What is an earnout in M&A deals?

When a private market M&A transaction occurs, it may seem that the buyer and seller of the target company easily agree on the business’s valuation. 

After all, we’ve all seen headlines that read, “Company X acquired by [insert buyer name] for $250M.”

However, settling on a valuation is far from simple. Each party typically has their own interpretation of what the business is worth—sellers may be overly optimistic with their valuation, while buyers want to pay the lowest price. To address this challenge, buyers and sellers often use what’s called an “earnout”— a contractual mechanism that can help bridge the gap between what a buyer is willing to pay for a business and what the seller is willing to sell for.

Understanding the concept of an earnout

In its simplest form, an earnout is a provision in an acquisition agreement that ties a portion of the sale proceeds to the future performance of the acquired business. 

Instead of paying the full purchase price upfront, the buyer agrees to make an initial payment to the seller, followed by additional payments over time based on the company meeting certain pre-determined performance targets—commonly tied to revenue, EBITDA, or profit milestones. 

Earnouts allow the buyer to mitigate the risk of overpaying for a business while enabling the seller to earn future compensation, maximizing the value of their sale—a compromise for both the buyer and seller.

Why are earnouts used?

Earnouts are primarily used to address the gap between the buyer’s and seller’s proposed valuation for the business being transacted. 

Earnouts are particularly common when a business is at a growth stage or relies on unproven products and markets. Specific industries may impact the use of an earnout as well—life sciences, biotechnology, and other research and development (R&D)-heavy industries where progress may be contingent on a clinical trial or regulatory approval can use an earnout structure to tie compensation to the success of those milestones. 

Earnouts have become more common over the years. In a recent 2024 study, they were included in 33% of non-life science deals, a 50+% increase year over year. 

By using an earnout, both parties share the risk involved in a transaction. If the company performs in line with the seller's predictions, the seller reaps the reward. If it underperforms, the buyer avoids overpaying.

Key components of an earnout 

Earnout agreements can involve lengthy negotiations between the buyer and seller, making the final structure of an earnout more of an art than a science. However, a few key components make up most earnout structures. 

Performance Metrics: Any earnout agreement must be anchored by certain performance metrics or key milestones. 

Roughly two-thirds of earnouts are based on the company reaching certain revenue targets, while 23% are based on EBITDA targets. Business sellers generally prefer to use revenue targets to invest resources into growing top-line revenue, while business buyers lean toward EBITDA targets, prioritizing efficiency and profitability. 

Other key milestones that earnouts may be based on can include unit sales, product launches, divestiture of assets, customer acquisition rates, or certain regulatory approvals. 

Payment Structure: Earnout agreements can spread payments over a set number of months or years after the initial acquisition, commonly between 1-3 years. As for the amount of the earnout, most deals tie earnout payments to a range of 10-30% of the total business purchase price.

Payments to the seller might be made annually or triggered once certain milestones are met—which can either be a single payout or a tiered payout structure. Importantly, the agreement should outline how these metrics are measured, verified, and reported, particularly as the conditions are increasingly complex.

Performance tracking and accounting: Clear, transparent reporting is critical to avoid disputes. Earnout agreements should specify how performance will be measured—whether through audited financial statements, external third-party verification, or internal metrics approved by both sides as well as the accounting standard being used. 

Sellers often require detailed information rights in the transaction documents to ensure they are able to stay up-to-date on the progress of achieving their earnout targets. 

Advantages and disadvantages of earnouts

Advantages of earnouts:

• Risk mitigation: Earnouts help mitigate buyer risks by tying part of the purchase price to the future performance of the acquired business.
• Alignment of interests: Sellers are incentivized to remain involved and perform well after the acquisition to maximize their earnout payments.
• Incentivizing growth: Sellers are motivated to focus on growth and performance targets, potentially enhancing long-term business value.
• Bridging valuation gaps: Earnouts can resolve disagreements between buyers and sellers on the business’s value by deferring part of the payment.
• Cash flow management: Buyers can spread out their financial obligations, making it easier to manage cash flow during the acquisition.

Disadvantages of earnouts:

• Complex negotiations: Structuring earnouts can be complex and time-consuming, requiring detailed agreements and performance metrics.
• Potential for disputes: Differences in interpretation or manipulation of performance metrics can lead to conflicts between buyers and sellers.
• Uncertain payouts: Sellers face uncertainty about receiving the full payout, especially if market conditions or management decisions affect performance.
• Integration challenges: Earnouts can complicate the post-acquisition integration process, as seller involvement may clash with new management styles or strategies.
• Administrative burden: Monitoring and verifying performance targets over the earnout period adds administrative complexity and cost.

Negotiating and drafting an earnout agreement

A well-structured earnout starts with a clear alignment between the buyer and seller on the performance targets and reporting methods to measure success. Beyond the basic components of an earnout, these agreements should include additional covenants detailing who has decision-making authority over the business and how to resolve disputes. 

Naturally, business sellers want to retain as much control as possible over the decisions to maximize their likelihood of reaching their targets. Sellers typically request that the buyer support the business's endeavors financially to help the business succeed. On the other hand, buyers may seek control over certain business decisions as they are eager to execute their vision.

Including covenants for resolving disputes is also wise—often called an “alternative dispute resolution” (ADR) provision. This might involve an independent auditor, arbitration, or a pre-agreed formula for adjusting targets if market conditions evolve beyond anyone’s control. In rare circumstances, disputes over the scope of this provision have led to litigation between the two parties. However, with proper planning and detailed earnout agreements, you can reduce the chances of serious misalignment. 

What we know about earnouts

Earnouts can be a powerful tool to close the valuation gaps between buyers and sellers, addressing the risk that can arise from information asymmetry in a private market transaction. 

Buyers and sellers can compromise and increase the chances of a successful transaction by tying part of the purchase price to measurable post-close performance metrics. However, both parties should ensure that their expectations of the earnout structure are communicated with each other and detailed in the transaction documents to avoid lengthy or expensive future disputes. You should work with your counsel early on in the process to assist with creating your earnout agreement.

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