What is an earnout?
Takeaway: An "earnout" is a common M&A tool that bridges a valuation gap by making a portion of the purchase price contingent on the startup achieving specific performance milestones after the acquisition has closed.
In many M&A negotiations, the buyer and the seller have a fundamental disagreement about the future value of the startup. The founders, who are optimistic about their new product, believe the company is worth $100 million. The buyer, who is more skeptical about the product's adoption, believes it is only worth $70 million. How do you bridge this $30 million valuation gap to get a deal done? The most common solution is an earnout.
An earnout is a contractual provision in a merger agreement that makes a portion of the total purchase price contingent upon the acquired business achieving certain, pre-defined performance milestones in the future, after the acquisition has closed.
How an Earnout Works
The earnout is a creative way to align incentives and share risk.
The Structure: The buyer agrees to pay a certain amount of guaranteed cash at closing (e.g., $70 million) plus a series of additional, contingent payments if the business hits specific targets over the next one to two years.
The Milestones: The earnout milestones must be objective, measurable, and within the control of the founders and key employees who are joining the acquiring company. Common earnout milestones include:
Revenue Targets: Achieving a specific revenue or bookings target in the first year post-closing.
Product Development Milestones: Successfully launching a key new feature or product.
Customer Retention Goals: Maintaining a certain level of customer retention.
The Pros and Cons of an Earnout
The Pros:
It Bridges the Valuation Gap: An earnout is often the only way to get a deal done when there is a significant disagreement on valuation. It allows the sellers to get the higher price they want, but only if they deliver on the future performance they are promising.
It Incentivizes the Team: It can be a powerful tool for retaining and motivating the key employees who join the acquiring company. They now have a direct financial incentive to hit their post-closing targets.
The Cons:
It Creates Post-Closing Disputes: Earnouts are a notorious source of post-closing litigation. The sellers may claim they hit the milestone, while the buyer disagrees. The buyer may also take actions that make it more difficult for the sellers to achieve their earnout targets (e.g., by under-investing in the acquired business).
Complexity: Drafting the earnout provisions in the merger agreement is incredibly complex. The milestones must be defined with extreme precision to avoid any ambiguity.
An earnout is a powerful but complex tool. It can be the creative solution that gets a difficult deal over the finish line, but it requires careful negotiation and a deep level of trust between the buyer and the seller to ensure the post-closing relationship is a productive and successful one.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.