Glossary
Earnout
An earnout is a portion of an acquisition's purchase price that is paid to the seller after closing only if the business achieves specified performance targets, such as revenue or EBITDA levels, within a defined period. It bridges valuation gaps between buyers and sellers by tying part of the price to future results.
Formula
Example
A buyer pays $40,000,000 at closing plus an earnout equal to 2.0x the amount by which year 2 EBITDA exceeds $6,000,000, capped at $10,000,000. If year 2 EBITDA is $8,500,000, the earnout is 2.0 x $2,500,000 = $5,000,000. If EBITDA reaches $12,000,000, the formula gives $12,000,000 but the cap limits payment to $10,000,000. If EBITDA is $5,500,000, no earnout is paid.
How it is used in underwriting
Earnouts are useful when the buyer and seller disagree about future performance, such as a company with a new product, a large pending contract or a recent growth spurt. The buyer pays for proven earnings at closing and defers payment for projected upside until it materializes. Underwriters treat the earnout as contingent consideration: equity investors model it in valuation and returns, and lenders evaluate whether future earnout payments will compete with debt service. Many credit agreements restrict earnout payments unless leverage or coverage tests are met at the time of payment.
Earnouts are a frequent source of post-closing disputes. Sellers worry that the buyer will run the business in a way that depresses the metric, by integrating it, shifting costs or changing accounting policies, while buyers worry about sellers inflating short-term results. Good agreements define the metric precisely, specify accounting principles, set operating covenants and provide a dispute resolution process. Revenue-based earnouts are easier to measure but can encourage unprofitable growth; EBITDA-based earnouts align with value but are easier to manipulate. Accounting rules may require buyers to estimate and revalue earnout liabilities over time.
Frequently asked questions
How long do earnouts typically last?
Earnout periods commonly run one to three years after closing, long enough to test whether projected performance materializes but short enough to remain measurable before the business is fully integrated. Longer periods increase the risk of disputes because more changes in operations and strategy occur after closing.
Are earnouts good for sellers?
Earnouts can let sellers capture a higher total price if the business performs, but payment is uncertain and depends partly on decisions the buyer controls after closing. Sellers should negotiate clear definitions, operating covenants, information rights and acceleration on a change of control to protect their ability to earn the payment.
How do lenders treat earnouts?
Lenders view earnouts as future obligations that could divert cash from debt service. Credit agreements often subordinate earnout payments or permit them only if the borrower meets leverage or coverage tests at the time. Underwriters include probable earnout payments in cash flow projections when assessing repayment capacity.
Related terms
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