Earnout

What is an earnout?

An earnout is a contractual provision in a business sale that makes part of the purchase price contingent on the business achieving specified future performance targets. Instead of one lump-sum payment, the buyer pays an upfront amount and additional payments only if agreed metrics—such as revenue, gross sales, net income, or EBITDA—are met over a defined period.

How an earnout works

• Buyer pays a base purchase price at closing and promises contingent payments if future targets are reached.
• Targets are defined in the purchase agreement and may be measured over one or several years.
• Payments are typically made in cash but can also be in stock or other consideration.
• The earnout can apply to the seller, former owners who remain involved, or other key employees.

Common earnout structures and terms

Key elements to negotiate and document clearly:
* Performance metrics: revenue, adjusted EBITDA, net income, customer retention, etc.
* Measurement period: length of the earnout (often 1–3 years, but can vary).
* Payment mechanics: timing, form (cash vs. stock), and calculation method.
* Accounting assumptions: which accounting standards apply and any adjustments (e.g., reserves, return allowances).
* Management and retention: roles the seller or key employees will have after closing and incentives to remain.
* Operational covenants: buyer commitments (e.g., maintain product lines or marketing support) that affect the seller’s ability to hit targets.
* Dispute resolution: clear procedures for resolving disagreements (audits, arbitration) to reduce litigation risk.

Advantages

• Bridges valuation gaps between buyer and seller by sharing future performance risk.
• Reduces buyer’s upfront cash exposure and aligns payment with realized results.
• Motivates sellers (or retained executives) to support post-acquisition performance.
• Can allow sellers to spread tax liabilities over multiple years.

Disadvantages and risks

• Potential for post-closing disputes over calculations, accounting choices, or buyer conduct that affects results.
• Sellers may have reduced control and depend on buyer actions to achieve targets.
• Buyers may be reluctant to operate the business in ways that maximize earnout payments.
• Complex deals incur higher legal and advisory costs.
• Sellers risk receiving less than expected if targets are missed.

Example (high level)

A large acquisition might pay a base price plus tiers of contingent payments tied to cumulative earnings. For example, additional payouts could scale from $0 at low outcomes up to large sums at high-performance tiers, aligning the total purchase price with how well the acquired business performs post-close.

Accounting and tax treatment

• Accounting: Under IFRS, if an earnout is considered part of the purchase consideration it is measured at fair value at the acquisition date and included in goodwill. If it represents compensation for services after closing, it is expensed in post-combination financial statements.
• Tax: Tax treatment depends on characterization. If the earnout is treated as part of the purchase price, it may be taxed as capital gains. If treated as compensation for services, it is taxed as ordinary income.

Earnout vs. holdback

• Earnout: Deferred payment tied to future business performance or milestones.
• Holdback (or escrow): A portion of the purchase price retained for a defined period to cover indemnity claims, post-closing adjustments, or liabilities—generally not tied to performance.

Practical tips

• Define metrics, accounting rules, and dispute-resolution mechanisms in detail to minimize ambiguity.
• Build protections for both parties: covenants that prevent the buyer from sabotaging performance and seller obligations that define required involvement.
• Consider tiered payouts and cap amounts to balance risk and reward.
• Engage experienced legal, tax, and valuation advisors to draft and negotiate the earnout.

Conclusion

Earnouts are a flexible tool to bridge valuation differences and align incentives between buyers and sellers. When well-structured with clear metrics, accounting rules, and governance, they can share risk and reward effectively. Poorly drafted earnouts, however, often lead to disputes—so precise documentation and professional advice are essential.