Earnout
Earnout An earnout is a contractual provision in an M&A transaction where a portion of the purchase price is contingent upon the acquired business achieving specified performance targets after closing.
Earnouts bridge valuation gaps between buyers and sellers by tying part of the payment to future performance, reducing buyer risk while giving sellers the opportunity to capture additional value.
| Also Called | Earn-Out, Contingent Consideration, Performance-Based Payment, Contingent Purchase Price |
| Category | Deal Structure |
| When Used | Negotiation / Post-Close |
| Related |
How Earnout Works
The core purpose of an earnout is to align buyer and seller expectations when they disagree on the business's value. If a seller believes their company will achieve strong growth and a buyer is skeptical, an earnout lets both parties put their money where their mouth is. The seller receives less upfront but has the opportunity to earn more if performance materializes; the buyer pays the full price only if the business delivers.
Earnouts are measured against specific metrics defined in the purchase agreement. The most common metrics are revenue and EBITDA, though milestone-based earnouts tied to product launches, regulatory approvals, or customer retention are also used. The measurement period typically runs 1-3 years, with payments made annually or upon final calculation at the end of the period.
The challenge with earnouts is that post-closing, the buyer controls the business. This creates inherent tension: the buyer operates the company day-to-day while the seller watches from the sidelines, hoping the earnout targets are met. This is why earnout provisions often include operating covenants, separate accounting requirements, and "no manipulation" clauses to protect the seller's interests.
In lower middle market deals, earnouts typically represent 15-30% of total purchase consideration, though they can reach 50% or more for businesses with significant uncertainty or seller-dependent revenue. Smaller deals often have proportionally larger earnout components as buyers seek additional protection.
Key Points
- •Revenue and EBITDA are the most common earnout metrics; milestones are used for early-stage or R&D-intensive businesses
- •Typical earnout periods run 18-36 months in lower middle market transactions
- •Earnouts represent 15-30% of purchase price in typical deals, higher for riskier businesses
- •Requires clear definitions of metrics, calculation methodology, and adjustment provisions
- •"No manipulation" covenants protect sellers from buyer actions that reduce earnout payments
- •Contingent consideration must be recorded at fair value under ASC 805 and remeasured each reporting period
Calculation
Earnout Payment = (Achieved Metric - Threshold) × Earnout Multiple
Where:
- Achieved Metric = Actual performance (revenue, EBITDA, etc.) during the earnout period
- Threshold = Minimum performance level before earnout payments begin
- Earnout Multiple = Multiplier applied to excess performance (e.g., 1x revenue, 5x EBITDA)
Worked Example
A software company is acquired with a $10M upfront payment and an EBITDA-based earnout over 2 years.
| Upfront Payment | $10,000,000 |
| Earnout Structure | Up to $5,000,000 |
| Year 1 EBITDA Achieved | $2,800,000 |
| Year 1 Earnout | $4,000,000 |
| Year 2 EBITDA Achieved | $2,200,000 |
| Year 2 Earnout | $1,000,000 |
| Total Purchase Price | $15,000,000 |
The seller achieved the maximum earnout by exceeding the EBITDA threshold in both years, earning the full $15M total consideration.
How This Applies in Lower Middle Market M&A
Earnouts are often pitched as a win-win, but in practice they're the most litigated component of M&A transactions. The fundamental problem is structural: the party who controls the outcome (the buyer) isn't the party whose money is at stake (the seller). Every operational decision—pricing, investment, resource allocation—can impact earnout metrics.
We advise sellers to treat earnouts as a discount to the purchase price when evaluating offers, not as guaranteed upside. If a buyer offers $12M with a $3M earnout versus another buyer at $13M all cash, the $13M offer is almost always better. Earnouts fail to pay out more often than sellers expect.
When earnouts are unavoidable, the negotiation focus should shift to protection mechanisms: specific metric definitions, GAAP-consistent accounting requirements, operating covenants that preserve the business's ability to achieve targets, acceleration clauses if the buyer sells or materially changes the business, and clear dispute resolution procedures.
Common Scenarios We See:
- •Buyer dramatically increases overhead allocations to the acquired business, depressing EBITDA earnout
- •Revenue earnout becomes unachievable after buyer raises prices or changes go-to-market strategy
- •Key customers not retained because buyer integrates too aggressively
- •Milestone earnout disputed because buyer interprets achievement criteria differently than seller expected
- •Buyer sells business before earnout period ends without acceleration provisions
What Sellers Should Know:
Get the definition of your earnout metric in the LOI, not the definitive agreement. Once you've signed the LOI with price terms, you've lost negotiating leverage on earnout mechanics. The specific calculation methodology, excluded items, and adjustment provisions are where earnouts succeed or fail.
Frequently Asked Questions
Related M&A Concepts
Purchase Price Allocation
Accounting process of assigning acquisition cost to individual assets and liabilities
Learn moreWorking Capital Adjustment
Post-closing true-up based on actual vs. target working capital at close
Learn moreSeller Note
Deferred payment from buyer to seller, typically with fixed terms and interest
Learn moreLetter of Intent (LOI)
Non-binding document outlining key deal terms before definitive agreement
Learn moreEscrow
Funds held by third party to secure buyer indemnification claims
Learn moreIndemnification
Contractual protection for losses arising from breaches or specified matters
Learn moreReady to Move Forward?
Earnouts can bridge a valuation gap or become a post-close nightmare. Let's structure your deal to protect your interests and maximize the probability of collecting what you've earned.