Earnouts serve a valuable role in bridging valuation gaps that frequently arise when buyers and sellers negotiate the pricing for an acquisition. Buyers typically apply conservative projections and valuations to limit overpaying, while sellers push for valuations based on their more optimistic future performance expectations. Earnouts allow a portion of the purchase price to be contingent on the acquired business actually achieving certain predetermined operational milestones and financial metrics post-closing.
Incentive Alignment & Key Employee Retention
A key benefit of earnouts is their ability to keep the seller’s management team and key employees motivated and aligned with the buyer’s interests after the deal closes. By tying a significant portion of their purchase compensation to hitting earnout targets like revenue, profitability or other operational goals, the seller’s team has strong incentives to remain focused on driving the business’s success under the new ownership. This helps facilitate integration and knowledge transfer.
Risk Mitigation
From the buyer’s perspective, earnout structures reduce the amount of upfront cash required at closing while transferring some of the future performance risk back to the seller. If the acquired business falls short of earnout targets, the buyer avoids overpaying. Earnouts allow buyers to pay a guaranteed baseline price upfront while putting a portion of the valuation “at risk” based on actual results delivered.
Tax Benefits
For sellers, earnout payments are often treated as capital gains when paid out over time rather than ordinary income if all proceeds were received upfront. This can help defer and spread out taxes owed on the overall proceeds. Sellers must weigh this potential tax benefit against the risk of not fully achieving earnout milestones.
Common Earnout Structures:
- Revenue Earnouts – Additional payments for achieving predetermined revenue milestones over one to three year periods post-close. Aligns pricing with top-line growth projections.
- EBITDA/Profitability Earnouts – Contingent payments for hitting EBITDA, net income or other profitability metric thresholds each year. Focuses on delivering projected earnings and cash flow.
- Milestone Earnouts – Payments triggered by achieving specific integration, product, regulatory or other operational milestones crucial to the deal’s strategic rationale.
- Combination Earnouts – Using a blend of multiple metrics like revenue and EBITDA in a single hybrid earnout calculation.
Designing an effective earnout may require extensive negotiation between buyers and sellers. Targets should be achievable yet stringent, with clear definitions around metric calculations, accounting treatments, and provisions addressing contingencies like future acquisitions or divestitures impacting the business. Dispute resolution mechanisms are also crucial given the high-stakes involved. When structured properly, earnouts provide a useful tool for getting M&A deals done by bridging valuation divides.