Earnout
An earnout is a contingent payment mechanism in M&A transactions whereby the seller receives additional consideration after closing if the acquired business achieves specified financial or operational milestones over a defined post-closing period.
Earnouts are deal-structuring tools used when a buyer and seller disagree on the value of the target business — particularly when the seller believes the business has strong growth prospects that the buyer is not willing to pay for upfront. By deferring a portion of the purchase price and tying it to future performance, earnouts bridge valuation gaps and allow deals to close that might otherwise stall.
Typical earnout metrics include revenue targets, EBITDA thresholds, product approval milestones (common in pharmaceutical acquisitions), or customer retention benchmarks. The earnout period often ranges from one to three years post-closing, and the contingent payment can be structured as a fixed amount, a sliding scale, or a percentage of performance above a threshold.
Earnouts introduce significant post-closing complexity. The seller, who often remains involved in the business during the earnout period, has strong incentives to maximize the earnout metric — which may conflict with the buyer's broader strategic goals. A buyer may want to integrate operations, reallocate resources, or change the business model in ways that depress the earnout metric, leading to disputes. Delaware courts have frequently adjudicated earnout disputes, generally holding that buyers must act in good faith and not deliberately undermine earnout achievement.
From an accounting perspective, under ASC 805 (Business Combinations), contingent earnout obligations are measured at fair value on the acquisition date and re-measured at each reporting period with changes flowing through the income statement. This can create earnings volatility unrelated to operating performance.
For sellers, key negotiating points include the precision of metric definitions, what accounting policies govern measurement, what post-closing conduct restrictions apply to the buyer, and whether there are acceleration provisions if the business is sold again before the earnout period expires. Poorly drafted earnout clauses are a frequent source of post-closing litigation.