performance targets, the buyer pays additional consideration over time (the earnout).

Earnouts solve a real problem. Buyers and sellers often disagree on the value of a business, especially when the seller is projecting significant growth that the buyer doubts. The earnout bridges the gap: if the seller is right, they get paid the full value; if the buyer is right, they don't overpay.

In practice, the gap rarely gets bridged cleanly. Earnouts come with measurement, control, and accounting issues that produce disputes more often than payments.

Three things that determine whether an earnout pays

1. Who controls the earnout period

If the buyer takes operational control on day one (which is the default in any acquisition), the buyer can engineer the EBITDA, revenue, or whatever metric the earnout is based on.

How buyers reduce earnout payments:

• Allocate corporate overhead from the parent company to the acquired business
• Shift cost centers (R&D, marketing) into the acquired business
• Defer revenue recognition (delay closing contracts to push revenue past the earnout period)
• Accelerate expense recognition (pull forward investments)
• Close customer accounts that fall outside the buyer's strategic priorities

None of this is necessarily bad faith. It's normal post acquisition operational management. But it's also the difference between hitting an earnout target and missing it.

2. Measurement clarity

"EBITDA per the financial statements" is not enough.

What needs to be defined in the earnout language:

• Which add backs survive the close (owner salary, related party expenses, one time items, etc.)
• Which accounting policies apply (the seller's, the buyer's, or a hybrid specified in the agreement)
• How shared services or transition services agreement costs are allocated
• How acquisition costs are treated
• How financing costs are treated (the buyer's debt service or interest)
• How non recurring items are identified and excluded

Without specificity, every dispute about whether the target was hit becomes a multi month accounting argument resolved by a neutral arbitrator.

3. Cap structure

Earnout caps determine the upper bound of what the buyer pays. Three common structures:

• No cap. The seller earns the full earnout if targets are hit, regardless of how high. Rare in LMM deals because buyers don't underwrite unlimited downside.
• Tight cap. The earnout maxes out at a defined dollar amount. Most common structure. Buyer's downside is capped; seller's upside is capped at the cap.
• Floor and cap. The seller earns nothing below a floor (e.g., 80% of target), full earnout above the cap (e.g., 120% of target), and pro rated between. Provides downside protection for the seller but typically caps the upside.

Buyers prefer floor structures (downside protection for them). Sellers prefer no floor (full earnout above target). The negotiation usually lands at a floor with proportional payment.

The 30% rule

A useful heuristic: if the earnout is more than 30% of total deal consideration, the seller is functionally financing the buyer at zero interest.

Reason: most LMM earnouts have payment risk (the buyer might engineer the target downward), measurement risk (the parties might dispute the calculation), and time value of money risk (the seller waits 1 to 3 years for the cash).

Negotiating principle: maximize base, minimize earnout. The earnout should be a bridge for legitimate disagreement, not the bulk of the deal value.

Common earnout structures in LMM deals

Revenue based earnout

Pay if the business hits revenue targets in years 1, 2, or 3 post close.

• Pros: revenue is harder for the buyer to manipulate than EBITDA.
• Cons: the buyer can still defer or accelerate revenue recognition.

EBITDA based earnout

Pay if the business hits EBITDA targets.

• Pros: aligns incentives around profitability.
• Cons: extremely manipulable through cost allocations and accounting policies.

Customer retention earnout

Pay if specified customer accounts retain through year 1 or 2 post close.

• Pros: clear, measurable, hard to manipulate.
• Cons: limited to deals where customer retention is the central concern.

Synergy earnout

Pay if the buyer realizes specific cost synergies or revenue synergies post close.

• Pros: tied to specific actions the buyer commits to taking.
• Cons: rare in LMM; more common in strategic acquirer deals.

Milestone earnout

Pay on specific milestones (regulatory approval, product launch, customer signing).

• Pros: clearest measurement, lowest dispute risk.
• Cons: limited to deals where specific milestones drive value.

For most LMM deals, EBITDA based earnouts are the default. Sellers should push for measurable, defensible alternatives where possible.

Real example: the math on a typical earnout

Consider a $20M deal with $15M base plus $5M earnout based on year 1 EBITDA hitting an agreed target:

Scenario A: Earnout pays full. Year 1 EBITDA hits target. Seller receives $5M. Total deal value $20M as advertised.

Scenario B: Earnout pays partial. Year 1 EBITDA misses target by 15% due to buyer cost allocation. Seller receives $0 (no floor). Total deal value $15M, 25% below headline.

Scenario C: Earnout disputed. Year 1 EBITDA calculation disputed. Seller and buyer fight over add backs and cost allocations for 9 months. Seller eventually receives $2.5M after settlement. Total deal value $17.5M, 12.5% below headline, plus 9 months of dispute time and legal fees.

What to negotiate before signing

Before agreeing to an earnout in any LOI, the seller should have:

• Specific calculation methodology written into the LOI (not "to be defined in purchase agreement")
• Floor structure that protects against buyer engineering ("seller earns 50% of earnout if target hit at 80% of plan")
• Anti dilution provisions (preventing buyer from shifting costs into the acquired business)
• Audit rights for the seller during the earnout period
• Acceleration clauses (full earnout payable if buyer is acquired or sold before earnout period ends)
• Specific accounting policies that apply (with seller's input on the methodology)

If the buyer refuses to specify these in the LOI, the seller is taking unbounded risk on the earnout amount.

Where to read next

For the broader LOI checklist that wraps the earnout decision into the full set of terms to lock down before exclusivity, see LOI and Exclusivity in Lower Middle Market M&A. For the working capital adjustment that often comes alongside earnouts at close, see Working Capital Adjustments in LMM LOIs. For the broader sell side process timeline that frames where the earnout conversation happens, see The Sell Side M&A Process: 26 Week Timeline.