An earnout is a deal structure where a portion of the purchase price is contingent on the business achieving defined performance targets after closing, bridging the valuation gap between what a buyer will pay today and what a seller believes the business will earn.
Earnouts are proposed when buyer and seller cannot agree on value. The buyer believes current performance is the right basis for valuation. The seller believes future performance, a new contract, a growth trajectory, a margin improvement, justifies a higher price. The earnout lets both parties be right: the seller receives the higher price if the performance materializes, the buyer pays it only if it does.
The practical experience of earnouts is considerably more complicated than the concept. The metrics must be precisely defined, revenue, EBITDA, gross margin, and the accounting policies used to measure them must be agreed before closing. The seller’s ability to influence the metrics must be preserved in the post-closing governance structure. And the relationship between seller and buyer during the earnout period must be functional enough to allow the business to perform. Earnouts that are poorly structured or that assume a cooperative post-closing relationship that does not materialize are among the most litigated provisions in private transaction agreements.
See also: Deal Structure · Vendor Take-Back (VTB) · Risk ToleranceAn earnout that looks attractive in a term sheet can be difficult to collect in practice. See how Wefinx approaches exit planning.