Quick answer: An earnout is a part of the purchase price that the buyer pays after closing, and only if the business meets agreed targets such as revenue, gross profit, EBITDA or customer retention. Buyers use earnouts to bridge a gap between what they will pay today and what the seller believes the business is worth. Sellers should value an earnout below its face amount, because it depends on results that the buyer, not the seller, will largely control.
Key points
- An earnout is a way to share risk. The buyer pays for performance it has seen, and the seller is paid for performance that has not happened yet.
- The metric matters more than the headline amount. Revenue, gross profit and EBITDA each give the buyer and the seller different room to influence the result.
- After closing, the buyer controls the company. Operating covenants, accounting rules and information rights in the agreement are what protect the seller’s ability to earn the payment.
- Value the earnout as a probability-weighted, time-discounted amount and compare it with the cash offered at closing. Certain cash and contingent cash are different things.
What an earnout is
Most of the price in a business sale is paid in cash at closing. An earnout changes that for a portion of the price. The buyer agrees to pay an additional amount later, but only if the business achieves a result that both sides write into the agreement. The result is often a revenue or profit target, and it is measured over a period that begins at closing.
The technical name is contingent consideration, which simply means payment that depends on a future event. In practice, an earnout is a negotiated answer to a disagreement: the seller believes the business will do well, the buyer is not certain, and the earnout lets each side rely on its own view.
Why buyers propose them
Buyers do not suggest earnouts to be difficult. They use them in recognizable situations.
- A valuation gap. The seller wants a price based on projected results, and the buyer will pay for historical ones. An earnout pays the difference if the projections come true.
- Concentration. A large share of earnings comes from one or two customers. The buyer ties part of the price to keeping them. The customer concentration guide explains the underlying risk.
- Owner dependence. The business relies on the owner, and the buyer wants the owner to stay engaged and the results to hold. The guide to key-person risk covers this.
- A turnaround or recent change. Earnings have recently improved, or a new product or contract has not yet shown results, and the buyer wants to see them continue.
- Limited financing. The buyer cannot or will not pay the full price in cash at closing, and shifting part to the future improves its financing position.
Understanding why the buyer proposed the earnout tells the seller what to ask for. If the concern is customer retention, an earnout measured on the customer relationship answers it directly, while a broad EBITDA target adds risk the seller cannot control.
The choice of metric
The metric is the most consequential decision in an earnout. Each option favors one side.
| Metric | What it measures | Strength | Weakness |
|---|---|---|---|
| Revenue | Sales in the period | Simple to measure and hard to manipulate | Does not protect the buyer if growth is bought at low margin |
| Gross profit | Sales less direct costs | Captures pricing and product mix | Depends on how costs are classified |
| EBITDA | Operating profit before financing and depreciation | Matches how the price was set | The buyer controls overhead, allocations and investment decisions |
| Retention or milestones | Specific customers kept, contract signed, product launched | Directly tied to the concern | May be binary, so a narrow miss pays nothing |
Sellers generally prefer measures near the top of the business, such as revenue or gross profit, because there are fewer decisions between the seller’s efforts and the number. Buyers prefer EBITDA because it is what they are paying for. A common compromise uses gross profit, or EBITDA with tightly defined rules for what is charged to the acquired business.
Structures that change the result
Beyond the metric, the shape of the payment matters.
All-or-nothing versus sliding scale. A cliff structure pays the full amount if the target is reached and nothing if it is missed by a small margin. A sliding scale pays in proportion to performance between a floor and a cap. Sellers usually favor the sliding scale, because it avoids a total loss from a narrow miss.
Annual versus cumulative measurement. Measuring each year separately means a bad year cannot be offset by a good one. Measuring cumulatively over the whole period allows the seller to make up a shortfall. Sellers often ask for a catch-up provision.
Cap and floor. A cap limits what the buyer will pay. A floor guarantees a minimum, which makes that portion closer to a deferred payment than an earnout.
Acceleration. If the buyer sells the business or changes its control during the earnout period, the agreement can require the remaining payments to be made immediately or the new owner to assume the obligation.
Set-off. The buyer may want the right to deduct indemnification claims from earnout payments. That turns the earnout into security for the seller’s promises and increases the seller’s risk.
Protecting the ability to earn it
After closing, the buyer decides how to run the company. It can change pricing, reassign staff, merge the business with another or cut spending in ways that help the buyer overall but reduce the measured result. The seller’s protection is in the written terms.
- Operating covenants. A promise to operate the business in good faith, to maintain the conditions needed to reach the target and not to take actions designed to avoid the payment.
- Separate accounting. A requirement to keep books for the acquired business, using the same accounting policies as in the financial statements the price was based on.
- Clear definitions. Precise language on what counts as revenue or EBITDA, how overhead is allocated and how one-time items are treated.
- Information rights. The right to receive the calculations and the supporting records, and time to review them.
- Dispute process. A defined path, often an independent accountant, for resolving disagreements about the calculation.
- Payment security. Whether the earnout is subordinated to the buyer’s lenders, whether it is backed by a guarantor and what happens if the buyer defaults.
- Treatment of the seller’s role. What happens to the earnout if the seller is removed from a role after closing. Agreements treat this differently.
Illustrative example: Valuing an earnout against cash at closing
Two offers are made for a business with adjusted EBITDA of $2,700,000. Offer A is $15,500,000 in cash at closing. Offer B is $16,200,000 in total, made up of $13,500,000 at closing and a $2,700,000 earnout paid two years after closing if EBITDA reaches an agreed target.
A seller who thinks there is a 60 percent chance of reaching the target, with the payment received two years after closing, can compare the offers by weighting the earnout. Using an illustrative discount rate of 10 percent, the expected present value of the earnout is about $1,340,000, so Offer B is worth about $14,840,000 on this basis. Offer A is worth more even though its headline is lower. If the seller believes the chance is 90 percent, the earnout is worth about $2,010,000 and Offer B is worth about $15,510,000, which is roughly equal. The probabilities, discount rate and amounts are invented to show the method and are not benchmarks.
How to evaluate an offer with an earnout
A practical comparison has four steps.
- Separate the certain from the contingent. The amount paid at closing, plus any deferred amount that is not tied to performance, is the baseline.
- Estimate the chance of success honestly. Look at the target against recent results, the seller’s control over the drivers, and what the buyer plans to do with the business.
- Adjust for time and risk. A payment received in two years is worth less today, and a contingent payment is worth less than a certain one.
- Check the terms that determine whether the payment is real. The covenants, definitions and security often matter more than the target.
A valuation prepared before the process can help here. It shows the range of defensible prices and the reasons a buyer might offer less, which lets the owner decide how much of a gap is worth bridging with contingent payment and how much should be cash. The overview of transactional valuation explains that analysis.
Alternatives that share some features
Earnouts are one of several tools for deferring or conditioning part of the price. Rollover equity and seller notes serve related purposes with different risks, and they are covered in the guide to rollover equity and seller notes. Escrows and holdbacks protect the buyer against specific claims rather than measuring performance. Reading the structure term by term is part of reviewing a letter of intent, and the letter of intent guide lists where these terms usually appear. The calculation of what the owner finally receives is set out in the bridge from enterprise value to equity value.
Frequently asked questions
Why would a buyer propose an earnout?
Usually because the buyer and seller disagree about the future. The seller expects growth, a new contract or a recovery, and the buyer is not willing to pay in full for something that has not yet happened. An earnout also reduces the buyer’s risk when the business depends on a few customers or on the owner, because part of the price is paid only if the risk does not materialize.
Is an earnout better or worse than a lower price paid in cash?
Neither by itself. A higher headline price with an earnout can be worth more than a lower cash price if the targets are realistic and the seller has a fair chance of reaching them. It can be worth less if the targets are hard to reach, the buyer controls the outcome or the payment is not secured. Compare the two on a risk-adjusted basis.
How long do earnouts usually last?
They commonly run for a year or two after closing, and some run longer. A shorter period reduces the seller’s exposure to events it cannot control, and a longer period gives the buyer more time to see whether a risk was real. The right length depends on how long it takes to find out the thing the earnout is meant to measure.
Can the buyer reduce my earnout by running the business differently?
It can try to, and that is why the agreement matters. Sellers negotiate operating covenants that restrict actions taken mainly to avoid the payment, requirements to keep separate books for the acquired business, and rights to receive financial information and dispute calculations.
Are earnout payments taxed the same way as the closing payment?
Not necessarily. The treatment depends on how the deal is structured, whether the payment is tied to the seller’s continued employment and how it is characterized in the agreement. Ask a tax advisor to review the structure before signing, because the same dollar can be taxed differently.
Need a valuation you can use in a sale or acquisition decision?
The Impetus Group prepares transactional valuations from the standpoint of strategic and financial buyers. A valuation is a standalone engagement with its own scope and fee, and it can be the first step before a sale or acquisition process.
Related guides
- Customer Concentration and Valuation: How Buyers Price the Risk: Why buyers pay less for businesses that depend on a few customers, how they measure concentration, and what owners can do to reduce the discount before a sale.
- Key-Person Risk: How Owner Dependence Affects Valuation: How buyers measure owner dependence, why it lowers value and shapes deal structure, and what an owner can change in the years before a sale to reduce it.
- Rollover Equity and Seller Notes: Deferred Consideration Explained: Rollover equity and seller notes defer part of a sale price. Learn how each works, how their risks differ and what to ask before accepting either.
- How to Read a Letter of Intent: The Terms That Decide What You Receive: A plain-language guide to the letter of intent in a business sale: price, structure, working capital, exclusivity, diligence and the terms that move your proceeds.
- From Enterprise Value to Equity Value: What the Owner Receives: Enterprise value is the price of the business. Equity value is what owners receive after debt, debt-like items, cash and working capital. See the bridge.
- Transactional Valuation: What It Is and How It Works: A transactional valuation estimates what a strategic or financial buyer would pay for a business. Learn what goes into one and how it differs from an appraisal.
This guide is general education. It is not a valuation opinion, appraisal, investment advice, or legal or tax advice. How these guides are made.