What is an Earnout?

There is a lot that goes into buying or selling a business. It’s not as simple as agreeing on a purchasing price. Sometimes, the buyer and seller will agree that part of the purchase price will be paid later, depending on how the business performs after closing. This structure is called an earnout.

Earnouts can be useful, especially when there is a gap between what the buyer and seller believe the business to be worth, but they can also lead to major disputes if they are not drafted carefully.

An earnout is a deal structure where the seller receives additional payment after closing, if the business meets certain pre-determined targets. In simpler terms, instead of paying the entire purchase price upfront, part of the purchase price is contingent on future performance.

For example, a buyer might pay $2 million at closing, but if the business hits a certain revenue target within a year, they pay another $200,000.

Earnouts might be used when the value of a business is uncertain. This could be due to recent growth, new contracts, changing market conditions, or disagreements on financial projections.

For buyers, an earnout reduces the risk of overpaying. They don’t have to pay the full amount unless the business performs. For sellers, an earnout means they can potentially receive a higher purchase price than what the buyer was willing to pay at closing.

Earnouts can be helpful in closing a deal, but only when they are used correctly. The best earnouts are specific, measurable, and realistic. They define the target, formula, timeline, and a process for resolving any disputes.