Mergers and acquisitions (M&A) in the agency world often involve a mix of upfront cash and earnouts which are future payments tied to performance. Earnouts are a common tool when buyers and sellers have different views on the agency’s value. Whether you are a buyer or seller, it is important to understand how earnouts work — and their potential risks — to structure a successful outcome.

What Is an Earnout?

An earnout is a part of the purchase price that is paid based on whether the selling agency hits specific performance targets after the sale. This essentially requires the seller to ​“prove” that the earning power of its business matches up to expectations. Targets typically focus on financial metrics like revenue or EBITDA, but they can also include client retention or new business development.

When Are Earnouts Used?

Earnouts help bridge the gap between a seller’s optimism and a buyer’s caution. The earnout seller gets the chance to receive additional purchase price, while the buyer mitigates risk by tying part of the deal to actual performance.

Earnouts are particularly common when a deal involves an agency with strong but uncertain growth potential, or when the buyer believes that past results don’t reflect the true earning power of the business. They’re also used when a buyer and seller disagree on valuation or when a significant portion of the agency’s revenue depends on relationships with a few key clients. If those clients stay after the acquisition, an earnout ensures the seller is compensated for retention of those relationships.

In deals containing an earnout, it is common for the seller to remain actively involved in the business post-sale. While now just an employee of the buyer, the selling-agency owner is often able to influence performance to hit earnout targets. This structure aligns incentives, but it can also create tension if the seller and buyer don’t see eye to eye on how the business should be run after the acquisition.

Typical Duration of an Earnout

Most earnouts last between one and three years. The length depends on factors like industry norms, the buyer’s risk tolerance, typical project duration, sales lead-time, and the seller’s role post-acquisition. A longer earnout period gives the buyer more assurance that the agency can sustain its performance, but it also increases the risk for the seller, as more variables come into play over time. 

When negotiating, the length of the earnout may affect its amount. Suppose a buyer and seller are $3,000,000 apart on valuation and the buyer suggests an earnout to bridge the gap. Recognizing that additional time brings additional uncertainty, the seller may offer to accept a $2,500,000 earnout if the term is set at 12 months or demand $3,250,000 if a full, three-year earnout is required. Sellers need to also consider that interest is typically not accrued on earnout payments so there may be negotiation of the amounts to reflect the time value of money.

Examples of Earnout Structures

Earnouts can take different forms depending on the deal structure and the specific concerns of the buyer and seller. A revenue-based earnout is one of the simplest structures, where the seller receives an additional payout if the agency maintains or increases its revenue over a set period. This structure is generally most favorable for sellers since it is quick and easy to calculate and seller isn’t exposed to the uncertainty of buyer’s accounting methods.

A more sophisticated version ties payments to profits or EBITDA (earnings before interest, taxes, depreciation and amortization), ensuring that profitability — not just top-line growth — determines the earnout. Buyers often prefer this approach since it best measures the true earning power of the purchased agency. However, because the buyer and seller’s accounting policies likely aren’t identical, a seller shouldn’t assume that a projected $500,000 when using its own cost structure will be the same under the buyer’s cost structure. when negotiating, a seller should run projections to determine how the buyer’s expense structure will affect EBITDA and adjust the amount of the earnout accordingly.

In some cases, earnouts are linked to client retention, where the seller receives payments based on key clients staying on board for a certain period after the acquisition. Seller’s facing these types of earnouts will want to ensure that its employees that are responsible for client retention are part of the deal and incentivized to stay with buyer over the term of the earnout.

How Earnouts Are Calculated and Paid

Regardless of structure, earnouts are typically paid annually. This ensures the effects of a full accounting cycle are reflected in results. Some deals pay quarterly to smooth cash flow or where top-line revenue or where the metric is new client origination.

A key concern for sellers is transparency in how the earnout is calculated. The purchase agreements should contain details about how calculations are made, what reports are provided to sellers, what financial data will be used, how a seller can challenge calculations, and use of an independent audit to resolve a dispute. 

While Sellers are often able to get access to financial reports, most buyers will jealously guard their ability to run the combined business as they see fit. If there are any fundamental assumptions to achieving an earnout (e.g., retention of key employees, amount of advertising spend, etc.), the seller should work to include covenants ensuring that the buyer doesn’t interfere with these requirements. 

How to Protect Yourself in an Earnout

Earnouts can be a valuable tool in agency M&A, helping buyers and sellers navigate valuation differences and align incentives for post-acquisition success. However, they also introduce complexities that require careful negotiation and clear terms. Sellers should ensure they fully understand how earnouts are structured, calculated, and paid, while buyers must balance their need for risk mitigation with the motivation of the selling party. Both sides benefit from transparency, well-defined performance metrics, and safeguards to prevent disputes over financial calculations and business operations.

Ultimately, the success of an earnout depends on trust and collaboration between the buyer and seller. While earnouts can help bridge valuation gaps, they also require the seller to remain engaged in the business and depend on factors outside their full control. By carefully structuring earnouts with realistic targets, fair timelines, and clear accountability measures, both parties can improve the likelihood of a smooth transition and maximize value from the acquisition.