In today’s unpredictable M&A landscape, one classic deal structure is seeing a major resurgence: the earn-out.
With economic uncertainty, shifting interest rates, and wide gaps in valuation expectations between buyers and sellers, earnouts are emerging as a practical and increasingly common tool to keep deals moving forward in the middle market. For dealmakers navigating this complex environment, understanding the strategic value and risks of earn-outs is more important than ever.
What’s Driving the Comeback?
The past few years have shaken the M&A world. Interest rate hikes, volatile capital markets, and a murky macroeconomic outlook have made it harder for buyers to confidently assess the future performance of target companies. At the same time, sellers—especially those in high-growth sectors like tech-enabled services, niche manufacturing, and business process outsourcing—often hold out for pre-2022 valuation multiples.
Enter the earnout: a creative mechanism to reconcile these differing views without killing the deal.
An earnout ties a portion of the purchase price to the future performance of the acquired business, usually based on revenue or EBITDA targets over a defined period (commonly 12 to 36 months). This allows buyers to mitigate risk and sellers to potentially realize full value—if the business delivers as promised.
Why They Work in the Middle Market
Middle market transactions ($10M–$500M enterprise value) are especially ripe for earnouts. Many of these businesses lack the scale or data maturity of larger enterprises, making valuation more art than science. Earnouts help address this uncertainty, particularly in industries where customer concentration, cyclical demand, or fast-changing competitive dynamics make forecasting difficult.
Earnouts also offer a way to accommodate sellers who are emotionally or strategically invested in the future of their business. By tying part of their payout to future success, sellers stay aligned with the growth of the company post-close—an attractive feature for buyers prioritizing a smooth transition and performance continuity.
Key Trends We’re Seeing
Several recent trends are amplifying earnout usage:
- Longer timelines for closing: Diligence is taking longer as buyers scrutinize financials more closely. Earnouts give both sides breathing room to close the gap and move forward.
- More structure creativity: Beyond traditional EBITDA-based earnouts, we’re seeing innovation—milestone earnouts tied to customer renewals, expansion into new markets, or operational cost savings.
- Private equity influence: PE firms, especially those executing buy-and-build strategies in sectors like industrial services and commercial contracting, are increasingly comfortable with earnouts as a portfolio-wide tool for downside protection.
- Sector-specific relevance: In industries like logistics, IT services, and light manufacturing—where future growth is a central part of the valuation story—earnouts are not just useful; they’re becoming standard.
Earnout Pitfalls to Watch For
Despite their benefits, earnouts can be a double-edged sword. Poorly structured earnouts can create post-close tension, especially if sellers feel performance targets are unattainable or buyers control too many variables. Legal disputes over earnout achievement are not uncommon.
To avoid this, both sides need clarity and alignment up front. This includes:
- Clear definitions of performance metrics (e.g., GAAP vs. non-GAAP EBITDA)
- Post-close governance rights or transparency for sellers
- Caps and floors to avoid open-ended liabilities
- Alignment on operational plans that impact the ability to hit targets
How to Make Earnouts Work
Here are some best practices for using earnouts effectively in middle market M&A:
- Start with trust: If there’s no relational or reputational trust between buyer and seller, no structure—earnout or otherwise—will save the deal.
- Use earnouts to solve for a gap—not to play hardball: Earnouts should bridge reasonable differences, not exploit uncertainty.
- Communicate early: Earnouts introduced late in a deal process can feel like a bait-and-switch. Bake them into early-stage conversations.
- Consider hybrid structures: Some acquirers are pairing smaller upfront payments with seller notes or equity rollovers, using earnouts as just one component of a larger alignment strategy.
- Get the right advisors: Lawyers and advisors experienced with earnouts can help avoid vague or unenforceable language that can derail future payouts.
The Bottom Line
As the middle market continues to evolve, earnouts are becoming less of a fallback and more of a strategic tool. They can keep deals alive in uncertain times, align incentives, and unlock value for both sides when used wisely.
But they’re not plug-and-play. Earn-outs demand thoughtful structuring, honest communication, and a shared belief in the future potential of the business. When those ingredients are present, earn-outs can turn valuation gaps into growth opportunities—and get deals across the finish line.
