Earnouts Bridge a Price Gap and Create the Next Argument
When buyer and seller cannot agree on what a business is worth, they defer part of the payment and tie it to performance. Then they litigate about the performance.
The Disagreement It Solves
A seller believes their business will grow revenue 40 percent next year. The buyer believes 15 percent. Both are sincere, and the difference between those two views might be a third of the purchase price.
An earnout resolves the standoff by not resolving it. The buyer pays an agreed amount at closing and promises further payments if the business hits specified targets over a defined period, typically one to three years.
If the seller was right, they get paid. If the buyer was right, they do not. Nobody has to concede the argument in order to sign.
Where They Show Up
Earnouts cluster in situations with genuine forecasting uncertainty: founder led businesses, companies with concentrated customer bases, biotech assets awaiting trial results, and any acquisition where a small number of future events determine most of the value.
They are also used to keep a founder engaged. A seller who receives everything at closing has limited reason to stay through a transition. One with half their consideration tied to next year's results has a great deal of reason.
An earnout is a bet placed between two parties who could not agree on the odds, settled later by an outcome that one of them now controls.
The Structural Problem
That last clause is the whole difficulty. After closing, the buyer owns the business. The seller's remaining payment depends on how that business performs, and the buyer makes every decision affecting performance.
The buyer might integrate the acquired unit into a larger division, making its standalone results unmeasurable. It might reallocate the sales force, cut marketing, raise transfer pricing on internal services, or delay a product launch for reasons entirely unrelated to the earnout.
Each of these could be a legitimate business decision and each reduces the payment owed. Distinguishing sound management from deliberate suppression is difficult, and that is precisely what the resulting disputes turn on.
The Metric Matters Enormously
| Metric | Manipulable by buyer | Comment |
|---|---|---|
| Revenue | Hardest to distort | Common choice, ignores profitability |
| EBITDA | Highly manipulable | Cost allocations decide the answer |
| Net income | Very manipulable | Every accounting choice flows through |
| Unit or milestone based | Objective | Regulatory approval, units shipped |
Revenue based earnouts are the most common precisely because revenue is the hardest line for a buyer to suppress without visible commercial damage. Profit based earnouts hand the buyer a large set of levers, since the allocation of shared overhead alone can move the number decisively.
What the Agreement Has to Say
Good earnout drafting anticipates the conflict rather than hoping it will not arise. The provisions that matter most are covenants requiring the buyer to operate the business in the ordinary course, to keep separate accounting records for the earnout period, and to refrain from specified actions such as relocating operations or terminating key contracts.
The definition of the metric needs to be written out in full rather than left to generally accepted accounting principles, because the accounting standard offers legitimate choices that produce different answers.
An acceleration clause covers the case where the buyer sells the business or reorganises it during the period, which would otherwise end the earnout by making the target unmeasurable.
The Cliff Problem
An earnout paying a fixed sum for hitting 100 million in revenue and nothing at 99 million creates an enormous incentive at the boundary. Sellers still involved in operations have pulled revenue forward, discounted aggressively, or booked marginal deals to cross the line.
Sliding scales avoid this. Paying proportionally across a range removes the cliff, and removes the reason to damage the business in order to clear it.
How Accountants Treat It
Under current standards a buyer records the earnout as contingent consideration at fair value on the acquisition date, then remeasures it each period with changes running through the income statement.
The counterintuitive result is that an acquisition performing well creates an accounting loss, because the expected payment rises. An analyst seeing an unexplained charge should check whether an earnout is being marked up, since it may be reporting good news in a form that looks like bad news.
The Bottom Line
Earnouts close the gap between what a seller thinks a business is worth and what a buyer will pay, by deferring the argument. They are useful and they are the single most litigated provision in private M&A, because the party who determines the outcome is the party who has to pay. Choose a metric the buyer cannot easily suppress, write the operating covenants carefully, and avoid cliffs.