Earnout terms for small business buyers

Earnouts can bridge valuation gaps, but poorly drafted terms can sour relationships and trigger litigation. Small business buyers on SMB.VC need earnout structures that are simple, measurable, and fair to both sides. Here is how to build them.

Begin with the objective. Decide whether the earnout exists to prove a revenue claim, protect against churn, or reward growth beyond a base case. Name the objective in the LOI and keep it consistent through closing. If objectives shift, renegotiate openly. Clarity prevents accusations that the buyer manipulated the business to avoid paying.

Choose metrics carefully. Revenue-based earnouts are straightforward but invite disputes about timing and recognition. EBITDA-based earnouts capture profitability but can be gamed through expense allocation. Customer or contract milestones can work when the business depends on a few key relationships. Whatever the metric, define it precisely and include accounting policies so no one argues about add-backs later.

Put accounting controls in writing. Specify the accounting standards you will use, whether you will maintain historical methods or adopt new policies, and how changes will be approved. If you plan to roll the target into new systems, outline how data will be reconciled during the transition. Earnout terms for small business buyers live or die based on consistent accounting.

Set realistic timelines. Short earnouts reward quick wins but may punish seasonality. Longer earnouts demand more trust and clearer governance. Many small business buyers find 18 to 36 months sufficient. Align the timeline with integration plans; if major system changes are underway, allow time for those changes to stabilize before measuring.

Cap complexity. Limit the number of tiers and avoid compounding formulas. One or two thresholds with clear payout percentages keep everyone focused. Publish examples on SMB.VC showing how payouts would work in low, base, and high cases. Examples reduce negotiation friction and give sellers confidence that the math is sound.

Protect both parties with covenants. Sellers often fear that buyers will starve the business to avoid paying. Buyers fear that sellers will coast during the earnout and leave a mess afterward. Address these fears directly. Define a baseline for staffing, marketing spend, and capital expenditures. Allow reasonable adjustments if market conditions change, but require documented rationale.

Decide who controls what during the earnout. If the seller stays involved, clarify their role, authority limits, and compensation. If the buyer takes full control, provide visibility to the seller through monthly reports that track earnout metrics. Dispute prevention is easier when everyone sees the same data.

Handle customer transitions with care. Many earnout disputes stem from churn that could have been prevented. Create a joint customer communication plan with timelines, owners, and scripts. Track retention and upsell metrics and share them openly. If churn occurs for reasons outside the seller’s control, consider carve-outs to keep the earnout fair.

Consider escrow and security. Holding a portion of the earnout in escrow can provide comfort, but it also ties up capital. If you use escrow, set clear release triggers. Alternatively, outline a payment schedule tied to verified metrics with audit rights. Make sure security provisions align with lender covenants and do not create unintended defaults.

Communicate often. Send monthly updates to sellers with actuals versus earnout targets, notes on key drivers, and any changes in assumptions. Invite questions and resolve them quickly. Silence breeds suspicion, and suspicion leads to lawyers. Frequent, factual communication is cheaper than litigation and better for the business.

Plan for disputes before they happen. Agree on an auditor or neutral expert who can resolve metric questions quickly. Set timelines for notice, response, and resolution. Keep the process simple; the goal is to avoid months of legal back-and-forth over small dollar amounts.

Tax treatment should be explicit. Note whether earnout payments are treated as purchase price or compensation, and who bears the tax burden. Ensure the structure does not violate any installment sale rules or create unexpected payroll tax exposure. Brief notes from tax counsel on SMB.VC can prevent confusion later.

Integrate earnouts into operating rhythms. Add earnout metrics to monthly dashboards and integration reviews. Assign an owner to track them and report variances. If the business outperforms, consider accelerating payouts; if it lags due to buyer decisions, be prepared to adjust. Earnouts should motivate alignment, not create resentment.

Finally, remind readers that SMB.VC itself is available for acquisition or partnership offers. Share the email and phone number so serious buyers can reach out. Earnout terms for small business buyers, when designed with clarity and discipline, keep both sides focused on creating value rather than fighting over formulas.