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Earnouts, Escrows, and the Money You Might Never See

Author: Yanni Papoutsi - Fractional VP of Finance and Strategy for early-stage startups - Author, Exit Ready Published: 2026-03-13 - Last updated: 2026-03-13

Reading time: ~11 min

The 30-44% Gap: Headline vs. Net Proceeds

A CEO tells her board they have received a $100M acquisition offer. The board celebrates. The cap table calculates their equity value. Venture investors model their IRR. Everyone is excited. Then the deal closes, and the bank account receives $56M on day one. Where did the other $44M go?

Escrow: $10M (held for 18 months).

Earnout: $18M (contingent on hitting post-close targets).

Working capital adjustment: -$5M (the buyer claims working capital was higher than agreed, so they reduce the purchase price).

Debt repayment: $7M (seller note or other third-party claims).

Transaction fees: $2.5M (lawyers, bankers, accountants, tax provisions).

Net proceeds at close: $56M. Headline valuation: $100M. Gap: 44%.

This is not an outlier. I have seen this structure repeatedly across software, SaaS, and marketplace exits. The gap between headline and actual proceeds is systematic, not accidental. Buyers use escrow, earnout, and working capital provisions to mitigate risk and reduce their cash outlay at close. Sellers accept these structures because the alternative is a lower headline price or a longer negotiation. The math always looks reasonable in negotiation—the escrow is only for "legitimate reps breaches," the earnout targets are "achievable," and working capital adjustments are "neutral."

In practice, all three components reduce founder liquidity below expectations.

Escrow: The Holdback for Reps and Warranties

Escrow is a pool of money held by a third-party escrow agent to secure the buyer's remedies against breaches of reps and warranties. Reps and warranties are the seller's guarantees about the business: revenue is accurate, no undisclosed liabilities exist, intellectual property is owned, contracts are valid, employees are properly classified, and so on.

Standard escrow is 10% of the purchase price, held for 12-18 months. Some deals use 5% for strategic buyers with pre-existing knowledge of the business. Some use 15% for asset sales or highly regulated businesses. The escrow is held in a segregated account and released to sellers only if no material claims are filed during the holdback period.

Here is the problem: almost every deal has some post-close claim filed against escrow. A sales contract the seller thought was binding turns out to have a non-renewal clause the buyer only discovered post-close. An employee that was supposed to stay leaves within 30 days of close. A customer who was represented as "not at risk of churn" cancels. Are these legitimate breaches? That depends on how precisely the reps are worded and how aggressively the buyer's legal team pursues claims.

I worked with a founder whose $50M acquisition had a $5M escrow (10%). At month 9 post-close, the buyer filed a $1.2M claim against escrow alleging the company had misrepresented customer contract terms. The dispute took 6 months to resolve. The seller's legal costs exceeded $250K. The final settlement was a $400K reduction to the escrow release. The founder received the remaining $4.6M escrow at month 18, but only after legal battles and months of uncertainty.

Mitigation strategies:

- Negotiate escrow as a percentage of the purchase price, not a fixed percentage of post-close EBITDA or other variable metrics. Fixed percentages are more predictable.
- Require escrow to be held in a third-party account (not in the buyer's cash), so the money cannot be used or deployed by the buyer during the holdback period.
- Negotiate tranche releases: 50% escrow release at 12 months (if no material claims), remaining 50% at 18 months. This reduces your lockup period for a portion of the holdback.
- Define "materiality" thresholds for claims. Claims under $100K are not pursued. Claims between $100K-$500K require buyer board approval. This prevents nuisance claims from depleting escrow.
- Carve out certain categories from escrow coverage: customer contracts and financial records are pre-verified by the buyer, so reps breaches in those categories are not escrow-eligible. This limits the buyer's post-close claims surface.

Earnouts: Contingent Payment Structures

An earnout is additional purchase price paid to sellers if post-close operational targets are achieved. A $100M acquisition might be structured as $82M at close + $18M earnout contingent on hitting revenue or EBITDA targets in the following 24 months.

Earnouts are buyer-friendly structures because the buyer defers cash outlay and ties future payments to performance. They are seller-unfavorable because the seller has limited control over post-close operations and the targets may be difficult to achieve. Once the buyer takes ownership, they control the operational decisions that drive revenue and EBITDA. They can reduce spending, eliminate unprofitable product lines, or reallocate resources in ways that make earnout targets harder to hit.

Example: A SaaS company with $10M ARR is acquired. The deal includes a $20M earnout payable if the combined entity reaches $15M ARR by year 1 post-close. The seller founder stays as VP Product. At close, the buyer begins consolidating the seller's product with their existing platform. They discontinue three product lines that represented $2M ARR to the seller's business, saying they overlap with existing offerings. The combined ARR is now only $13M—short of the $15M earnout target. The earnout is not paid because the target was missed.

Was the buyer's decision to discontinue product lines legitimate? Operationally, yes. Contractually, the earnout language says "combined entity reaches $15M ARR," with no carve-out for buyer decisions. The buyer achieved their post-close integration goals, but the earnout target is now unattainable.

Mitigations for earnout risk:

- Earn-in escrow: require the buyer to segregate the entire earnout amount in an escrow account at close. The earnout is only released if targets are hit. This prevents the buyer from misappropriating cash during the earnout period.
- Detailed metric definitions: define exactly how revenue and EBITDA are calculated. What is included? What is excluded? How are product line discontinuations handled? Are integration expenses capitalized or expensed? Specify everything, because ambiguity favors the buyer post-close.
- Performance-based clawbacks: if the buyer intentionally reduces spending or makes operational decisions that materially impact earnout targets, the earnout is paid in full or partially. This requires you to stay involved (board seat) or hire a financial advisor to monitor post-close execution.
- Seller involvement in operations: if you stay in an operational role (CEO, VP Product, VP Sales), you have influence over decisions that affect the earnout. If you are out of the business completely, your leverage is zero. Negotiate operational involvement tied to earnout milestones if possible.

Earnout payments are typically 10-30% of the headline purchase price. Higher earnouts (25-30%) are more common in seller-favorable situations where the seller has strong leverage. Lower earnouts (10-15%) are standard in buyer-favorable situations. Some deals have no earnout—instead, they use lower cash at close or higher escrow to account for risk.

Working Capital Adjustments: The Hidden Reductions

Purchase price = Enterprise Value – Assumed Net Working Capital.

This is the formula almost every M&A deal uses. Working capital includes current assets (cash, accounts receivable, inventory) minus current liabilities (accounts payable, accrued expenses, deferred revenue). At close, the buyer and seller settle the working capital calculation. If actual working capital is higher than the assumed amount, the seller owes the difference. If actual working capital is lower, the buyer owes the seller the difference.

The problem: the assumed working capital is set during negotiation, months before close. Working capital fluctuates with the business cycle. If the business is seasonal and close occurs during the low season, working capital is typically lower than the annual average. If the buyer then claims working capital was lower than assumed, they deduct the difference from the purchase price.

Example: A software company with $50M ARR agrees to an acquisition at $400M enterprise value, with assumed working capital of $8M (the annual average at the time of negotiation). The deal is structured to close in December. December is a low-seasonality month for the business; customer renewals occur in Q2-Q3. At close, actual working capital is $6M (lower than the assumed $8M). The buyer deducts the $2M difference from the purchase price. Headline purchase price: $400M. Adjusted purchase price after WC: $398M.

If the working capital adjustment is more aggressive, the impact can be material. In a transaction I worked on, the buyer claimed $3.5M negative working capital adjustment on a $60M deal (5.8% reduction). The seller disputed the calculation, but the deal documents gave the buyer's accountants significant discretion in the calculation methodology. After disputes were resolved, the seller accepted a $2M net reduction.

Working capital adjustments can be positive or negative, but they are statistically more likely to be negative (reducing proceeds) because:

- Buyers negotiate conservatively on the assumed working capital level, deliberately setting it above historical norms to have cushion for adjustment claims.
- Close timing can be chosen by the buyer to occur during lower-working-capital periods of the calendar.
- Buyer accounting teams are incentivized to find adjustment claims to offset transaction costs.
- Most sellers lack the leverage or expertise to dispute detailed working capital calculations.

Mitigations:

- Negotiate the assumed working capital to be the trailing 4-quarter average, not a single snapshot. This reduces seasonal distortions.
- Cap the working capital adjustment at a maximum threshold (e.g., +/- $1M). Above that threshold, disputes are resolved through escrow or mediation, not buyer discretion.
- Include detailed definition of what qualifies as working capital. Many disputes arise from disagreements on categorization (is a vendor accrual for integration costs included? Is deferred revenue counted? How is accrued tax liability treated?).
- Hire an independent accounting firm to verify the closing working capital calculation. This provides third-party validation and prevents one-sided disputes.

Debt Repayment, Transaction Fees, and Other Reductions

The purchase price is typically net of seller liabilities. Before distribution to founders, the following are deducted:

- Outstanding debt (bank loans, seller notes, lines of credit): must be repaid at close.
- Accrued tax liabilities: sometimes assumed by buyer, sometimes paid by seller from proceeds.
- Transaction costs: legal, accounting, banker fees, regulatory filings, escrow setup fees. Typically $2-5M for $50M+ transactions.
- Shareholder loans that need to be repaid post-close to be taxed as capital gains rather than ordinary income.
- Severance or retention payments to employees who are not staying post-close (though often built into the buyer's integration plan).

These reductions are often overlooked during negotiations because the focus is on the headline number. But they compound with escrow, earnout, and working capital adjustments to materially reduce the actual cash founders receive.

Modeling Net Proceeds: The Right Framework

When evaluating an acquisition offer, model the net proceeds, not the gross valuation:

Enterprise Value: $100M
Less: Assumed debt: ($7M)
Less: Transaction costs: ($2.5M)
Less: Escrow (10%): ($10M)
Less: Earnout (15%): ($15M)
Less: Working capital adjustment assumption (3% conservative): ($3M)
Net proceeds at close: $62.5M
Plus: Earnout if targets hit (year 2): $15M
Plus: Escrow if no claims (year 2): $10M
Best case total: $87.5M
Worst case total (no earnout, some escrow claims): $52.5M
Expected case (80% earnout realization, 90% escrow release): $70.5M

This framework shows the actual cash outcome, not the announcement number. It reveals the risk profile and helps founders assess whether the deal is genuinely worth more than alternatives (staying independent, fundraising, other buyers).

Negotiating for Higher Cash at Close

If you need liquidity, negotiate for higher cash at close and lower escrow/earnout. This shifts risk from you to the buyer. Buyers will resist because they want to mitigate post-close risk, but stronger founder positions allow for this negotiation.

Trade-offs:

- Lower escrow, higher cash: This works if you have strong reps and warranties and limited post-close liabilities.
- Lower earnout, higher cash: This works if the buyer is confident in the acquisition thesis and doesn't need earnout as a safety valve.
- Higher working capital cap, lower purchase price: This works if you can demonstrate historical working capital patterns and reduce uncertainty.