Earnouts and Contingent Consideration

A buyer values a target at $80 million based on conservative assumptions about its growth. The seller, convinced the business is about to take off, insists it's worth $120 million. Rather than walk away, they split the difference in a way that lets both be right: pay $80 million now, and up to another $40 million later, but only if the business actually delivers the growth the seller is promising. That deferred, conditional piece is an earnout.

How it's structured

An earnout agreement specifies a metric (commonly revenue or EBITDA), a measurement period (often one to three years post-closing), a target level, and a payout formula — sometimes an all-or-nothing threshold, sometimes a sliding scale that pays proportionally more as performance exceeds the target. The deferred amount is called contingent consideration, and it typically sits on the acquirer's balance sheet as an estimated liability from day one, adjusted each period as the outlook for hitting the targets changes.

Earnouts are common specifically when there's a genuine information gap between buyer and seller — a young, fast-growing company with limited operating history, or a business heavily dependent on a founder's future involvement, are classic candidates. They also create an obvious tension after closing: the seller (often now an employee of the acquirer, running the acquired business) wants decisions made that maximize the earnout metric, while the acquirer wants to run the combined business the way that's best for the whole company, which may not be the same thing.

Worked example

A deal is structured as $80 million upfront plus an earnout of up to $40 million if the target's EBITDA over the next two years averages at least $20 million, paid proportionally between $15 million (0% payout) and $20 million (100% payout).

• If average EBITDA comes in at $16 million: that's 20% of the way from $15 million to $20 million, so the seller receives 20\% \times \40\text{m} = $8 million on top of the \80 million upfront — a total of $88 million.
• If average EBITDA comes in at $22 million, above the $20 million target: the seller receives the full $40 million earnout, for a total of $120 million — exactly the price the seller originally wanted, now justified by actual performance rather than a projection.
• If average EBITDA comes in at $14 million, below the $15 million floor: the seller receives no earnout at all, and the deal's real price turns out to have been just the $80 million upfront.

What this means in practice

Earnouts shift real risk onto the seller and are a frequent source of post-closing disputes — sellers commonly allege that the acquirer under-invested in the business or made accounting choices during the earnout period specifically to minimize the metric and avoid paying out, which is why well-drafted earnout agreements spell out detailed operating covenants (minimum marketing spend, no major restructuring, dedicated management autonomy) governing how the business must be run during the measurement period.