Earnout: Overview, definition and example
What is an earnout?
An earnout is a payment structure in a business deal where part of the purchase price is tied to the future performance of the acquired business. The buyer agrees to pay additional amounts to the seller if the business meets certain financial or operational targets after the deal closes. This structure is commonly used in mergers and acquisitions when the value of the business depends on its future results.
For example, a buyer might pay $10 million upfront to acquire a company, with an additional $5 million to be paid if the company achieves specific revenue milestones within two years.
Why is an earnout important?
Earnouts are important because they balance risk between the buyer and the seller. For the buyer, an earnout ensures they’re not overpaying upfront for a business that may not perform as expected. For the seller, it provides an opportunity to earn more if the business thrives under the buyer’s ownership.
Earnouts also help resolve valuation disagreements. When the buyer and seller have different views on the business's future potential, an earnout allows them to move forward without locking in a fixed price based solely on uncertain projections.
Understanding earnouts through an example
Imagine a tech startup is being acquired by a larger software company. The buyer offers $5 million upfront, with an additional $2 million in earnouts if the startup’s product achieves $1 million in revenue within the next 12 months. If the target is met, the seller gets the extra $2 million; if not, the buyer doesn’t have to pay more.
In another case, a manufacturing business is sold with an earnout provision tied to profits. The seller agrees to accept a lower upfront payment but could receive extra payments over three years if the company’s profits exceed certain thresholds.
An example of an earnout clause
Here’s how an earnout clause might look in a contract:
“In addition to the Base Purchase Price, the Seller shall be entitled to receive Earnout Payments of up to $2,000,000, contingent upon the Company achieving gross revenues of $10,000,000 or more within the 12-month period following the Closing Date. Earnout Payments shall be calculated and paid annually based on the financial statements provided by the Buyer.”
Conclusion
Earnouts provide a flexible way to structure business deals, aligning the interests of buyers and sellers by tying part of the purchase price to future performance. They help bridge valuation gaps and reduce risks while offering sellers the potential for higher payouts.
By including clear and measurable earnout terms in agreements, businesses can ensure fairness, transparency, and smoother transactions, making them a valuable tool in mergers and acquisitions.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.