What is an Earnout? Structure, Examples, and Negotiation

Earnouts represent one of the most powerful tools for bridging valuation gaps in M&A transactions. When buyers and sellers disagree about a company's future prospects, earnouts allow them to structure deals where part of the purchase price depends on the business achieving specific performance targets after closing.

Understanding earnouts matters for investment banking professionals because they appear frequently in deal negotiations, particularly in sectors with high uncertainty like life sciences and technology. Earnout provisions require careful structuring, and poorly designed earnouts often lead to disputes that create problems for all parties.

This guide explains what earnouts are, how they work, common structures, real-world examples, and negotiation strategies from both buyer and seller perspectives. Whether you are preparing for interviews or working on transactions involving earnouts, this knowledge helps you contribute meaningfully to deal discussions.

What is an Earnout?

An earnout is a contingent payment mechanism in M&A transactions where sellers receive additional purchase price only if the acquired business achieves specified performance targets after closing. The buyer pays a portion of the purchase price upfront, with the remainder contingent on future performance.

The Core Concept

Earnouts address a fundamental problem in M&A: disagreement about the future. The seller may believe their company will achieve aggressive growth projections, while the buyer views those projections as unrealistic. Rather than walking away from the deal, earnouts let both parties proceed by making part of the price contingent on whether the seller's optimistic view proves correct.

Consider a simplified example:

If the seller's projections prove accurate, they receive the full $100 million. If growth disappoints, the buyer pays less than they would have under a higher fixed price. Both parties can proceed with a deal structure that aligns incentives.

Prevalence in M&A

Earnouts have become increasingly common, with deal usage jumping from approximately 20% in 2021 to 33% in 2023. They appear much more frequently in private company acquisitions, where earnouts are included in roughly 14% of transactions, compared to only about 1% of public company deals.

Certain industries rely heavily on earnouts. In life sciences, earnouts appear in approximately 79% of biopharmaceutical transactions and 78% of medical device deals, reflecting the inherent uncertainty around drug development and regulatory approval.

Key Components of Earnout Structure

Effective earnout provisions require careful attention to several interconnected elements.

Performance Metrics

The metric that triggers earnout payments is the foundation of the structure. Common metrics include:

The choice of metric should reflect what actually drives value in the specific business. Revenue-based earnouts make sense for growth-stage companies, while EBITDA-based earnouts better suit mature businesses where profitability matters most.

Payment Structure

Earnout payments can take various forms:

Cash payments are most common, funded from company cash flow, buyer equity contributions, or additional financing.

Equity grants give sellers ownership stakes in the combined company, aligning ongoing incentives.

Hybrid structures combine cash and equity, perhaps offering base cash payments plus equity upside for exceptional performance.

Payment structures can also be tiered or linear. A tiered structure might pay nothing below a threshold, a fixed amount at target, and additional amounts for exceeding targets. Linear structures pay proportionally to performance across a range.

Duration and Timing

Earnout periods typically span one to five years after closing. Shorter periods reduce uncertainty for both parties but may not capture the full trajectory of performance improvements. Longer periods create more opportunity for external factors to affect results.

Measurement timing matters significantly. Annual measurements allow time for performance to develop but delay payments. Quarterly or milestone-based measurements provide faster feedback but may create short-term incentive distortions.

For more on deal structure mechanics, see our guide on types of mergers and acquisitions.

Why Deals Use Earnouts

Earnouts serve several strategic purposes beyond simply bridging valuation gaps.

Bridging Valuation Disagreements

The primary use case remains resolving disagreements about future performance. When sellers project hockey-stick growth that buyers find unrealistic, earnouts let the deal proceed by putting the seller's conviction to the test.

This mechanism enables transactions that otherwise would not happen. Without earnouts, valuation impasses would kill deals where both parties could benefit from finding common ground.

Managing Uncertainty and Risk

Earnouts help buyers manage risk in inherently uncertain situations:

By shifting some risk to sellers through contingent payments, buyers can justify acquisitions they might otherwise avoid.

Ensuring Smooth Transitions

Earnouts create incentives for sellers to support successful transitions. When sellers' compensation depends on post-closing performance, they have strong motivation to:

This alignment proves particularly valuable when selling shareholders will continue in management roles.

Financing Flexibility

In high interest rate environments, earnouts provide financing flexibility by deferring purchase price payments. Buyers can fund earnouts from the acquired company's future cash flows rather than arranging all financing upfront.

This can make deals viable when upfront financing is expensive or constrained.

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Real-World Earnout Examples

Examining actual earnout structures illustrates how these provisions work in practice.

Sanofi-Genzyme Acquisition

Sanofi's $20.1 billion acquisition of Genzyme in 2011 included significant earnout provisions to bridge valuation disagreements. Sanofi was skeptical about Genzyme's claims regarding resolved production issues and pipeline drug potential.

The parties agreed that Sanofi would pay an additional $14 per share in contingent value rights (CVRs) tied to specific milestones:

This structure let Sanofi pay a premium only if Genzyme's optimistic claims proved accurate, while giving Genzyme shareholders upside they believed was deserved.

Technology and Software Acquisitions

Technology deals frequently use earnouts tied to revenue retention or growth metrics. A typical structure might include:

These structures protect buyers against customer churn while rewarding sellers for growth execution.

Life Sciences Milestone Earnouts

Biotech and pharmaceutical acquisitions often tie earnouts to regulatory and commercial milestones rather than financial metrics:

This approach aligns payments with actual value realization in an industry where success depends heavily on binary regulatory outcomes.

Buyer's Perspective on Earnouts

Buyers approach earnouts with specific objectives and concerns that shape negotiation positions.

Key Buyer Objectives

Risk mitigation drives most buyer interest in earnouts. By shifting payment contingency to sellers, buyers reduce downside exposure to overvalued acquisitions.

Operating flexibility matters significantly. Buyers want to integrate acquisitions into their operations without earnout constraints limiting strategic decisions. Longer earnout periods heighten concerns about operational restrictions.

Alignment with profitability leads many buyers to prefer profit-based metrics over revenue metrics. Buyers recognize that sellers can drive revenue growth at the expense of profitability, creating misaligned incentives.

Buyer Negotiation Priorities

Buyers typically seek:

Buyers may also request statements disclaiming fiduciary duties to sellers regarding earnout outcomes, particularly for longer earnout periods.

Seller's Perspective on Earnouts

Sellers face different concerns that shape their negotiation approach.

Key Seller Concerns

Achievement risk represents sellers' primary worry. Only approximately 59% of deals with earnouts result in partial or full payment. Sellers must assess whether they can actually achieve targets and what happens if circumstances outside their control prevent success.

Buyer manipulation concerns arise because buyers typically control the business post-closing. Sellers worry that buyers might make decisions that undermine earnout achievement, whether intentionally or through neglect.

Measurement disputes frequently emerge when earnout calculations involve subjective elements or when accounting treatments affect results.

Seller Negotiation Priorities

Sellers typically seek:

Acceleration provisions can protect sellers if buyers take actions that undermine earnout achievement, such as selling the business or substantially changing operations.

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Common Earnout Disputes and How to Avoid Them

Earnouts are sometimes called "litigation magnets" because poorly structured provisions frequently lead to disputes.

Sources of Disputes

Metric calculation disagreements arise when parties interpret earnout formulas differently. Disputes over revenue recognition, expense allocation, or accounting treatment can significantly affect outcomes.

Operating decision disputes occur when sellers believe buyer decisions undermined earnout achievement. Sellers may claim buyers loaded the business with expenses, changed strategy, provided insufficient capital, or diverted opportunities to competing products.

Definitional ambiguities create problems when earnout language does not clearly address specific situations. What happens if the buyer sells the business? How are unusual items treated? What if accounting standards change?

Changed circumstances can make original earnout structures unworkable. Economic disruptions, regulatory changes, or market shifts may affect achievement through no fault of either party.

Best Practices for Avoiding Disputes

Clear, objective metrics form the foundation. Define exactly how metrics will be calculated, what accounting principles apply, and how unusual items will be treated.

Detailed operating covenants specify how the business should be run during the earnout period. Address capital expenditure levels, staffing commitments, pricing authority, and strategic decisions that could affect earnout metrics.

Regular reporting requirements keep sellers informed about progress and help identify issues early. Specify what information buyers must provide, how often, and in what format.

Good faith obligations require parties to negotiate reasonable adjustments if material circumstances change. This prevents rigid adherence to structures that no longer make sense while maintaining accountability.

Clear dispute resolution mechanisms define procedures for resolving disagreements before they escalate to litigation. Independent accountant determinations work well for calculation disputes, while arbitration may suit broader disagreements.

Earnouts in Investment Banking Interviews

Earnout knowledge frequently appears in technical interview questions, particularly for M&A-focused roles.

Common Interview Questions

"What is an earnout and when would you use one?"

Explain that earnouts are contingent payment mechanisms where sellers receive additional purchase price if performance targets are met. They bridge valuation gaps when buyers and sellers disagree about future prospects, shift risk to sellers, and align incentives during transitions.

"What are common earnout metrics?"

Discuss revenue, EBITDA, gross profit, and operational metrics for financial earnouts. Mention milestone-based earnouts using regulatory approvals, product development, or contract executions. Note that metric choice depends on what drives value in the specific business.

"What are the risks of earnouts for buyers and sellers?"

For buyers: sellers may manipulate metrics, operating restrictions may limit strategic flexibility, and disputes create distraction and cost. For sellers: achievement depends partly on buyer decisions, only about 59% of earnouts pay out, and measurement disputes are common.

"How would you structure an earnout for a technology company?"

Discuss revenue retention or growth metrics, appropriate measurement periods, tiered payment structures, and provisions protecting against customer churn or key employee departures.

Demonstrating Sophistication

Beyond answering direct questions, understanding earnouts helps you discuss deal structures intelligently. When analyzing transactions involving valuation uncertainty, you can reference how earnout provisions might bridge gaps.

This knowledge proves particularly relevant when discussing private equity case studies or situations involving high-growth companies with uncertain trajectories.

Key Takeaways

Earnouts are contingent payment mechanisms where sellers receive additional purchase price if performance targets are achieved after closing. They bridge valuation gaps and allocate risk between buyers and sellers.

Key structural elements include performance metrics, payment structure, duration, and measurement timing. Metric choice should reflect what actually drives value in the specific business.

Earnouts appear frequently in private company acquisitions and dominate life sciences transactions where uncertainty about regulatory outcomes and commercial success is inherent.

Buyer priorities include maintaining operating flexibility, using profit-based metrics, and limiting earnout periods. Sellers prioritize achievement probability, protection against manipulation, and clear dispute mechanisms.

Disputes are common due to calculation disagreements, operating decisions, and definitional ambiguities. Clear drafting, detailed covenants, and good faith obligations help minimize conflict.

Interview preparation should cover earnout definitions, common metrics, risks for both parties, and how to structure earnouts for specific situations.

Practical Application

When you encounter transactions involving earnouts, consider the underlying dynamics driving the structure. What valuation gap is the earnout bridging? Why do the parties disagree about future performance? How does the metric choice affect incentives?

Understanding these dynamics helps you contribute meaningfully to deal discussions and demonstrates the sophisticated deal knowledge that distinguishes strong investment banking candidates and practitioners.