What happens when a buyer and seller agree on what a company is worth today but disagree about what it could be worth tomorrow?
That valuation gap is one reason an earnout can become part of an acquisition’s purchase price. Instead of paying the entire agreed value at closing, the buyer makes part of the consideration contingent on the acquired business reaching specified performance targets after the transaction.
The structure can help both sides address uncertainty. Buyers can avoid paying the full premium for growth that has not yet materialized, while sellers can retain an opportunity to receive additional consideration if the business performs as expected.
But an earnout does not make uncertainty disappear. It moves that uncertainty into a contractual framework involving performance metrics, accounting definitions, measurement periods and post-closing decisions.
That makes the design of the earnout as important as the headline purchase price.
What Is an Earnout?
An earnout is a form of contingent consideration in which additional consideration may become payable to the seller if specified future conditions or performance targets are achieved. Deloitte’s accounting guidance describes contingent consideration as an obligation to transfer additional assets or equity interests if specified future events or conditions occur; arrangements requiring a future payment are commonly referred to as earnouts.
In a conventional acquisition, the buyer might pay a fixed amount at closing. With an earnout, part of the potential consideration remains contingent.
For example, imagine a hypothetical acquisition with:
- $8 million paid at closing
- Up to $2 million of additional earnout consideration
- A two-year measurement period
- Payments linked to specified revenue and EBITDA targets
The seller therefore does not receive the full $10 million immediately. The additional $2 million depends on how the agreed performance test works.
The example is hypothetical. Actual earnout structures vary substantially between transactions.
Why Buyers and Sellers Use Earnouts
The basic economic problem is straightforward.
A seller may believe a company deserves a higher valuation because revenue is growing rapidly, a new product is approaching commercial launch or margins are expected to improve. A buyer may agree with the potential but hesitate to pay for all of it before the results are visible.
An earnout can bridge that difference.
For the buyer, part of the purchase price becomes dependent on future performance. That can reduce the amount of cash committed at closing and make some consideration contingent on results.
For the seller, the trade-off is different. The seller accepts uncertainty over part of the final purchase price but retains access to potential upside.
This makes the earnout a risk-allocation mechanism, not simply a pricing technique.
The buyer takes on the risk that the business may underperform. The seller takes on the risk that the business may perform differently under new ownership or that the agreed conditions for payment may not be satisfied.
How an Earnout Is Structured
An earnout agreement can contain several moving parts.
| Component | What it determines | Performance metric | What the business must achieve | Threshold | The minimum performance required | Measurement period | When performance is tested | Payment formula | How achievement translates into consideration | Cap | The maximum additional amount payable | Calculation procedure | How the final result is determined | Review rights | How the seller can challenge the calculation |
|---|
Recent SEC-filed agreements demonstrate how detailed these provisions can become. One agreement, for example, tied payments to EBITDA above a $4 million threshold, capped the maximum payment at $4 million, required the purchaser to prepare a preliminary earnout statement and gave sellers a defined period to dispute the calculation.
Another filing used separate annual earnouts tied to revenue and adjusted EBITDA, with different eligibility tests and multipliers depending on the level of revenue growth achieved.
The lesson is important: an earnout is rarely just a single number.
A Simple Hypothetical
Suppose a buyer agrees to pay an additional $3 million if a business generates $15 million of revenue during the earnout period.
The agreement might specify:
- Below $12 million: no payment
- $12 million to $15 million: partial payment
- $15 million or more: full $3 million
- Maximum payment: $3 million
A different transaction could use a linear formula, multiple performance tiers or separate targets for revenue and EBITDA.
There is no universal earnout structure.
Revenue, EBITDA or Something Else?
The performance metric determines what the seller is being asked to achieve.
Revenue is relatively straightforward to understand but does not necessarily demonstrate profitability.
EBITDA can focus the earnout on earnings performance, but its calculation can become considerably more complex because the agreement may need to specify which expenses, adjustments and accounting principles apply.
Other transactions can use gross profit, recurring revenue, margins, customer milestones, regulatory approvals, product launches or other operational targets.
Recent SEC filings illustrate this variety. One agreement used both gross revenue and EBITDA targets, while another included revenue and EBITDA measures over successive fiscal years.
The critical issue is not simply choosing the metric. It is defining it precisely.
A target such as “$10 million of EBITDA” leaves important questions unanswered. Which accounting policies apply? How are extraordinary items treated? What happens with acquisitions made after closing? How are changes in accounting methodology handled?
Some SEC-filed agreements expressly establish calculation principles and exclusions to address these questions.
The Buyer’s Risk: Post-Closing Control
This is where the economics of an earnout become more complicated.
After closing, the buyer generally controls the acquired business. Decisions about pricing, hiring, marketing, capital expenditure, product development, integration and accounting can influence future results.
That creates a potential tension.
The seller may be measured against a performance target while no longer controlling all the decisions that affect whether the target is achieved.
Consequently, sophisticated earnout agreements can address operating conduct, reporting obligations, calculation procedures, access to information and dispute mechanisms.
The underlying issue is control: who controls the variables that determine whether the contingent payment becomes payable?
The Seller’s Risk: Will the Target Be Achieved?
From the seller’s perspective, the headline purchase price can be misleading if a significant portion is contingent.
An earnout can create valuable additional consideration, but the seller may have to wait months or years to receive it. The payment may also depend on conditions that are difficult to predict at closing.
There can be another complication when the seller remains involved after the acquisition. A seller who continues working for the buyer may have compensation arrangements alongside the earnout.
That distinction matters because contingent consideration and compensation can have different accounting and tax consequences. Deloitte notes that the substance and formula of a contingent payment can matter when determining whether an arrangement represents acquisition consideration or compensation for services.
The contractual documents therefore matter not only to the amount payable but also to how the arrangement is characterized.
Where Earnouts Turn Into Disputes
Many earnout disputes are ultimately disputes about measurement.
The agreement may establish a target, but the parties can disagree over how the target should be calculated.
Potential pressure points include:
- Revenue recognition
- EBITDA adjustments
- Accounting policies
- Extraordinary expenses
- Acquisitions or divestitures
- Integration costs
- Changes in pricing
- Reporting deadlines
- Access to financial information
- Calculation methodology
Recent SEC-filed agreements show how parties attempt to manage these issues through preliminary calculations, seller review periods and defined dispute procedures.
PwC also notes that earnout mechanisms can generate post-deal disputes and that expert determination is commonly used for certain purchase-price disputes.
The practical implication is clear: ambiguity in the formula can become a financial dispute later.
The Earnout Is Really a Risk-Sharing Mechanism
The most useful way to understand an earnout is not to ask whether it is good for the buyer or seller.
Ask instead:
Which risks does each party control, which risks does each party accept, and how are those risks measured?
A buyer may reduce the risk of paying entirely for projected growth that never appears. A seller may gain access to additional upside if the projections are achieved.
But the seller may also become dependent on post-closing decisions made by the buyer. Meanwhile, the buyer assumes the administrative and contractual burden of measuring performance and defending the calculation if it is challenged.
The structure therefore redistributes uncertainty rather than eliminating it.
That is why the most important provisions may be buried beneath the headline earnout amount: definitions, thresholds, measurement periods, accounting principles, caps, reporting rights and dispute procedures.
Conclusion
An earnout can solve a genuine M&A problem: the buyer and seller may agree on the business’s current value while disagreeing about how much of its future potential should be priced into today’s transaction.
By making part of the consideration contingent, an earnout can bridge that valuation gap and connect future performance with future payment.
But an earnout works only as well as the mechanism used to measure performance.
A $10 million target means little if the agreement does not clearly establish how that $10 million is calculated. Likewise, a generous contingent payment may provide less economic certainty than a smaller amount guaranteed at closing.
For both sides, the central question is therefore not simply how much the earnout could pay.
It is who controls the outcome, how success is measured and what happens when the numbers are disputed.
That is where acquisition risk becomes contract structure.
Frequently Asked Questions
What is an earnout in an acquisition?
An earnout is contingent consideration that becomes payable to a seller when specified future performance targets or other conditions are satisfied.
How does an earnout payment work?
The purchase agreement establishes the relevant targets, measurement period and payment formula. Depending on the structure, the seller may receive no additional payment, a partial payment or the maximum earnout.
Why do buyers and sellers use earnouts?
They can help bridge differences over valuation and make part of the purchase price dependent on future performance. Buyers can limit some upfront risk, while sellers retain potential additional consideration.
What happens if a buyer and seller disagree about an earnout calculation?
The acquisition agreement should establish the review and dispute process. Depending on the contract, this can involve information exchange, negotiation, an independent expert determination, arbitration or litigation.
Investment Disclaimer:
This article is provided for informational and educational purposes only and does not constitute legal, tax, investment or financial advice. Earnout provisions are contractual and their treatment can vary according to the transaction documents, accounting framework and applicable law. Buyers and sellers should obtain appropriate legal, accounting and tax advice before entering into an acquisition agreement.
David Seidman is the Principal of Seidman Law Group LLC, where he serves as outside general counsel for small to mid-sized companies. A seasoned legal advisor and entrepreneur, he specializes in contract negotiation, commercial litigation, and strategic risk management across the hospitality and finance sectors.
