An earnout is a contingent payment mechanism in M&A where a portion of the purchase price is paid after closing, contingent on the acquired company achieving specified performance targets. Earnouts bridge valuation gaps but are a frequent source of post-closing disputes.
What Is an Earnout?
An earnout entitles the seller to receive additional consideration after closing if the acquired business achieves specified performance milestones. Used when buyer and seller disagree on valuation.
When Earnouts Are Used
- Business has high growth potential but limited historical performance
- Seller's projections are significantly higher than buyer's
- Business is in a volatile or uncertain market
- Seller's continued involvement is important to performance
Earnout Structure Components
Performance Metric options: Revenue (simple but gameable), EBITDA (subject to buyer manipulation), Gross profit (middle ground), Milestone-based (specific events)
Measurement Period: Typically 1–3 years post-closing
Payment Structure: Binary (all or nothing), Linear (scales with performance), Tiered (different levels at different thresholds)
Negotiating Earnout Protections for Sellers
- Operational autonomy — buyer cannot make material changes without seller consent
- Resource commitments — buyer must maintain agreed investment levels
- Accounting consistency — buyer must use consistent accounting methods
- Acceleration provisions — earnout accelerates if buyer sells the business
- Dispute resolution — independent accountant arbitration mechanism
Common Earnout Disputes
- Buyer changing accounting methods post-closing
- Buyer reducing investment in the acquired business
- Buyer integrating the business in ways that make measurement impossible
- Disagreements over revenue recognition timing
Key Takeaways
- Earnouts bridge valuation gaps but are a frequent source of post-closing disputes.
- Revenue is the most common metric but is gameable; gross profit is often a better choice.
- Negotiate operational autonomy, resource commitments, and accounting consistency protections.
- Include acceleration provisions if the buyer sells or materially changes the business.
- Specify an independent arbitration mechanism for earnout disputes.
Filed under M&A, Partnering & Due Diligence. Working session: Calendly.
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