What Is an Earnout in M&A? Key Benefits & Risks

In tech-focused sectors like SaaS, ecommerce, and subscription-based businesses, earnouts often provide a solution to bridge valuation gaps and reduce risks for buyers and sellers.

This article explores earnouts, why they matter, and how to structure them effectively.

What is an earnout? Definition and purpose

An earnout is a payment agreement where part of the price for a company is paid later, based on the business reaching specific goals after the sale.

These milestones can be financial, such as achieving a particular amount of revenue or profitability levels, or operational, such as customer retention or product development.

One of the purposes of an earnout is to solve disputes related to the valuation of a business. Sellers are often optimistic about growth, while buyers take a more cautious approach. By deferring a portion of the payment tied to future performance, earnouts align the interests of both business sellers and buyers.

Why earnouts in M&A matter

Earnouts are especially important to:

• Bridge valuation gaps: Sellers aiming to justify a high price for their company can do so by agreeing to earnouts, while buyers mitigate the risk of overpaying.
• Incentivize performance: Sellers who remain involved with the business post-acquisition are motivated to reach specific targets.
• Mitigate risk for buyers: By deferring payment, buyers reduce their upfront financial exposure, safeguarding their investment until the business demonstrates its projected success.

Example: A buyer may agree to pay $15 million upfront for a SaaS company with the potential for an additional $5 million if the company reaches $10 million in annual recurring revenue within two years.

Read: M&A best practices: 5 Lessons from top experts

How earnouts are measured and timed

Earnouts usually span 1 to 3 years after the transaction closes, with performance metrics that are:

• Specific and measurable: Common choices include revenue, EBITDA, or customer acquisition rates.
• Relevant to business goals: Metrics should align with the buyer's strategic priorities and the business's nature.

Pros and cons of earnouts in M&A

Advantages of earnouts: Benefits for buyers and sellers

• Flexibility in deal structure: Allows greater customization of deal terms, accommodating differing perspectives on the target's potential future performance.
  Access to seller expertise: Encourages sellers to stay involved post-transaction, leveraging their expertise and relationships to ensure a smoother transition and sustained business growth.

• Risk mitigation for buyers: Reduces initial financial outlay, lowering the risk of overpaying for an underperforming business.

Disadvantages of earnouts: What to watch out for

• Potential disputes: Disagreements may arise over performance metrics or external factors impacting outcomes.
• Complex structuring: Poorly defined terms can create confusion or conflict.
• Seller risk: Achieving metrics may depend on market conditions or operational changes made by the buyer.

Read: The Buy-Side M&A Process: A Guide 

Structuring and managing earnouts: Strategies to avoid pitfalls

Selecting clear and objective metrics is critical for a successful M&A earnout deal. Examples include:

• Revenue-based metrics: Ideal for growth-oriented businesses like SaaS or e-commerce.
• Profitability metrics (EBITDA): Suitable for mature businesses with steady cash flow.
• Operational goals: Customer retention or product delivery milestones for businesses undergoing strategic shifts.

Protecting against disputes: Key provisions to include

To minimize conflicts, agreements should include:

• Detailed terms: Specify metrics, timelines, and payment schedules in writing.
• Dispute resolution mechanisms: Include provisions for third-party arbitration or mediation.
• Seller protections: Negotiate rights to monitor performance metrics and ensure timely payments.

Earnouts for Buyers and Sellers: Aligning Goals and Avoiding Conflicts

Aligning buyer and seller incentives

Earnouts are a powerful tool for aligning the incentives of buyers and sellers. For example, if a seller continues as an executive after the acquisition, they are motivated to meet the performance targets tied to the earnout. This alignment benefits both parties by driving the business toward shared goals.

Ensuring transparency and access to performance metrics

Transparency is key to avoiding disputes in earnout agreements. Buyers should provide sellers with regular updates on the metrics used to determine earnout payments. At the same time, sellers should negotiate for access to company records to independently verify performance data and ensure accurate calculations.

A real-world example: Bridging a valuation gap

In a notable case, a tech-driven business encountered a significant valuation gap that put the deal at risk. To resolve this, the Boopos team suggested an earnout arrangement linking additional payments to specific revenue milestones that were consistent with the current trend of the business, which the seller was confident would be maintained in the future.

This solution enabled the seller to secure the desired valuation if the agreed performance targets were achieved while offering the buyer confidence in the investment's future success. By aligning the goals of both parties, the earnout structure facilitated the successful completion of the deal.

Review: What do M&A advisors do?

Get expert guidance for structuring a successful earnout 

When structured properly, earnouts can be transformative in M&A transactions. They provide flexibility and shared incentives, helping buyers and sellers navigate valuation challenges and align their goals, but also require careful planning and execution.

At Boopos, we specialize in tech M&A advisory, offering tailored support to ensure smooth and rewarding transactions. Talk to an advisor today. 

Earnouts Frequently Asked Questions

What happens if the business doesn’t meet the performance targets?

If the business fails to meet the performance targets on the agreement, the payments are typically not made. However, this outcome is usually outlined clearly in the earnout agreement, so both parties understand the consequences in advance. Sellers should negotiate realistic targets to avoid this situation.

How can sellers ensure they get paid during the earnout period?

Sellers can protect themselves by negotiating safeguards in the earnout agreement, such as:

• Clear and measurable performance metrics to avoid disputes.
• Information rights to track performance and verify targets.
• Escrow accounts or guarantees to ensure funds are available for earnout payments.
  Additionally, dispute resolution clauses can provide a framework to address disagreements if they arise.

Can an earnout be renegotiated after the deal is closed?

Earnouts are legally binding agreements, so renegotiation after closing is uncommon and often challenging. However, in exceptional cases, both parties may agree to adjust terms if circumstances change significantly, such as unforeseen market conditions or operational disruptions. Sellers and buyers should anticipate potential scenarios during negotiations to minimize the need for renegotiation.

Are earnouts only used for tech or digital businesses?

No, earnouts can be used in a wide range of industries. Any business with significant growth potential or valuation uncertainty could benefit from an earnout structure.

What’s the typical length of an earnout period?

Earnouts generally last between 1 to 3 years. The duration depends on the complexity of the business and the time needed to achieve the agreed performance metrics. Longer earnouts may carry additional risks for both parties, so the timeline should be carefully considered during negotiations.

Who controls the business during the earnout period?

Control of the business typically shifts to the buyer after the sale closes, but the seller may remain involved in day-to-day operations, especially if their expertise is crucial to meeting earnout targets. The earnout agreement should clarify the seller’s role and responsibilities to avoid conflicts over business decisions.

Are earnout payments taxed?

Yes, earnout payments are usually subject to taxes, but the specifics depend on the tax laws in the relevant jurisdiction. Sellers should consult a tax advisor to understand their obligations and plan for tax-efficient earnout structures.