Definition. A portion of the purchase price paid to the seller contingent on the business hitting specified financial or operational targets in the period after close. Common in lower-middle-market transactions where the buyer and seller cannot agree on the headline price; the earnout bridges the gap by tying a portion of payment to outcomes.
Earnouts are common and contentious. Sellers typically receive less of the earnout than they expect, for three reasons: the earnout targets are usually set at levels the buyer can manage downward through operational decisions after close; the metrics chosen are often manipulable (revenue is the most manipulable, EBITDA less so, gross profit dollars are typically the least manipulable); and the period of the earnout is the period in which the buyer controls the business but the seller’s payment depends on it.
Sellers who must accept an earnout should negotiate the metrics carefully, prefer simpler metrics (gross profit dollars, or unit-based metrics) over complex ones, prefer shorter earnout periods, and prefer earnouts where the seller retains some operational role in the business through the earnout period.