What’s a Fair Earn-Out Structure in a Software M&A Deal?

In software M&A, earn-outs are often the bridge between a seller’s valuation expectations and a buyer’s risk tolerance. But while they can align incentives and unlock value, they can also become a source of post-closing tension if not structured thoughtfully. So, what does a “fair” earn-out look like in a software transaction?

This article explores the key principles of fair earn-out design, common pitfalls, and how experienced advisors like iMerge help both sides navigate this nuanced component of deal structuring.

Why Earn-Outs Are Common in Software M&A

Software companies—especially SaaS businesses—often trade at high revenue or EBITDA multiples based on future growth potential. Buyers, particularly private equity firms or strategic acquirers, may be hesitant to pay full value upfront if:

• The company is early-stage or has limited operating history
• Key customer contracts are short-term or not yet secured
• There’s significant founder dependency or key-person risk
• Revenue growth is accelerating but not yet proven sustainable

In these cases, an earn-out allows the seller to “earn” a portion of the purchase price based on post-closing performance—typically over 12 to 36 months. This structure can help close valuation gaps while giving the buyer downside protection.

Core Elements of a Fair Earn-Out

While every deal is unique, a fair earn-out structure typically includes the following characteristics:

1. Clear, Measurable Metrics

The most common earn-out metrics in software deals include:

• Revenue (e.g., ARR, MRR, or total bookings)
• EBITDA or Adjusted EBITDA
• Customer retention or churn
• Milestone-based metrics (e.g., launching a new product or entering a new market)

Fairness starts with clarity. Metrics should be objectively measurable, auditable, and tied to the seller’s influence post-close. For example, if the seller is staying on as CEO, EBITDA-based earn-outs may be appropriate. If the seller is exiting, revenue-based metrics are often more suitable.

2. Reasonable Time Horizon

Most earn-outs in software M&A range from 12 to 36 months. Longer periods increase uncertainty and reduce the seller’s control over outcomes. A fair structure balances the buyer’s need for performance validation with the seller’s desire for timely compensation.

3. Defined Payout Mechanics

Earn-out payments should be:

• Clearly scheduled (e.g., annually or quarterly)
• Based on tiered thresholds (e.g., 100% payout at $10M ARR, 50% at $8M)
• Not subject to buyer discretion—avoid vague language like “at buyer’s sole determination”

Some deals include a “catch-up” provision, allowing sellers to earn missed payments in later periods if cumulative targets are met. This can be a fair compromise when growth is lumpy or seasonal.

4. Protections Against Manipulation

One of the most contentious issues in earn-outs is post-close control. Sellers often worry that buyers will cut costs, reallocate resources, or change strategy in ways that depress performance. To mitigate this, fair earn-outs often include:

• Operating covenants requiring the buyer to run the business in the ordinary course
• Restrictions on reallocating key personnel or budgets
• Dispute resolution mechanisms (e.g., third-party accounting review)

As we noted in How Do I Handle Earn-Outs in the Sale of My Software Business?, these protections are especially important when the seller is not staying on in an operational role.

Illustrative Example: A $20M SaaS Exit

Consider a SaaS company with $5M ARR, growing 40% YoY. The seller believes the business is worth $25M based on forward ARR multiples. The buyer, however, is only comfortable paying $20M upfront due to customer concentration and limited contract terms.

A fair earn-out might look like this:

• Upfront payment: $20M at closing
• Earn-out period: 24 months
• Metric: ARR at end of Year 2
• Payout tiers:
  • $1M if ARR ≥ $6.5M
  • $2.5M if ARR ≥ $7.5M
  • $5M if ARR ≥ $9M
• Catch-up clause: If Year 1 misses target but Year 2 exceeds, seller can still earn full amount

This structure rewards the seller for continued growth, gives the buyer downside protection, and aligns incentives during the transition period.

Common Pitfalls to Avoid

Even well-intentioned earn-outs can go awry. Here are a few red flags to watch for:

• Overly complex formulas that are hard to track or audit
• Unrealistic targets that require hypergrowth to achieve
• Ambiguous definitions of key terms like “Adjusted EBITDA” or “Net Revenue”
• No dispute resolution process in case of disagreement

As we’ve seen in Mergers & Acquisitions: Allocation of Purchase Price Disagreements, even small ambiguities can lead to costly litigation or broken relationships post-close.

How iMerge Helps Structure Fair Earn-Outs

At iMerge, we’ve advised on dozens of software and SaaS transactions where earn-outs played a pivotal role. Our approach includes:

• Valuation modeling to test different earn-out scenarios
• Negotiation support to align buyer and seller expectations
• Legal coordination to ensure terms are clearly documented
• Post-close advisory to monitor performance and mitigate disputes

We believe earn-outs should be a tool for value creation—not a source of friction. With the right structure, they can unlock upside for both parties while preserving trust and alignment.

Conclusion

A fair earn-out structure in a software M&A deal is one that balances risk, rewards performance, and minimizes ambiguity. It should be grounded in measurable metrics, realistic targets, and mutual trust. Whether you’re a founder preparing for exit or a buyer managing downside risk, thoughtful earn-out design is essential to a successful transaction.

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.