Earnouts, Holdbacks, and Working Capital Pegs: The Terms That Change What You Take Home

Earnouts

An earnout is a portion of the price paid later, contingent on the business hitting a target after the sale. Revenue above a threshold, gross profit, retention of a key customer, renewal of a contract. Buyers propose earnouts when they are not confident the earnings will continue, and the earnout lets them pay for performance rather than promises.

Earnouts can make sense. When a business has a large customer, a recent growth spurt, or a pending contract, an earnout can bridge a gap between what the seller believes and what the buyer will pay today, and a well-designed one can pay the seller more in total than a reduced cash price.

Most earnouts favor the buyer, because the buyer controls the business during the measurement period. If the buyer raises prices and loses the customer, cuts the sales team, changes the product, or reallocates overhead to the acquired business, the target is missed and the seller is not paid, through no fault of their own.

The protections are in the definitions. Use a metric the buyer cannot easily manipulate, revenue or gross profit rather than net income. Define exactly how it is calculated, with the accounting method fixed. Require the buyer to operate the business in the ordinary course and in good faith toward achieving the earnout, and spell out what that means. Provide for acceleration if the buyer sells the business, changes its operations materially, or terminates the seller's involvement early. Require access to the books. Set a dispute mechanism with an independent accountant. Keep the period short, one to two years. Cap the seller's downside by making the earnout an addition to a fair base price, not a substitute for it.

An earnout that is more than 20 to 25 percent of the total price is a sign the buyer and seller do not agree on what the business is worth, and the seller should ask whether the right answer is a different buyer.

Holdbacks and escrows

A holdback is a portion of the price, commonly 5 to 10 percent, held in escrow for a period after closing, typically twelve to eighteen months, to cover the seller's indemnification obligations. If the buyer discovers a breach of a representation, an undisclosed liability, or a tax problem from before closing, they claim against the escrow rather than chasing the seller.

Holdbacks are standard in larger deals and appear in smaller ones when the buyer or lender wants comfort. They are reasonable in principle and negotiable in detail.

Negotiate the amount down to what the risk supports. Negotiate the period to match the exposure, twelve months is common and covers one tax cycle. Define what claims can be made against it, with a basket, a minimum aggregate claim amount before the buyer can recover anything, and a cap, usually the escrow amount itself for most claims. Require claims to be made in writing with specifics, and set a process and timeline for resolving them. Provide for release of the unclaimed balance automatically at the end of the period, without requiring the buyer's signature.

The escrow should be with a neutral third party, not held by the buyer. Interest should go to the seller.

Working capital adjustments

Most purchase agreements set a target level of working capital, current assets minus current liabilities, that the business is expected to have at closing. If working capital at closing is above the target, the price goes up. Below, it goes down. The purpose is to prevent the seller from draining receivables and inventory before closing, and to prevent the buyer from receiving a business that cannot make payroll on day one.

In many small business sales, the deal is structured cash-free, debt-free with the seller keeping receivables and paying payables, and inventory is counted and paid for separately. That avoids a working capital mechanism entirely and is simpler for both sides.

When there is a working capital peg, the definition is where the money moves. What counts as a current asset. Whether old receivables are included. How inventory is valued and whether obsolete inventory is excluded. What accrued liabilities are counted. Whether the target is a twelve-month average, a seasonal figure, or a single month. A buyer who sets the target off a peak month and measures at a trough month collects a price reduction that has nothing to do with the business's health.

Set the target off a trailing twelve-month average, define every component, agree on the accounting method, and set a short window and a clear process for the post-closing true-up. Ask for a collar, a range within which no adjustment is made, so that small variances do not become a negotiation.

How they interact

A buyer can propose a strong headline price and recover a large portion of it through these three mechanisms. A $2 million price with a $300,000 earnout the seller never receives, a $150,000 escrow that gets consumed by claims, and a $100,000 working capital adjustment is a $1.45 million deal. A $1.7 million all-cash offer with no earnout, a $50,000 escrow, and a cash-free debt-free structure may be the better deal, and the seller cannot tell without modeling both.

We prepare a net sheet for every offer that shows expected proceeds under each structure, with the earnout at a probability-weighted value rather than face value, so the seller compares what they are likely to receive rather than what the cover page says.

A worked example

A buyer offers $2 million for a business with $600,000 in SDE. The offer includes a $300,000 earnout payable if revenue in the twelve months after closing exceeds the trailing twelve months, a $150,000 escrow held for eighteen months, and a working capital target of $200,000 measured at closing.

The seller's advisor models it. Revenue has been flat for two years and the buyer will control the business, so the probability of beating trailing revenue is perhaps 40 percent, making the earnout worth about $120,000 in expected value. The escrow will likely be released in full, but eighteen months is long and a small claim is plausible, so it is valued at $130,000. Working capital in the business typically runs at $160,000, so the target implies a $60,000 reduction. Cash at closing is about $1.49 million. Expected total proceeds are about $1.74 million, with $250,000 of that uncertain and delayed.

A second buyer offers $1.75 million, all cash at closing, with a $75,000 escrow for twelve months and a cash-free debt-free structure with inventory at cost. Proceeds are $1.675 million at closing plus $75,000 in twelve months, about $1.75 million in total.

The second offer is lower on the cover page and higher in expected value, with $185,000 more cash at closing and far less that can go wrong. The seller takes it. Without the model, most sellers take the first.

Negotiating the earnout definition

If an earnout is unavoidable, the definitions do the work. Gross revenue is better than net income because the buyer cannot reduce it with overhead allocations. The measurement period should start at closing and run twelve months, with the target set off the trailing twelve months at LOI, so a soft quarter during diligence does not raise the bar. The buyer should be obligated to maintain pricing, staffing, and marketing at levels consistent with the prior year, and to not divert customers to another entity. The earnout should accelerate at the target amount if the buyer sells the business, materially changes it, or terminates the seller's transition role without cause. The seller should have audit rights and a dispute process with a neutral accountant whose decision is final. The earnout should be a general unsecured obligation of the buyer with a personal guarantee, since an unsecured promise from a new entity is worth little.

A buyer who agrees to those terms is proposing an earnout in good faith. A buyer who resists all of them is proposing a price reduction with extra steps.

In the LOI

All three belong in the letter of intent. The earnout metric, target, period, and protections. The holdback amount, period, basket, and cap. The working capital target and definition, or the statement that the deal is cash-free and debt-free with inventory counted separately. A buyer who says these are details for the purchase agreement is asking to negotiate them after exclusivity, and the seller should decline.