Mergers and acquisitions (M&A) are complex and multifaceted processes often riddled with valuation disputes, negotiation stalemates, and high-risk scenarios. In the world of M&A, breaking deadlocks and mitigating risk is key to successfully closing transactions. One particularly effective negotiation tool is the earnout—a structured mechanism designed to align the interests of buyers and sellers, bridge valuation gaps, and address concerns around the uncertain future performance of a target company.
In this article, we’ll explore the core framework of earnouts, when and how to use them most effectively, and the risks and benefits for both buyers and sellers. Whether you’re an M&A veteran or a newcomer to the practice, earnouts represent a crucial tool for resolving challenges that often arise in deal negotiations.
What Are Earnouts?
An earnout is a contractual agreement in which part of the purchase price for a company is contingent on the acquired company meeting certain predefined performance metrics post-acquisition. Unlike an upfront, lump-sum payment, earnouts delay a portion of the payout until specific financial or operational milestones are achieved, such as revenue growth, EBITDA, or customer acquisition targets.
Benefits of Earnouts
Earnouts offer distinct advantages to both buyers and sellers:
For Buyers:
- Manage Risk: Earnouts shift part of the risk for post-acquisition underperformance to the seller.
- Mitigate Upfront Costs: Buyers reduce the immediate capital outlay, which can help bridge funding gaps.
- Align Incentives: Earnouts encourage sellers or existing management to remain engaged and incentivized to deliver on agreed performance goals.
- Test True Value: Buyers gain clarity on whether their valuation assumptions align with the company’s actual results.
For Sellers:
- Maximize Price Potential: Sellers gain the opportunity to realize a higher total purchase price, provided the business performs well.
- Profit from Confidence: Sellers can build in their optimism about future results. For instance, if their valuation includes high growth projections, earnouts allow sellers to prove their estimates without immediate buyer skepticism hindering the deal.
Challenges and Risks of Earnouts
Despite their benefits, earnout arrangements are not without downsides.
- Risk of Disputes:
Earnouts often lead to litigation between buyers and sellers. Disagreements may arise over how the company is managed after acquisition, with sellers accusing buyers of not acting in “good faith” to help achieve earnout milestones. - Complex Negotiations:
Structuring earnouts requires careful attention to terms, potential risks, and mitigation strategies. Legal ambiguity or misaligned target metrics can lead to misunderstandings. - Buyer Control Post-Acquisition:
As buyers retain operational control, sellers may feel the company is being run in a way that diminishes their chances of receiving contingent payments. To address this, carefully structured earnouts with clear governance agreements are essential.
When Should Earnouts Be Used?
Earnouts are particularly useful in situations where disagreements over valuation stem from uncertainty about the company’s future performance. Such scenarios include:
- Limited Operating Track Record:
Startups or firms with minimal financial history may present higher risk due to a lack of proven performance. - Recent Restructuring:
Companies that have undergone major strategic pivots or operational changes may have unreliable projections, making a traditional valuation difficult. - High Concentration Risks:
Firms with heavy reliance on a few key customers or suppliers may carry “key-man” or revenue concentration risks. - Innovative Products or Markets:
In industries like technology or pharmaceuticals, where success hinges on the development of new products or market expansion, short-term revenues may be insufficient to justify the seller’s valuation.
How to Structure an Effective Earnout
Earnouts can take many forms, but there are seven key elements to designing a balanced and effective earnout agreement:
1. Total Purchase Price
The total price agreed upon should include both the upfront payment and potential earnout payments. Buyers often frame the total price to meet the seller’s valuation expectations while retaining flexibility through contingent structures.
2. Upfront Payment
From the buyer’s perspective, the upfront payment represents their capital at risk. For higher-risk acquisitions, buyers may prefer to keep upfront payments low in proportion to the total purchase price.
3. Contingent Payment
The contingent payment is the balance of the total purchase price, contingent on the target company meeting agreed milestones. Structuring this payment as milestone-based ensures the buyer only pays for value actually delivered over time.
4. Earnout Period
The earnout period typically ranges from one to five years, with three years being the average. The period should give sellers sufficient time to meet milestones while avoiding excessive “drag” on resources or operational focus.
5. Performance Metrics
The metrics used to determine payouts should be clearly defined and measurable. Common metrics include:
- Financial: Revenue or EBITDA.
- Operational: Product development milestones, geographic expansion, or other tangible business goals.
For example, a tech company may tie earnouts to the production and launch of a specific product. Meanwhile, a more established business may tie earnouts to year-over-year revenue growth or EBITDA improvements.
6. Measurement & Payment Frequency
Earnouts can operate as either:
- Single-Measurement: Offering one payout at the end of the earnout period.
- Multiple-Measurement: Staggered payouts based on periodic reviews (e.g., annual performance targets).
While sellers typically prefer staggered payments for risk reduction, buyers often favor single-measurement earnouts to minimize administrative complexity.
7. Payment Formula
The earnout payout formula is typically structured around thresholds:
- Minimum Thresholds: A baseline level of performance required to trigger any payment.
- Maximum Thresholds: A cap on the contingent payment, ensuring the buyer doesn’t overpay if the target’s performance greatly exceeds expectations.
Payments between thresholds are often calculated using linear or exponential interpolation.
Case Study: Structuring an Earnout Scenario
Scenario:
- Buyer: Firm A seeks to acquire Firm B, a small startup specializing in a unique product.
- Valuation Gap:
- Buyer valuation: $4 million.
- Seller expectation: $16 million.
Solution:
Firm A agrees to an uptick earnout structure, offering $4 million upfront (aligned with its internal valuation) and an additional $12 million contingent on Firm B achieving a three-year EBITDA CAGR of 68%. If the CAGR falls below 19.7%, no contingent payment is made.
This structure closes the deal and mitigates the buyer’s risk while allowing the seller to achieve its valuation.
Earnouts as Risk Mitigation Tools
Earnouts also protect buyers in cases of uncertainty, such as economic downturns or operational risks. By tying a portion of the deal to performance, buyers reduce the downside risk of overpaying.
For example:
- Scenario 1: Buyer A pays $16 million upfront with no earnout.
- Scenario 2: Buyer B uses the earnout structure outlined above.
If the company significantly underperforms, Buyer A’s investment is at greater risk, while Buyer B delivers a healthier IRR due to reduced capital at risk.
Final Thoughts
The success of M&A transactions often hinges on creative structuring to overcome barriers like valuation gaps and performance concerns. Earnouts are one of the most valuable tools available to bridge these gaps, align buyer and seller expectations, and mitigate risk.
While earnouts require careful planning, clear metric definitions, and strong governance provisions, they empower both sides to achieve aligned outcomes and address key uncertainties. Aspiring and experienced M&A practitioners alike will find earnouts an essential addition to their negotiation toolkit. By balancing incentives, risk, and flexibility, earnouts help unlock transaction opportunities that might otherwise seem unattainable.