The Earnout: Protecting Value when Relationships Drive Revenue.

by Roy Watson - Founder & CFO - True North CFO's

In small to middle-market acquisitions, Independent Sponsors and Private Equity investors often focus on tangible deal metrics: financial statements, EBITDA trends, and customer concentration, while overlooking a critical factor: the personal relationships that sustained and built the seller’s revenue base.

Many lifestyle or founder-led companies rely on decades-long trust between the owner and key customers. In industries like manufacturing, professional services, or distribution, relationships spanning 10 to 40 years are common and not easily transferred at closing. Assuming revenue will remain stable without accounting for those relationships can lead to

disappointment. This is where the Earn Out becomes an essential tool—not just a pricing mechanism, but a strategic safeguard of enterprise value.

The Intangible That Drives Tangible Value

Recurring revenue may look strong on paper, but in relationship-driven businesses, that stability is often personal, not structural. Even if a seller stays on post-close, the dynamic changes and loyalty can erode.

Buyers should research this risk during diligence:

• Who truly owns the customer relationship—the company, founder, or sales team?

• How much revenue depends on those relationships?

• Will the customers stay when leadership changes?

• Are contracts or formal agreements in place?

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If a company’s success rests heavily on individual relationships, that intangible must be quantified and mitigated with the Earn Out, not just priced into the deal.

Why the Earn Out Belongs at the Center of These Deals

A traditional Quality of Earnings (QofE) report prices the past, validating historical performance. Yet value realization is a forward-looking exercise. The key question isn’t what the company earned in the past; it’s whether those earnings will hold after closing.

An Earn Out shifts part of the purchase price into future payments based on performance metrics such as revenue, gross margin, or EBITDA. This creates two clear advantages:

• Ties compensation to continuity. The seller remains financially motivated to maintain customer relationships and revenue.

• Reduces buyer risk. Less capital is paid upfront, protecting value if post-close revenue declines.

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A well-structured Earn Out becomes a bridge of accountability linking historical validation with future performance. This Earn Out should stabilize the revenue base through the transition.

Designing the Earn Out to Safeguard Revenue

1. Decrease the Initial Payment

   Reduce upfront consideration in proportion to relational risk.

2. Increase the Earn Out Component

   Shift more value to the earn out period to align incentives and protect the buyer.

3. Define Clear Performance Metrics

   Tie payments to maintaining revenue and gross margin during the first 12 months post-close.

4. Include Buyer Obligations

   Commit to preserving customer relationships, key personnel, and pricing stability.

5. Ensure Transparency and Accountability

   Require timely reporting, certification, and a dispute-resolution process.

6. Keep the Seller Involved

   Maintain the founder as an advisor or consultant to ensure customer continuity.

The Buyer’s Responsibility: Grow the Asset Purchased

An earn out isn’t a hedge; it’s a continuity mechanism to smooth revenues through the transition. Once control transfers, the buyer’s responsibility is to grow the acquired asset. By the end of the earn out period, the business should evolve from founder-dependent to management-driven, with stronger systems, broader relationships, and sustainable earnings.

Conclusion: The Earn Out as a Strategic Tool

For Independent Sponsors and PE buyers, understanding how personal relationships drive revenue is essential. When those relationships underpin enterprise value, they must be protected. A well-crafted Earn Out aligns incentives, sustains performance through transition, and ensures both sides share in the risk and reward of continued success.

At True North CFO, we focus not only on the “historical / compliance” based Quality of Earnings, but on the entire transaction lifecycle and what happens after the close. We welcome the opportunity to discuss what makes us different from your traditional CPA-based QofE process.