Earnout
Quick Facts
- Purpose: Bridges valuation gaps between buyer and seller
- Typical size: 10-25% of deal value (higher in life sciences)
- Duration: Usually 1-3 years post-closing
- Prevalence: ~14% of private deals; 71% of biopharma deals
An earnout is a portion of the purchase price that is paid contingently based on the target company achieving specified milestones after the acquisition closes. It allows buyers and sellers to share the risk when they disagree about the target's future performance.
In Plain English
An earnout is a "prove it" payment. You think your company is worth $50M; the buyer thinks it's worth $35M. Solution: the buyer pays $35M now, plus an additional $15M if the company hits certain revenue targets over the next two years. If you're right about the business, you get your full price. If not, the buyer was right to be skeptical.
How Earnouts Work
- Negotiation: Buyer and seller agree on upfront payment + earnout structure
- Closing: Buyer pays the upfront portion
- Earnout period: Target operates under buyer ownership
- Milestone measurement: Performance tracked against agreed metrics
- Earnout payment: Paid if milestones achieved (all, some, or none)
Common Earnout Metrics
Financial Milestones
| Metric | Best For |
|---|---|
| Revenue | Growth-stage companies |
| EBITDA | Profitable businesses |
| Gross margin | Product companies |
| Recurring revenue | SaaS/subscription |
| Customer retention | Service businesses |
Non-Financial Milestones
- FDA approval: Biotech and pharma
- Product launch: Technology companies
- Customer acquisition: Specific contract wins
- Patent grants: IP-focused businesses
- Employee retention: Key personnel staying
- Regulatory clearance: Healthcare, fintech
Earnout Structure Examples
Simple Revenue Target
- Upfront: $30M
- Earnout: $10M if Year 1 revenue exceeds $20M
- Maximum total: $40M
Tiered EBITDA Earnout
- Upfront: $50M
- Year 1 EBITDA $10M+: $5M earnout
- Year 2 EBITDA $15M+: Additional $5M
- Year 3 EBITDA $20M+: Additional $5M
- Maximum total: $65M
Life Sciences Structure
Sanofi's acquisition of Genzyme (2011) included:
- Upfront: $74/share
- FDA approval milestone: $1/share
- Production milestone: $1/share
- Sales milestones: Up to $12/share
The Earnout Dispute Problem
Earnouts frequently lead to litigation because:
Buyer Incentives
- Reduce earnout payments: Less cash out the door
- Integrate aggressively: May hurt legacy metrics
- Reallocate resources: Away from earnout products/customers
- Change accounting: Legitimate changes may reduce measured performance
Seller Concerns
- Lost control: No longer running the business
- Metric manipulation: Buyer decisions affecting earnout metrics
- Integration conflicts: Earnout vs. synergy goals
- Access to information: Can't verify calculations
Protecting Earnout Rights
For Sellers:
Operational Protections:
- Conduct of business covenants: Buyer must operate consistently
- Dedicated resources: Specified employees/budget for earnout products
- Separation period: Keep business separate during earnout
- Approval rights: Consent required for major changes
Financial Protections:
- Acceleration clauses: Earnout paid if business sold/merged
- Audit rights: Right to examine earnout calculations
- Dispute resolution: Clear process for disagreements
- Interest on late payments: Incentive for timely payment
For Buyers:
- Clear metric definitions: Avoid ambiguity
- Control of operations: Flexibility to integrate
- Reasonable covenants: Don't handcuff the business
- Cap on payments: Limit maximum earnout
Industry Variations
| Industry | Earnout Prevalence | Typical Metrics |
|---|---|---|
| Life Sciences | 71% | FDA approval, sales milestones |
| Technology | 25% | Revenue, customer metrics |
| Manufacturing | 15% | EBITDA, production targets |
| Services | 20% | Revenue retention, margins |
Life sciences deals have much higher earnout usage because value depends heavily on regulatory milestones.
Accounting Treatment
For buyers:
- Contingent consideration: Recorded at fair value at closing
- Subsequent changes: Generally flow through P&L
- Complexity: Creates ongoing accounting burden
Tax Considerations
- Earnout payments: Generally taxed when received
- Character: May be capital gain or ordinary income
- Installment sale: May qualify for deferred recognition
- Structure matters: Consult tax advisors
Practical Takeaways
For sellers: Earnouts can bridge valuation gaps, but you're giving up control. Negotiate strong operational protections and clear metric definitions. Consider whether the earnout is achievable given buyer integration plans. If you don't trust the buyer to act fairly, don't accept a large earnout.
For buyers: Earnouts shift risk to sellers and can make deals work when upfront price expectations differ. But they create complexity and potential disputes. Define metrics clearly, and don't promise operational covenants you can't keep.
Related Reading
- Break-Up Fee — Other contingent payments in M&A
- Material Adverse Change — Risk allocation in deals
- Tender Offer — Deal structures where earnouts apply