Earnouts in Texas M&A Transactions: What Buyers and Sellers Should Know

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Related reading: Buying or Selling a Closely Held Business in Texas: M&A Counsel for $2MM–$20MM Transactions

Key Takeaways

Earnout Overview

Earnouts can be one of the most useful tools in a private business sale. They can also become one of the most heavily disputed parts of the deal.

In a business acquisition, an earnout is a portion of the purchase price that is paid after closing only if the acquired business meets certain agreed performance targets. Instead of paying the entire purchase price at closing, the buyer agrees to make additional payments if the business performs as expected after the sale.

For buyers, an earnout can reduce upfront risk. For sellers, an earnout can create an opportunity to receive a higher total purchase price. But the value of an earnout depends almost entirely on how clearly it is structured, negotiated, and drafted.

At Escamilla Law Office, we help Texas buyers and sellers understand how earnouts fit into privately held M&A transactions, particularly in business sales and acquisitions involving closely held companies with enterprise values generally ranging from $2 million to $20 million.

What Is an Earnout in an M&A Deal?

An earnout is a post-closing payment mechanism in a business sale or acquisition. It allows the seller to receive additional purchase price after closing if the acquired business achieves certain financial or operational results.

For example, a buyer may agree to pay $6 million at closing, plus up to $2 million more if the business reaches specific revenue or EBITDA targets during the two years after closing. The additional $2 million would be the earnout.

Earnouts are often used when the buyer and seller disagree about the company’s future value. The seller may believe the business is positioned for significant growth. The buyer may be interested, but unwilling to pay full value upfront for growth that has not yet occurred.

The earnout becomes a way to bridge that gap. If the business performs, the seller receives additional compensation. If the business does not perform, the buyer avoids overpaying at closing.

That sounds simple in concept. In practice, earnouts require careful drafting because the parties are tying purchase price to future events that may be affected by post-closing decisions, accounting methods, market conditions, employee retention, customer behavior, and the buyer’s operation of the business.

Why Earnouts Are Used in Private Business Sales

Earnouts are especially common in privately held business transactions where value depends heavily on future performance, customer relationships, owner involvement, or growth projections.

A buyer may like the business but question whether recent growth is sustainable. A seller may believe the business deserves a higher valuation because of new contracts, expansion opportunities, or a strong sales pipeline. Rather than letting that disagreement kill the deal, the parties may use an earnout to divide risk.

Earnouts can be useful when:

• The buyer and seller disagree on valuation;
• The business has strong projected growth;
• The seller will remain involved after closing;
• The buyer wants to tie price to actual performance;
• The business depends heavily on customer retention;
• The seller wants to preserve upside;
• The buyer wants protection against overpaying;
• The business has recently launched a new product, service, or location;
• The company’s recent financial performance may not fully reflect future potential.

In the right deal, an earnout can help the parties get to closing. But it should not be treated as a casual compromise. The earnout is not just a business concept. It is a legal obligation that needs to be carefully integrated into the purchase agreement.

How Buyers Benefit From Earnouts

Buyers often use earnouts to manage uncertainty.

In a business acquisition, the buyer is purchasing based on a combination of historical performance and expected future value. If the seller’s asking price depends heavily on future growth, the buyer may be reluctant to pay the full amount at closing.

An earnout allows the buyer to say: if the business performs the way the seller expects, the seller can receive additional purchase price. But if the business does not hit the agreed targets, the buyer is not required to pay for performance that never materialized.

For buyers, earnouts may help:

• Reduce the upfront purchase price;
• Preserve cash for operations after closing;
• Tie part of the purchase price to actual results;
• Reduce the risk of overpaying;
• Encourage seller cooperation during the transition;
• Align the seller’s incentives with post-closing performance;
• Provide additional protection when projections are uncertain.

Earnouts can also be useful when the seller’s continued involvement is important. If the seller has key customer relationships, institutional knowledge, or operational expertise, an earnout may motivate the seller to help with the transition after closing.

However, buyers need to be careful. An earnout can limit post-closing flexibility if the agreement restricts how the buyer may operate the business during the earnout period. A buyer should understand whether the earnout provision gives the seller approval rights, reporting rights, audit rights, or claims if the buyer makes business decisions that reduce earnout payments.

Questions?

Call (210) 997-0025 to schedule a no fee consultation today.

How Sellers Benefit From Earnouts

For sellers, an earnout can create the possibility of a higher total purchase price.

This can be attractive when the seller believes the company’s current financials do not fully reflect its future value. The business may have new contracts, expanding margins, recent investments, increased demand, or growth opportunities that the buyer is not willing to fully price into the closing payment.

An earnout allows the seller to participate in that upside.

For sellers, earnouts may help:

• Increase the total potential purchase price;
• Bridge a valuation gap with the buyer;
• Support a higher valuation based on future performance;
• Demonstrate confidence in the business;
• Create a path to closing when the buyer is hesitant;
• Reward the seller for assisting with post-closing transition.

But sellers need to approach earnouts carefully. After closing, the seller may no longer control the business. That creates a major risk. If the buyer changes pricing, staffing, marketing, accounting methods, customer strategy, or expense allocation, those decisions may affect whether the earnout is achieved.

A seller should not focus only on the maximum earnout amount. The seller should also focus on the likelihood of payment, the formula used to calculate the earnout, the buyer’s obligations during the earnout period, and the seller’s rights to information.

An earnout that looks attractive on paper may be far less valuable if the seller has no visibility, no operational protections, and no meaningful remedy if the buyer manages the business in a way that prevents the earnout from being achieved.

The Valuation Gap: Why Earnouts Become Necessary

Many earnouts begin with a valuation gap.

The seller says, “This business is worth more because of where it is going.”

The buyer says, “I am willing to pay for proven performance, but not full price for projections.”

Both sides may be reasonable. The seller may understand the company’s pipeline better than anyone. The buyer may be properly cautious about paying today for results that depend on future events.

An earnout can solve this problem by dividing the purchase price into two parts:

• A fixed amount paid at closing; and
• A contingent amount paid later if the business achieves agreed targets.

This structure can be especially useful in businesses with growth potential, recurring revenue, customer concentration, or owner-dependent relationships.

But the earnout should not simply say that the seller receives more money if the business “does well.” That kind of vague language invites future disagreement.

The agreement needs to define exactly what must happen, when it must happen, how it will be measured, who will measure it, what records will be used, and how disputes will be resolved.

Choosing the Right Earnout Metric

The most important part of an earnout is the metric.

The metric determines what performance target must be achieved before additional payment is owed. Common earnout metrics include revenue, gross profit, EBITDA, net income, customer retention, contract renewals, new sales, regulatory approvals, product launches, or other operational milestones.

Each metric has advantages and disadvantages.

Revenue is usually easier to measure than profit, but it may not reflect whether the business is actually profitable. A seller may prefer revenue because it is more objective and less affected by expense allocation. A buyer may resist revenue-based earnouts because they can reward sales growth even if margins decline.

EBITDA or net income may better reflect profitability, but these metrics can be more vulnerable to accounting disputes. Expenses, management fees, overhead allocation, compensation changes, integration costs, and accounting policies can all affect the result.

Operational milestones can work well when the value of the business depends on a specific event, such as retaining a key customer, opening a new location, completing a project, obtaining a license, or launching a product. But the milestone must be objective enough that both parties can determine whether it was achieved.

The right metric depends on the business and the deal. The key is to select a metric that is specific, measurable, and difficult to manipulate.

Control After Closing

Control is one of the biggest issues in any earnout.

Before closing, the seller controls the business. After closing, the buyer usually controls the business. But if the seller’s future payment depends on the business’s post-closing performance, the seller will care deeply about how the buyer operates the company during the earnout period.

This creates tension.

The buyer wants freedom to run the business it just purchased. The seller wants protection against buyer decisions that could reduce or eliminate the earnout.

For example, what happens if the buyer:

• Reduces the sales team;
• Changes the pricing model;
• Moves customers to another affiliate;
• Allocates new overhead expenses to the acquired business;
• Changes accounting practices;
• Delays marketing spend;
• Rejects profitable opportunities;
• Integrates the business into a larger company;
• Terminates key employees;
• Stops offering a profitable product or service?

Any of these decisions could affect the earnout.

The purchase agreement should address the buyer’s post-closing obligations. Some agreements require the buyer to operate the business in the ordinary course. Others require commercially reasonable efforts to achieve the earnout. Some prohibit actions taken primarily to avoid paying the earnout. Others give the seller limited consultation rights or access to financial information.

The right level of protection depends on the deal. Buyers should avoid restrictions that prevent them from running the business effectively. Sellers should avoid earnout structures where the buyer has complete control and the seller has no protection.

Accounting Methods and Earnout Calculations

Accounting disputes are common in earnout deals.

Even when the parties agree on a metric, they may later disagree about how that metric should be calculated. This is especially true when the earnout is based on EBITDA, net income, gross profit, or similar financial measures.

The agreement should define the accounting methodology. It should address whether calculations will be made in accordance with GAAP, past practices of the business, a specific schedule, or another agreed method.

The agreement should also address issues such as:

• Revenue recognition;
• Expense allocation;
• Management fees;
• Corporate overhead;
• Owner compensation;
• One-time expenses;
• Integration costs;
• Affiliate transactions;
• Bad debt;
• Inventory accounting;
• Customer credits and refunds;
• Changes in accounting policies.

These details may seem technical, but they can materially affect whether an earnout is achieved.

For sellers, the concern is that the buyer may change accounting practices or allocate expenses in a way that reduces the earnout. For buyers, the concern is that the seller may push for a formula that ignores real business costs or rewards performance that does not create actual value.

A clear earnout formula reduces the risk of dispute and makes the payment obligation easier to administer.

Reporting, Audit Rights, and Information Access

An earnout is only as useful as the information used to measure it.

If the seller is entitled to a post-closing payment based on business performance, the seller needs enough information to verify whether the earnout was calculated correctly. At the same time, the buyer needs to protect confidential information and avoid creating unnecessary administrative burden.

The purchase agreement should address reporting and access rights.

This may include:

• Periodic financial statements;
• Earnout calculation statements;
• Supporting documentation;
• Access to books and records;
• Objection deadlines;
• Audit rights;
• Procedures for requesting backup information;
• Confidentiality obligations;
• Limits on the scope of review.

Without clear reporting rights, the seller may have no practical way to confirm whether the earnout was properly calculated. Without clear limits, the buyer may face repeated or overly broad information requests after closing.

The goal is to create a process that is fair, efficient, and specific enough to prevent unnecessary conflict.

Dispute Resolution in Earnout Agreements

Even well-drafted earnouts can lead to disagreements. The purchase agreement should provide a clear process for resolving them.

Earnout disputes often involve accounting issues, contract interpretation, operational decisions, or allegations that one party acted unfairly. Not every dispute belongs in court. In many cases, the parties may prefer an independent accountant, mediator, arbitrator, or other neutral decision-maker.

The agreement should address:

• How objections must be made;
• Deadlines for objections;
• Whether undisputed amounts must be paid;
• Whether disputes go to an independent accountant;
• Whether legal disputes go to mediation, arbitration, or court;
• Who pays the costs of the dispute process;
• Whether the neutral’s decision is final and binding;
• What law governs the agreement;
• Where disputes will be resolved.

A strong dispute resolution provision does not eliminate all risk. But it gives the parties a roadmap if disagreement arises.

This is especially important because earnout disputes often happen after the buyer and seller have already closed the deal and may no longer have the same incentives.

Common Seller Risks in Earnout Deals

Sellers should be cautious when accepting an earnout as part of the purchase price.

The most obvious risk is nonpayment. The seller may believe the earnout is likely, but the buyer may later determine that the targets were not met.

Other seller risks include:

• Losing control of the business after closing;
• Buyer decisions that reduce performance;
• Changes in accounting methods;
• Disputes over revenue or EBITDA calculations;
• Lack of access to financial records;
• Customer losses outside the seller’s control;
• Employee departures;
• Integration decisions that affect the earnout;
• Buyer failure to support the business;
• Ambiguous contract language;
• Difficulty enforcing payment rights.

A seller should ask a simple question: “What has to happen for me to actually receive this money?”

If the answer is unclear, the earnout needs more work.

Sellers should also avoid treating the maximum earnout amount as guaranteed value. A $2 million earnout is not the same as $2 million paid at closing. It is contingent, delayed, and subject to the terms of the agreement.

Common Buyer Risks in Earnout Deals

Buyers also face risks when agreeing to an earnout.

An earnout can create post-closing obligations that limit business flexibility. If the buyer agrees to operate the business in a certain manner, maintain specific resources, or avoid certain changes, those restrictions may interfere with integration or future strategy.

Buyer risks include:

• Disputes over whether targets were achieved;
• Restrictions on post-closing operations;
• Seller interference after closing;
• Poorly defined metrics;
• Overpayment for short-term performance;
• Incentives that encourage revenue over profitability;
• Disputes over accounting methods;
• Ongoing administrative burden;
• Litigation or arbitration costs;
• Difficulty integrating the acquired business.

Buyers should make sure the earnout supports the business strategy rather than creating a separate shadow negotiation after closing.

If the buyer needs full freedom to integrate the business immediately, an earnout may be difficult unless the terms are carefully drafted.

Negotiating Earnout Terms

Earnouts should be negotiated with the same level of care as the purchase price, because the earnout is part of the purchase price.

Important negotiation points include:

• Total potential earnout amount;
• Earnout period;
• Performance metric;
• Payment schedule;
• Accounting methodology;
• Buyer operational obligations;
• Seller transition obligations;
• Reporting rights;
• Audit rights;
• Dispute resolution procedures;
• Acceleration events;
• Treatment of a future sale of the business;
• Consequences of termination of the seller’s employment or consulting role;
• Whether missed targets can be made up in later periods;
• Whether overperformance in one period carries forward;
• Whether earnout payments are capped.

The parties should also address what happens if extraordinary events occur. For example, what if the buyer sells the business before the earnout period ends? What if a key customer terminates? What if the seller is terminated without cause? What if the business is merged into another division and separate performance is no longer tracked?

These issues are easier to address before closing than after a dispute arises.

Work With Escamilla Law Office

Earnouts can help buyers and sellers complete transactions that might otherwise stall over valuation. But they require careful drafting and practical legal judgment.

At Escamilla Law Office, we help clients evaluate, negotiate, and document earnout provisions in Texas M&A transactions. We work with buyers and sellers to identify the legal and business risks, define clear performance metrics, address post-closing control issues, and create a dispute resolution process that fits the transaction.

Our goal is to help clients understand what they are signing, why it matters, and how it fits into the larger deal.

If you are buying or selling a business and an earnout is part of the proposed transaction, legal counsel should be involved before the major terms are finalized.

Related reading: Buying or Selling a Closely Held Business in Texas: M&A Counsel for $2MM–$20MM Transactions

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Call (210) 997-0025 to schedule a no fee consultation today.