How to Handle Earn-Outs in the Sale of Your Software Business

For many software founders, the sale of their company is the culmination of years—sometimes decades—of innovation, risk-taking, and relentless execution. But when it comes time to negotiate the final terms, one element often introduces both opportunity and uncertainty: the earn-out.

Earn-outs are a common feature in software M&A transactions, especially when there’s a gap between the seller’s valuation expectations and the buyer’s risk tolerance. Handled well, they can bridge that gap and unlock additional value. Handled poorly, they can lead to misaligned incentives, post-closing disputes, and missed payouts.

This article explores how to structure, negotiate, and manage earn-outs effectively in the sale of a software business—drawing on insights 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 which a portion of the purchase price is contingent on the business achieving certain post-closing performance targets. These targets are typically tied to financial metrics such as:

• Revenue (e.g., ARR or MRR growth)
• EBITDA or net income
• Customer retention or expansion
• Product milestones or integration goals

Earn-outs are especially prevalent in software deals where future growth potential is high but not yet fully realized—such as early-stage SaaS companies with strong KPIs but limited operating history.

Why Earn-Outs Are Common in Software M&A

Software businesses, particularly SaaS companies, often command high valuation multiples based on forward-looking metrics. Buyers—whether private equity firms or strategic acquirers—may be hesitant to pay a full premium upfront without some assurance that projected growth will materialize.

Earn-outs offer a compromise: the seller receives a base purchase price at closing, with the potential to earn additional consideration if the business performs as expected. This structure can help close valuation gaps, align incentives, and reduce buyer risk.

However, as we’ve seen in numerous transactions, the devil is in the details.

Key Considerations When Structuring an Earn-Out

1. Define Clear, Objective Metrics

Ambiguity is the enemy of a successful earn-out. Metrics should be:

• Quantifiable — e.g., “$10M in ARR by Year 2”
• Auditable — based on GAAP-compliant financials or agreed-upon accounting methods
• Within the seller’s influence — avoid tying payouts to metrics the seller can’t control post-closing

For example, tying an earn-out to EBITDA may seem straightforward, but if the buyer integrates the business and changes cost structures, the seller may lose visibility or control. In such cases, revenue-based earn-outs may be more appropriate.

2. Align Time Horizons

Earn-outs typically span 12 to 36 months. Shorter periods reduce uncertainty but may not capture the full value of long-term initiatives. Longer periods increase risk for the seller, especially if they’re no longer involved in day-to-day operations.

In founder-led businesses, buyers often request that the founder stay on during the earn-out period. If that’s the case, negotiate compensation, reporting lines, and decision-making authority upfront.

3. Anticipate Post-Closing Changes

One of the most common earn-out disputes arises when the buyer makes operational changes that affect performance. To mitigate this risk, sellers should negotiate covenants that:

• Require the buyer to operate the business in the ordinary course
• Restrict major changes to sales strategy, pricing, or staffing
• Provide the seller with ongoing access to performance data

Some sellers also negotiate “catch-up” provisions—so if a target is missed one year but exceeded the next, the earn-out can still be partially or fully earned.

4. Cap and Floor the Earn-Out

Earn-outs should include a maximum payout (cap) and, in some cases, a minimum threshold (floor). This helps both parties model the financial impact and reduces the risk of open-ended obligations.

For instance, a $20 million deal might include $15 million at closing and up to $5 million in earn-out payments over two years, contingent on hitting revenue milestones. The cap ensures the buyer’s exposure is limited, while the seller knows the upside potential.

5. Tax and Legal Implications

Earn-out payments are typically taxed as ordinary income or capital gains, depending on how they’re structured. Sellers should work with tax advisors to optimize the treatment and avoid surprises. For more on this, see Tax Law Changes And The Impact on Personal Taxes From Selling A Software Company.

Additionally, earn-outs should be clearly documented in the purchase agreement, with dispute resolution mechanisms (e.g., arbitration) in case of disagreement.

Case Study: A SaaS Exit with a Tiered Earn-Out

Consider a mid-market SaaS company with $8M in ARR and strong YoY growth. The founder received multiple offers, but the highest valuation—$40M—came with a $25M upfront payment and a $15M earn-out tied to hitting $12M ARR within 24 months.

With guidance from iMerge, the founder negotiated:

• A tiered earn-out: $5M at $10M ARR, $10M at $12M ARR
• Monthly reporting access and a seat on the integration steering committee
• A clause preventing the acquirer from reallocating key sales resources without consent

The result: the company hit $11.5M ARR in 18 months, triggering a $7.5M payout—more than the founder would have received in a flat $35M offer with no earn-out.

When to Push Back on an Earn-Out

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

• The earn-out comprises more than 40% of total consideration
• The buyer refuses to provide operational transparency
• The metrics are vague or subject to manipulation
• The seller has no post-closing role or influence

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

Final Thoughts

Earn-outs can be a powerful tool in software M&A, but they require careful structuring, clear communication, and experienced negotiation. Founders should approach them not as a gamble, but as a strategic component of the deal—one that can unlock additional value if aligned properly.

Firms like iMerge help software founders navigate these complexities, from exit planning strategy to post-closing integration. With the right guidance, earn-outs can become a win-win for both buyer and seller.

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.