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A Permanent Podcast episode on earnouts as a way to bridge valuation gaps in business sales. The hosts focus on when earnouts help, how they can be manipulated, and why trust in the buyer matters as much as the headline payout.
Buyers and sellers evaluating earnouts in SMB transactions, especially anyone negotiating valuation gaps and post-close risk.
Earnouts work best as a bridge when the seller is more optimistic about future performance than the buyer.
The usefulness of an earnout depends on who controls the metrics and whether the calculation can be changed after closing.
Metrics lower in the income statement are easier to manipulate than revenue, so earnouts tied to pre-tax income are inherently riskier than revenue-based structures.
A buyer's reputation and post-close behavior matter as much as the payout formula because a bad actor can move the goalposts.
A seller should treat an earnout as only as good as the buyer's durability over the next 5 to 10 years.
Earnouts can meaningfully increase seller proceeds, but only when the seller understands exactly how the KPI is calculated and protected.
Cash at close is the only fully certain consideration when the buyer is untrustworthy or the capital structure is highly leveraged.
An earnout is a valuation tool used to split the difference when buyer and seller disagree about future earnings. The structure lets each side share upside and downside instead of forcing a single fixed price.
When to use: Use it when there is a genuine forecast disagreement but enough trust to make the payout mechanics credible.
Earnouts can be tied to almost any measurable metric or event, including EBITDA, gross profit, revenue, add-on acquisitions, employee retention, customer retention, owner employment duration, cost reductions, or other milestones.
The hosts list the range of performance triggers that can be used in an earnout.
A seller can sometimes earn an additional $2 million if the company hits a target within five years.
Emily gives an example of a time-based earnout payout.
An earnout can pay out an outsized percentage once earnings exceed $5 million.
Emily uses a numeric example to show how payout formulas can be layered.
Pre-tax net income is easier to manipulate than gross profit, and gross profit is easier to manipulate than revenue.
Brent explains why the chosen metric changes the buyer's ability to alter the outcome.
Earnout risk rises when the seller is subordinated behind multiple layers of debt.
The hosts note that a heavily levered capital structure can make an earnout much less dependable.
The buyer's history over the next 5 to 10 years matters because the earnout often depends on the acquirer's durability.
Brent emphasizes that earnout payments can become meaningless if the buyer does not stay in place.
Choose an earnout only when you can verify how the KPI will be calculated and who controls the inputs.
Why: A clear formula reduces the chance that a buyer can later change the measurement basis.
Ask the buyer about their history of post-close disputes before agreeing to an earnout.
Why: Past contentious behavior is a warning sign that the structure may be used opportunistically.
Talk to people the buyer has done business with before signing an earnout.
Why: Reference checks help reveal whether the acquirer has a pattern of honoring contingent payments.
Prefer metrics that are harder to manipulate if you are the seller.
Why: Revenue is generally harder to game than gross profit or pre-tax earnings.
Treat a heavily levered capital stack as a red flag for contingent consideration.
Why: Multiple layers of debt can sit ahead of seller proceeds and increase the chance that an earnout never pays.
The hosts describe situations where a buyer offers an unusually large earnout that appears achievable on paper, but the calculation can be changed through accounting choices and KPI manipulation after closing.
Lesson: A large contingent payout is worthless if the buyer can rewrite the measurement process.