Earnout

Sometimes buyers and sellers can’t agree on the value of a target company during mergers and acquisitions (M&A). It mostly happens when they have different views about the firm’s future performance, growth potential, and risk, especially when assumptions in a Discounted Cash Flow (DCF) model or around EBITDA projections differ significantly. The seller may believe the company is on the verge of a massive breakthrough and aim to maximize their exit value. But the acquirer may be skeptical about projections and the implied Enterprise Value, and hence aim to protect their investment from overpayment.

To bridge that valuation gap and close the deal, the parties may use an earnout agreement which ties part of the payment to future performance. Read on to learn more about an earnout in M&A including the definition, characteristics, risks, use cases, and common interview questions.
 

What Is an Earnout?

An earnout, also called earn-out or contingent consideration, is a pricing structure in M&A where a portion of the purchase price is delayed and depends on the company's actual performance post-acquisition. The acquirer pays a certain percentage upfront, often based on an agreed Enterprise Value. Then the seller ‘earns’ the rest of the purchase price if the company achieves specific targets within a set timeframe post-closing.

The targets a company should meet during the earnout period are usually based on financial metrics such as revenue, EBITDA, net income, or Free Cash Flow. Non-financial milestones may include the successful launch of a new product or the retention of key clients.

Once the specified conditions are satisfied, the buyer is responsible for paying the earnout. However, earnouts are treated as contingent liabilities on the buyer's balance sheet and must be measured at fair value based on their Present Value, rather than being classified as traditional debt.

Key Characteristics of Earnouts

Earnout structures have different characteristics compared to other deal types. Below is an overview of the key features of earnouts and their comparison to fixed-price deals.

Deferred Payments Linked to Performance

One of the major characteristics of an earnout is the deferred payment tied to achieving certain targets post-closing. That’s different from fixed-price deals where full payment is guaranteed and occurs at closing.

Performance Risk Shifts to Sellers

By paying full price upfront, buyers assume all post-acquisition performance risk in fixed-price deals. The sellers may exit immediately without future financial exposure. But earnouts shift this risk partially back to sellers, who often leave behind some key people to help deliver on targets during the earnout period to receive full consideration.

Complex Contracts and Operational Restrictions

Another feature is the use of comprehensive earnout agreements with clearly defined performance metrics. The agreements also include detailed operational covenants specifying how buyers must manage acquired businesses during earnout periods. 

For instance, the provisions might restrict capital expenditures, prohibit headcount reductions, or require maintaining business practices. Such agreements, restrictions, and metrics are absent in fixed-price deals where buyers gain complete operational freedom immediately.

Accounting Complexity and Financial Volatility

Besides, earnouts introduce accounting complexities that fixed-price deals do not. Acquirers must estimate the fair value of the contingent consideration at closing, record it on the balance sheet, and reassess it periodically. Changes in expected performance can lead to gains or losses on the income statement. Such accounting treatment adds efforts and volatility that are absent in simple cash transactions.

Benefits & Risks for Companies and Buyers

The unique characteristics of ​earnout structures result in several benefits and risks for both buyers and sellers. Some overlap while others are specific to each party.

Earnout Pros and Cons for Buyers

Here’s an overview of the pros of earnouts to buyers:

• Risk Mitigation and Capital Preservation: Acquirers only pay the full price if the agreed upon metrics actually materialize during the earnout period.
• Management Retention and Performance Incentives: The earnout payment structure acts as a retention tool, keeping the original founders motivated to hit targets during the transition.
• Financing Flexibility: Deferred payments can act as a form of seller financing.

The earnout risks for buyers include: 

• Misaligned Incentives: Sellers may boost short-term revenue at the expense of long-term profitability to trigger payments, such as cutting marketing costs or slashing prices.
• Costly Litigation: Disputes over earnout calculations, target achievement, and disagreements about whether buyer actions suppressed performance can lead to lawsuits.
• Complex Operations: If the seller is retained to achieve targets, they can make operations harder by resisting restructuring and challenging daily management decisions.

Earnout Pros and Cons for Sellers

Below are some of the benefits of earnouts for sellers:

• Share in Upside Potential: The seller gets the opportunity to receive a higher total price if the business performs as expected or outperforms targets.
• Deal Closing: Earnouts can facilitate the completion of a deal that might otherwise fall through due to disagreements on price.
• Retaining Influence or Control: Sellers often stay on post-closing to ensure the company is managed in a way that helps hit the targets for the earnout payment.
• Access to Buyer Resources: Being part of a larger, well-resourced company can make hitting targets easier and more likely.

Here are some of the earnout risks for sellers:

• Operational Control Issues: Sellers may not have control over the operations required to hit those critical milestones. If the buyer makes poor strategic decisions, the seller might miss their payout through no fault of their own.
• Misaligned Incentives: The acquirer might prioritize long-term growth at the expense of short-term profitability or might not invest in the business, both of which can kill an earnout
• Delayed Exit: Earnouts usually require ongoing involvement or cooperation from the seller for 1-3 years which prevents a clean, immediate exit.
• Increased Risk allocation: Earnouts somewhat shifts performance pressure or burden of proof regarding future growth back onto the seller. They risk not getting paid the earnout amount if the business underperforms.

Typical Use Cases of Earnouts

Earnouts are more common in private-target acquisitions than public companies. That’s because public companies already have a lot of financial disclosure out there as part of compliance. Thus, it would be difficult for them to misrepresent or manipulate the firm’s financials.

These deals are also heavily used in industries or transactions where future performance is difficult to predict and valuation gaps are wide. For instance, technology and software companies frequently use earnouts because revenue growth depends on product development milestones or customer adoption, which is difficult to verify at closing.

Earnouts are also common in industries with significant intangible assets, such as technology, healthcare, professional services firms, and media. In these sectors, value often depends on innovation, intellectual property, or key personnel. The founder’s personal relationships or expertise might be critical to the company’s continued success. 

Other use cases of earnouts include early-stage companies with limited financial history but strong potential and periods of economic volatility where market multiples are fluctuating rapidly.

Common Interview Questions about Earnouts

If you’re seeking a career in the finance industry, whether it’s in investment banking or private equity, you may encounter interview questions about earnouts. Here are some of the common questions about earnouts during finance interviews.

Why might a seller prefer an earnout over a lower, all-cash offer? 

A seller might choose an earnout if they believe the buyer is drastically undervaluing their company’s near-term growth potential. It provides a mechanism to capture the extra value that an all-cash offer would simply leave on the table. If the seller is staying on to manage the company, they have the agency to ensure those targets are actually reached.

Walk me through the accounting treatment for earnouts.

Earnouts are recorded on the buyer’s balance sheet as contingent consideration liability at fair value on acquisition date. Buyers estimate probability-weighted earnout payments and record as liability with corresponding increase to goodwill. Each period, buyers reassess fair value based on updated assumptions. Changes in fair value are recognized in the income statement, not as goodwill adjustments. When payments are made, liability is reduced.

What are the main conflicts that arise during an earnout period and how can they be avoided? 

Conflicts often center on accounting games or operational interference that might artificially depress the earnout metrics. For instance, a buyer might front-load expenses or delay revenue recognition to avoid hitting a payout threshold. On the other hand, sellers might focus solely on short-term targets at the expense of the company’s long-term health.

The parties can minimize potential disputes by using clear performance metrics, well-drafted contracts, and thoughtful integration planning.

Key Takeaways 

If buyers and sellers can't agree on the current value of a target, earnouts help to bridge the valuation gap by making a portion of the payment contingent on actual results. The earnout structure splits the purchase price into an upfront payment at closing and contingent payments over a defined period, typically one to five years. This allows buyers to pay lower initial prices while giving sellers opportunities to capture additional value if performance meets expectations.

But earnouts also carry risks for both buyers and sellers, with the most common ones being disputes over calculations, integration difficulties if alignment deteriorates, and complexity in managing operations with contractual restrictions.