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Buying a business is rarely straightforward. In search fund acquisitions, and increasingly in SaaS deals, earnouts often show up as the “lubricant” that gets a deal across the finish line. They can bridge valuation gaps, shift risk, and give sellers a sense of upside. But they also carry real risks, operational complexity, and unintended consequences.
This post distills key insights from the Yale School of Management’s recent case study Exploring Earnouts and Their Use in Search Fund Acquisitions into a practical guide for entrepreneurs.
What Exactly Is an Earnout?
An earnout is a deal structure where part of the seller’s compensation depends on the company’s future performance.
Example: A seller wants $12M for a business generating $2M EBITDA. The buyer only sees $10M of value today. Instead of walking away, the buyer offers $10M up front plus an additional $2M if EBITDA reaches $2.4M within 24 months.
It is essentially a “wait and see” mechanism. If future growth materializes, the seller gets rewarded. If not, the buyer avoids overpaying.
In SaaS, earnouts often tie to recurring revenue or churn improvements, metrics that directly drive enterprise value but can be hard to project with certainty at closing.
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Why Buyers Use Earnouts
For search fund entrepreneurs, earnouts solve four common problems:
Closing the Deal
Deals stall when buyers and sellers cannot align on valuation. An earnout creates a synthetic zone of agreement, moving a transaction forward instead of collapsing in deadlock.
Sharing Risk
Sellers often believe their business has smooth growth ahead. Buyers see potholes. Earnouts let sellers take on some of that risk. For example, if the key customer leaves, the payout does not happen.
Reducing Upfront Cash
Especially in ETA, buyers are often capital-constrained. Back-loading part of the purchase price through an earnout can make the transaction financeable.
Time Value of Money
Deferring payments is powerful. A $3M earnout payable two years out is essentially an interest-free loan for the buyer.
In SaaS acquisitions, these dynamics are amplified: buyers might hesitate to pay full price for aggressive revenue forecasts or projected churn reductions. An earnout can tie part of the price to whether those projections actually materialize.
Why Sellers Accept Earnouts
Sellers also have reasons to embrace earnouts:
Upside Option – If growth accelerates, they get rewarded.
Tax Deferral – Earnout payments are often taxed later, not at closing.
Headline Valuation – Brokers and sellers can tout a larger sale price (even if much of it is contingent).
Confidence in New Leadership – Sellers may trust a new, ambitious CEO (common in search fund deals) to unlock growth they could not achieve alone.
Best Practices for Structuring Earnouts
Earnouts are useful, but they require careful design. Four best practices stand out:
Pick the Right Metric
Revenue: Easy to measure, but can incentivize unprofitable sales.
EBITDA: Aligns with profitability, but disputes can arise if new owners reinvest in growth.
Gross Profit or ARR (for SaaS): Often a middle ground. ARR is especially relevant in SaaS, but needs clear definitions (renewals, upsells, bundled services).
Choose the Right Currency
Cash is simple but strains liquidity.
Equity aligns incentives but dilutes ownership.
Seller Notes defer cash obligations but carry interest.
Set a Reasonable Timeframe
Short (12–18 months) = less uncertainty but may miss longer SaaS sales cycles.
Longer (3–5 years) = captures strategic growth, but increases tension and disputes.
Plan How to Fund It
Do not assume the business’s free cash flow will be there. Model scenarios where the earnout is fully triggered. If funding requires new debt or equity, your economics may shrink quickly.
Pitfalls and Misperceptions
Even well-structured earnouts can backfire. Four common traps to avoid:
Buyer–Seller Misalignment
Sellers may push for short-term revenue boosts at the expense of long-term value. Buyers may try to suppress earnings to avoid paying out. Expect conflict.
Underestimating Cost and Complexity
Earnouts require constant monitoring, legal review, and sometimes arbitration. Think of them less as “deferred consideration” and more as “potential litigation.”
Operational Control Issues
In ETA, sellers typically step aside. That makes it tricky to tie their payout to outcomes they no longer control. For SaaS, where seller knowledge is often critical, earnouts can prolong messy transitions.
The “It’s Free” Illusion
Earnouts are not free just because they are paid from future cash flow. Every dollar sent to the seller is a dollar not used for growth, debt reduction, or distributions.
Key Takeaways for Entrepreneurs
Earnouts can be powerful tools in search fund and SaaS acquisitions. They help bridge gaps, share risk, and get deals done. But they come with complexity and should be approached with caution.
Key points to remember:
Use earnouts as a last resort, not a default. Explore alternatives like seller notes, escrows, or rolled equity first.
If you use one, design it with discipline: pick the right metric, set clear definitions, and plan funding scenarios.
Assume disputes will happen, and bake in dispute resolution mechanisms from day one.
In short, earnouts can save a deal, but they can also sour relationships and erode returns if poorly structured. Handle with care.
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