Earnouts & Contingent Consideration
Earnouts are often the source of post-close disputes. While they can bridge valuation gaps and align incentives, they must be carefully structured with clear, objective metrics and dispute resolution mechanisms.
Earnouts are performance-based payments made to sellers after closing, contingent on the business achieving specified financial or operational targets. This guide covers how to structure, negotiate, and manage earnouts effectively.
What is an Earnout?
Definition: Contingent consideration paid to the seller based on the acquired business's post-closing performance over a specified period.
Formula:
Total Purchase Price = Base Payment (at close) + Earnout (if targets met)
Example:
$60M paid at close
+ Up to $20M earnout over 2 years if revenue targets met
= $60-80M total consideration
Why Use Earnouts?
Bridge Valuation Gaps
Most Common Reason
Buyer thinks company worth $60M, seller wants $80M. Earnout bridges the $20M gap based on future performance.
Align Incentives
Keep Seller Motivated
Seller stays engaged and drives performance during transition period, ensuring business momentum continues.
Share Risk
Risk Mitigation
Buyer reduces risk of overpaying if business underperforms. Seller gets upside if business exceeds expectations.
Transition Management
Retention Tool
Ensures seller/management stays through critical transition period, often 12-36 months.
Earnout Statistics
Market Data on Earnouts
Earnout Metrics: What to Measure
Revenue-Based Earnouts
Definition: Payment based on achieving revenue targets
Example Structure:
Year 1: $5M if revenue ≥ $70M
Year 2: $5M if revenue ≥ $85M
Year 3: $10M if cumulative revenue ≥ $260M
Pros:
- Objective and easy to measure
- Less susceptible to buyer manipulation
- Clear definition
- Aligns with growth objectives
Cons:
- Seller may prioritize revenue over profitability
- Doesn't account for margin erosion
- Can incentivize unprofitable growth
Best For: High-growth companies, SaaS businesses, situations where growth is primary objective
Typical Metric: Annual revenue, ARR (for SaaS), bookings
EBITDA-Based Earnouts
Definition: Payment based on achieving EBITDA/profitability targets
Example Structure:
Year 1: $3M if EBITDA ≥ $15M
Year 2: $4M if EBITDA ≥ $18M
Total earnout = Actual EBITDA × 2.5x multiple (capped at $10M)
Pros:
- Balances growth and profitability
- Standard M&A metric
- Reflects operational performance
- Common in mature businesses
Cons:
- Highly susceptible to buyer manipulation (expense allocation, accounting policies)
- Complex to define precisely
- Subject to interpretation disputes
- Buyer controls cost structure
Best For: Mature, profitable businesses where maintaining margins is key
Critical: Requires extremely detailed definition of EBITDA calculation and protections against manipulation
Gross Profit / Gross Margin
Definition: Payment based on gross profit or maintaining margins
Example Structure:
Earnout = 20% × Gross Profit over 2 years, capped at $15M
Minimum threshold: 70% gross margin maintained
Pros:
- Less manipulable than EBITDA (fewer expense allocations)
- Focuses on core business performance
- Protects against margin erosion
Cons:
- Still requires clear definition of COGS
- Buyer can influence through pricing
- Less common metric (harder to benchmark)
Best For: Businesses with clear gross margin definition, product companies
Operational/Milestone-Based
Definition: Payment based on achieving specific operational milestones
Example Structure:
$5M if FDA approval obtained by Year 2
$3M if 100 new customers added in Year 1
$2M if key product launched on schedule
Pros:
- Objective, binary outcomes
- Less susceptible to accounting manipulation
- Aligns with specific strategic goals
- Works for early-stage companies
Cons:
- May not reflect financial value
- Can be impacted by buyer actions
- All-or-nothing outcomes
Best For: Biotech/pharma (regulatory milestones), technology (product launches), early-stage companies
Earnout Structure Components
1. Performance Period
| Period | Typical Use Case | Considerations |
|---|---|---|
| 1 Year | Short-term uncertainty, specific milestones | Quick resolution, but may not capture full value |
| 2-3 Years | Most common, balances time and value | Longer seller involvement, reasonable forecast period |
| 4-5 Years | Long development cycles (pharma, large projects) | Hard to forecast, seller tied up for long period |
2. Payment Structure
Binary (All-or-Nothing):
Hit $20M EBITDA target → Earn $10M
Miss target → Earn $0
- Simple, clear
- High risk for seller
- Creates "cliff" effects
Sliding Scale (Linear):
Revenue Scale:
< $60M: $0
$60-80M: $500K per $1M of revenue above $60M
> $80M: $10M (cap)
- More nuanced, fair
- Rewards partial achievement
- Reduces gaming behavior
Tiered (Stepped):
EBITDA Tiers:
$12-14M: $5M earnout
$14-16M: $7M earnout
$16M+: $10M earnout
- Clear targets
- Motivates reaching tiers
- Can create gaming at tier boundaries
3. Threshold, Target, and Cap
Threshold (Floor)
Minimum performance needed for any earnout payment
Target
Expected performance level for full earnout
Cap (Ceiling)
Maximum earnout payment regardless of performance
Buyer Protections & Controls
Earn out Calculation Methodology
Critical: The earnout calculation methodology is the most disputed aspect. Define it with extreme precision.
Key Elements to Define:
- Accounting Standards: GAAP, IFRS, or seller's historical practices?
- Expense Allocations: Which corporate overhead is allocated? How much?
- Revenue Recognition: When is revenue recognized? What about deferred revenue?
- Extraordinary Items: How are one-time gains/losses treated?
- Capital Expenditures: Who decides on capex? Are they excluded from EBITDA?
- Working Capital: How are AR/AP changes handled?
Example Clause:
"EBITDA shall be calculated consistent with seller's historical accounting practices,
except that: (i) corporate overhead allocation shall not exceed $500K annually;
(ii) extraordinary items over $100K shall be excluded; (iii) calculation shall be
subject to independent audit by [Accounting Firm]"
Operational Control During Earnout
Key Considerations:
Buyer Wants: Full control to optimize integrated business
Seller Wants: Sufficient autonomy to achieve earnout targets
Typical Compromise:
- Buyer has full operational control
- Buyer agrees to operate business consistent with past practices
- Buyer cannot take actions specifically designed to reduce earnout
- Seller input on major strategic decisions affecting earnout
- Covenant not to take certain actions without seller consent
Example Protections for Seller:
Buyer shall not, without seller's consent:
- Change pricing below prior year levels
- Reduce sales/marketing spend below $X
- Terminate key employees
- Merge acquired business with another division (for EBITDA earnouts)
- Change accounting policies that reduce earnout metrics
Seller Protections
📋 Detailed Definitions
Define earnout metrics with extreme precision. Reference specific accounting treatments. Leave no ambiguity.
🤝 Independent Audit
Require independent accounting firm to calculate earnout. Specify who pays (often split or loser pays).
🛡️ Negative Covenants
Restrict buyer from taking actions specifically to reduce earnout (e.g., can't slash marketing budget).
⚡ Acceleration Triggers
Earnout becomes due immediately if buyer sells business, merges, or takes other actions that prevent earnout achievement.
📊 Regular Reporting
Require buyer to provide monthly/quarterly financial reports showing progress toward earnout targets.
⚖️ Dispute Resolution
Clear mechanism for resolving earnout disputes (arbitration, expert determination, specific accounting firm).
Common Earnout Pitfalls
❌ Vague Metric Definitions
Problem: "EBITDA as reasonably determined by buyer"
Result: Disputes over what counts as EBITDA, how expenses are allocated, etc.
Fix: 10-page exhibit defining exactly how to calculate EBITDA, including treatment of every material expense category
❌ Buyer Complete Control Over Results
Problem: Buyer controls all decisions that affect earnout, with no seller protections
Result: Buyer makes decisions that harm earnout (cut marketing, slash prices, reallocate expenses)
Fix: Covenant requiring buyer to operate business consistently with past practices and restricting actions that impair earnout
❌ No Dispute Resolution Mechanism
Problem: Parties disagree on earnout calculation, no process to resolve
Result: Expensive litigation, relationship destroyed
Fix: Independent expert determination or arbitration by specified accounting firm, with specific timeline (30 days notice, 60 days to resolve)
❌ Unrealistic Targets
Problem: Earnout targets based on best-case projections, not realistic
Result: Seller never achieves earnout, feels cheated
Fix: Ensure targets are based on reasonable projections, historical trends, and market conditions. Consider sliding scale rather than all-or-nothing.
Sample Earnout Structures
Example 1: SaaS Revenue Earnout
Base Purchase Price: $50M (paid at close)
Earnout Structure:
Year 1: $5M if ARR ≥ $65M on 12/31/2025
Year 2: $10M if ARR ≥ $80M on 12/31/2026
Total Potential: $50M + $15M earnout = $65M
Definitions:
- ARR = Annual Recurring Revenue from subscriptions
- Calculated using seller's historical methodology
- Includes only committed contracts, not bookings
- New customer ARR and expansion ARR both count
- Does not include one-time fees or professional services
Seller Protections:
- Buyer cannot reduce pricing below prior year without seller consent
- Buyer maintains minimum $5M annual sales & marketing spend
- Seller CEO remains employed and has authority over sales team
- Independent audit by Deloitte within 45 days of year-end
Acceleration:
- If buyer sells the business, earnout immediately due at target amount
- If buyer terminates seller CEO without cause, earnout immediately due
Dispute Resolution:
- Disputes resolved by Deloitte within 30 days
- Each party submits calculation, Deloitte chooses one
- Losing party pays arbitration fees
Example 2: EBITDA Earnout with Sliding Scale
Base Purchase Price: $40M (paid at close)
Earnout Structure:
Cumulative 2-year EBITDA earnout on sliding scale:
$25-30M EBITDA: $0
$30-35M EBITDA: $1M per $1M above $30M (max $5M)
$35-40M EBITDA: Additional $1.5M per $1M above $35M (max $7.5M)
$40M+ EBITDA: Additional $2M per $1M above $40M (capped at $12.5M total)
Maximum Earnout: $12.5M
Total Potential: $52.5M
EBITDA Definition:
[10-page exhibit with precise definition including]:
- Follows seller's historical accounting practices
- Corporate overhead allocation capped at $400K/year
- Excludes acquisition-related expenses
- Excludes extraordinary items > $75K
- Capital lease adjustments specified
- Calculation methodology for intercompany transactions
Seller Protections:
- Business operates as separate division for earnout period
- No integration with other divisions without seller consent
- Overhead allocation limited to actual shared services
- Seller CFO reviews quarterly financials
- Cannot transfer key employees out of division
Acceleration:
- Full earnout due if buyer merges division with another
- Pro-rata earnout due if business sold before earnout period ends
Independent Audit:
- EY to calculate final EBITDA within 60 days of period end
- Parties each provide calculation, EY determines final number
- Decision is binding and final
Example 3: Milestone-Based Earnout (Biotech)
Base Purchase Price: $100M (paid at close)
Milestone Earnout Structure:
Milestone 1: $25M upon FDA approval of Product X (by 12/31/2026)
Milestone 2: $15M upon achieving $50M in Product X sales (by 12/31/2027)
Milestone 3: $10M upon EMA approval in Europe (by 12/31/2027)
Total Potential: $100M + $50M = $150M
Seller Protections:
- Buyer commits to spend minimum $10M annually on Product X development
- Buyer cannot abandon or significantly delay Product X development
- Seller representatives on Product X steering committee
- Buyer provides quarterly updates on development progress
Acceleration:
- If buyer abandons Product X development, all milestone payments due
- If buyer licenses Product X to third party, milestones accelerate
- If buyer is acquired, milestones accelerate pro-rata based on probability
Dispute Resolution:
- Disputes over milestone achievement resolved by industry expert
- Specified expert firm (Covington LLP life sciences practice)
Best Practices
The 10 Rules of Earnouts
- Keep It Simple: Fewer metrics, clearer definitions, less complexity
- Use Objective Metrics: Revenue > EBITDA > Subjective milestones
- Define Everything: 10-page definition of earnout calculation is not unusual
- Protect Both Sides: Balance buyer control with seller protections
- Independent Verification: Third-party audit required
- Reasonable Targets: Based on realistic projections, not best-case
- Appropriate Period: 2-3 years typical, match to business cycle
- Clear Dispute Process: Specify how disagreements will be resolved
- Consider Acceleration: What happens if buyer sells, merges, or materially changes business?
- Model It Out: Run scenarios - what happens if business grows 20%? Declines 20%?
References
Last updated: Wed Jan 29 2025 19:00:00 GMT-0500 (Eastern Standard Time)