What Is an Earnout?
An earnout is contingent consideration in an M&A deal: the buyer pays a portion of the purchase price upfront and agrees to pay more later only if the business achieves specified performance targets after closing. Targets are usually financial, such as revenue, gross profit, or EBITDA thresholds measured over one to three years, though they can also be milestones like regulatory approval or key customer renewals.
Earnouts are most common in private company deals, especially for founder-owned businesses, biotech and pharma assets awaiting clinical results, and situations where recent performance is volatile or unproven.
How an Earnout Works: A Numeric Example
Suppose a seller believes their software company is worth 150 million dollars based on aggressive growth projections, while the buyer is only comfortable paying 120 million dollars on current numbers. The parties might agree to 120 million dollars at closing plus an earnout of up to 30 million dollars, payable if the company's revenue exceeds 50 million dollars in each of the next two years.
If the targets are hit, the seller receives the full 150 million dollars they wanted; if growth falls short, the buyer only paid for what actually materialized. Payouts can be all-or-nothing, tiered, or a sliding percentage of results above a floor.
Why Buyers and Sellers Agree to Earnouts
The core purpose is bridging a valuation gap rooted in different beliefs about the future, effectively making the seller put their money where their projections are. Earnouts also shift risk to the party best positioned to influence outcomes, which is why they pair naturally with founders who stay on to run the business post-close.
For buyers, an earnout reduces upfront cash needs and functions as retention glue for key sellers. In interviews and on the job, earnouts come up when discussing how to structure consideration in private deals and how contingent payments are recorded as a liability at fair value under purchase accounting.
Risks, Disputes, and Drafting Pitfalls
Earnouts are notorious sources of post-closing litigation because the buyer controls the business during the measurement period. A buyer could, intentionally or not, depress the earnout metric by cutting marketing spend, reallocating costs, or folding the target into a larger division where its results become untraceable.
Well-drafted agreements therefore define the metric precisely, specify accounting policies, require the business to be run consistently with past practice, and sometimes include covenants obligating the buyer to support the earnout in good faith. Sellers generally prefer revenue-based targets, which are harder to manipulate than EBITDA, and shorter measurement periods.
