How do I negotiate earn-outs in a tech M&A deal?

How to Negotiate Earn-Outs in a Tech M&A Deal

In the world of technology M&A, earn-outs are often the bridge between a seller’s valuation expectations and a buyer’s risk tolerance. But while they can unlock additional value for founders, they also introduce complexity, uncertainty, and—if not carefully structured—potential for post-deal conflict.

So how should a tech founder or CEO approach earn-out negotiations? The answer lies in understanding the strategic purpose of earn-outs, aligning incentives, and negotiating terms that are both measurable and achievable. This article explores how to do just that, with insights drawn from real-world transactions and the advisory experience of firms like iMerge, which specializes in software and technology M&A.

What Is an Earn-Out?

An earn-out is a contractual provision in an acquisition agreement that ties a portion of the purchase price to the future performance of the business. Typically, the seller receives an upfront payment at closing, with additional payments contingent on hitting specific financial or operational milestones over a defined period—usually 12 to 36 months.

Earn-outs are especially common in tech deals where:

The target is a high-growth SaaS or software company with limited operating history
There’s a valuation gap between buyer and seller expectations
The founder or key team members are expected to stay on post-acquisition

While earn-outs can help get deals across the finish line, they also require careful structuring to avoid misaligned incentives or post-close disputes.

Key Principles for Negotiating Earn-Outs

1. Define Clear, Objective Metrics

The most common earn-out metrics in tech M&A include:

Revenue (e.g., ARR or MRR growth)
EBITDA or Net Income
Customer acquisition or retention
Product milestones (e.g., feature releases, integrations)

Where possible, tie earn-outs to metrics that are within the seller’s control and not easily manipulated by the buyer post-close. For example, EBITDA-based earn-outs can be problematic if the buyer allocates overhead or changes accounting policies. In contrast, revenue-based earn-outs—especially recurring revenue—tend to be more transparent and defensible.

As we noted in Website Valuation and Discretionary Earnings, clarity in financial definitions is essential. The same applies here: define terms like “revenue” or “net income” precisely in the purchase agreement.

2. Align Incentives with Post-Close Realities

Earn-outs work best when the seller remains actively involved in the business post-acquisition. If the founder is stepping away, the buyer assumes operational control—and the seller’s ability to influence outcomes diminishes. In such cases, earn-outs may be inappropriate or should be heavily discounted in valuation discussions.

Conversely, if the founder is staying on as a division head or product lead, an earn-out can serve as a powerful incentive. But it must be structured to reflect the new reporting lines, decision-making authority, and resource allocation. For example, if the seller is responsible for hitting a revenue target, they must have the budget and autonomy to execute their go-to-market strategy.

3. Cap the Earn-Out Period and Amount

Earn-outs should be time-bound and capped. A typical structure might include:

12–36 months of performance measurement
Earn-out payments tied to annual or cumulative targets
A maximum earn-out amount (e.g., 20–40% of total deal value)

Open-ended or uncapped earn-outs create uncertainty and can lead to disputes. Buyers may also prefer shorter earn-out periods to accelerate integration and reduce contingent liabilities.

4. Negotiate Protections and Governance Rights

To protect your ability to achieve the earn-out, consider negotiating:

Operating covenants that prevent the buyer from materially changing the business model
Access to performance data and regular reporting
Dispute resolution mechanisms (e.g., third-party arbitration)

In some cases, sellers may also negotiate a “catch-up” provision—if the business misses a target one year but exceeds it the next, the seller can still earn a portion of the deferred payment.

5. Understand the Tax and Legal Implications

Earn-out payments are typically taxed as ordinary income or capital gains depending on how they’re structured. The timing of recognition, installment treatment, and potential escrow arrangements can all impact your after-tax proceeds.

As discussed in Tax Law Changes And The Impact on Personal Taxes From Selling A Software Company, early tax planning is essential. Work with your M&A advisor and tax counsel to model different scenarios and avoid surprises.

Case Example: A SaaS Founder’s Earn-Out Journey

Consider a fictional but representative example: a founder of a $5M ARR vertical SaaS company receives an acquisition offer of $15M—$10M upfront and $5M in earn-outs over two years, contingent on hitting 30% YoY ARR growth.

With guidance from an M&A advisor like iMerge, the founder negotiates:

Quarterly reporting and transparency rights
Defined sales and marketing budget commitments
A catch-up clause if ARR growth is delayed but recovers
Capital gains treatment for earn-out payments

Ultimately, the company hits 28% growth in year one and 35% in year two. Thanks to the catch-up clause, the founder receives 90% of the earn-out—preserving alignment and avoiding litigation.

When to Push Back on Earn-Outs

Not all earn-outs are worth accepting. Founders should be cautious if:

The earn-out comprises more than 50% of the total deal value
The buyer refuses to define performance metrics clearly
The seller has no post-close control or visibility
The earn-out is based on integration synergies or cost savings

In such cases, it may be better to negotiate a lower upfront price with fewer contingencies—or walk away entirely.

Final Thoughts

Earn-outs are a powerful but double-edged tool in tech M&A. When structured thoughtfully, they can bridge valuation gaps and reward performance. When poorly designed, they can lead to misalignment, disputes, and lost value.

Firms like iMerge help founders navigate these complexities by modeling earn-out scenarios, negotiating protective terms, and aligning deal structure with long-term goals. Whether you’re selling a SaaS platform, a niche software tool, or a data-driven application, the right advisory support can make the difference between a fair deal and a frustrating one.

Founders navigating valuation or deal structuring decisions can benefit from iMerge’s experience in software and tech exits — reach out for guidance tailored to your situation.