Earnout

Full Definition

An earnout is a contractual provision in an M&A agreement that makes a portion of the total purchase price contingent on the acquired company achieving defined performance milestones after closing. Earnouts bridge the valuation gap between buyer and seller: when the buyer believes the target's future performance will be materially lower than the seller's expectations, an earnout allows both parties to proceed with a deal by making part of the price contingent on future performance. If the business performs as the seller expects, the seller ultimately receives their expected total price. If the business underperforms, the buyer pays less—effectively transferring performance risk to the seller. Earnout structures define four critical parameters: the performance metric (revenue, EBITDA, gross margin, or a specific business milestone like achieving FDA approval or signing a defined number of customers); the measurement period (1-3 years post-closing); the payment schedule (single payment at period end, or milestone-triggered payments over the period); and the payment formula (typically a tiered structure that pays different amounts for different performance levels—no payment below threshold, specific payment amounts at target, maximum payment above ceiling). Earnout metrics should be specifically tied to the value drivers that justified the seller's valuation—if the seller is being paid for projected revenue growth, the earnout should measure that revenue specifically, not a broader business metric that the buyer can influence through integration decisions. Earnout disputes are disproportionately common in M&A litigation because post-closing integration decisions made by the buyer can directly affect whether earnout metrics are achieved. If the buyer reduces marketing investment, changes the go-to-market strategy, integrates the acquired product into a bundle, or redirects the acquired sales team to cross-sell other products, the acquired business may miss earnout metrics through buyer decisions rather than underperformance. Well-drafted earnout provisions include protective covenants requiring the buyer to operate the acquired business consistently with pre-closing practices, maintain sufficient resources to achieve earnout targets, and avoid actions that would adversely affect earnout achievement. These protections reduce the risk of buyers managing the business in ways that benefit the overall acquirer at the expense of earnout achievement.

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