The Complete Guide to Earnout in M&A: What Every Buyer and Seller Must Know

When bridging valuation gaps in mergers and acquisitions becomes challenging, earnouts (also spelled “earn out”) emerge as one of the most powerful tools in deal structuring. As an M&A solicitor with extensive experience in complex transactions, I’ve witnessed how properly structured earnout provisions can transform seemingly impossible deals into successful completions.

What exactly are earnouts, and how can they benefit both buyers and sellers in M&A transactions? This comprehensive guide explores everything you need to know about earnout payments, their practical implementation, and the critical legal considerations that determine their success. Earnouts are often used to bridge gaps in valuation and expectations between parties, helping to align interests and facilitate agreement.

What Are Earnouts?

An earnout is a contractual provision in a share purchase agreement (SPA) where part of the purchase price becomes contingent upon the target company achieving specific performance milestones post-completion. Rather than paying the entire consideration upfront, the buyer agrees to make additional earnout payments if predetermined earnout targets are met within a specified timeframe. These arrangements can be expanded on within earnout agreements or schedules to the SPA, which set out the terms and conditions for contingent payments.

Earnouts in M&As serve as a bridge between differing valuations. When sellers believe their business will achieve exceptional future performance and buyers remain cautious about paying premium valuations based on projections, earnouts provide an elegant solution that aligns both parties’ interests with actual business outcomes. Earnout agreements can help reconcile differences in the company’s valuation between buyers and sellers, especially when future performance is uncertain.

The earnout mechanism typically involves three core components:

Performance Metrics: These establish the specific earnout targets that trigger additional payments, such as revenue thresholds, EBITDA levels, customer acquisition numbers, or other key financial metrics relevant to the business. As with any contract, the parties are free to agree to whatever metric they want. The earnout metric is a crucial financial measure, such as Adjusted EBITDA, used to determine whether earnout payments are triggered. Selecting clear, objective, and easily verifiable financial metrics is essential to minimise disputes.

Measurement Period: This defines the timeframe during which performance is assessed, commonly ranging from 12 to 36 months post-completion, though longer periods may apply for businesses with extended sales cycles.

Payment Structure: This determines how earnout payments are calculated and distributed, whether as lump sums upon achieving financial milestones or graduated payments based on performance levels. Part of the purchase price is based on achieving these earnout targets, making the structure flexible and performance-driven.

Understanding what are earnouts fundamentally requires recognising their risk-sharing nature. They transfer some acquisition risk from buyers to sellers while providing sellers with upside potential if their confidence in future performance proves justified.

Earnout Structure and Key Elements

An earnout structure is a vital feature of many purchase agreements, designed to align the interests of the buyer and seller by tying a portion of the purchase price to the target company’s future performance. At its core, an earnout arrangement allows both parties to share in the risks and rewards associated with the target business after the transaction closes.

Specific milestones are set within the purchase agreement, outlining the targets the company must achieve to trigger contingent payments. These milestones might include hitting certain revenue thresholds, achieving a minimum level of net income, or reaching other agreed-upon financial or operational goals. The earnout payments themselves are the additional compensation paid to the seller if the target company meets or exceeds these milestones during the earnout period.

By incorporating these key elements, earnout arrangements provide a flexible solution for bridging valuation gaps. They allow the buyer and seller to agree on a base purchase price while leaving room for additional compensation if the business performs as expected. This structure not only helps to bridge valuation gaps but also incentivises both parties to work collaboratively toward the target company’s ongoing success.

How Do Earnouts Work in Practice?

The practical implementation of earnouts requires careful coordination between legal, financial, and operational considerations. During my years structuring these arrangements, I’ve observed that successful earnout mechanisms share several common characteristics.

The earnout calculation process typically begins with establishing baseline performance metrics. These might include the target company’s historical financial performance, market conditions, and realistic growth projections. The earnout amount is determined based on the agreed performance metrics, with specific calculations outlined in the transaction documents to ensure clarity and fairness.

Documentation and reporting procedures form the backbone of earnout administration. The SPA must specify how performance will be measured, who will prepare the relevant calculations, what accounting standards apply, and how disputes over earnout achievements will be resolved. In the event of disagreements over the calculation of the earnout amount, an independent accountant may be appointed to review the financials and make a binding determination. Without precise documentation, even straightforward earnouts can become sources of significant conflict.

Usually, the buyer’s and the seller’s accountants will be heavily involved to make sure that both parties calculate the performance metrics in the same way.

Integration planning becomes crucial when earnouts are involved. Buyers must balance their desire to integrate the acquired company with the need to maintain accurate earnout measurements. If the acquired company’s operations become too intertwined with the buyer’s existing business, calculating earnout metrics can become impossible or meaningless. Accordingly, during the earnout period, the buyer may not be able to make many changes to the target company, and very likely will be prohibited from disposing of its assets as part of a hive-up.

Earnout payments typically follow a structured timeline. Most arrangements involve annual assessments, with payments made within 60-90 days after each measurement period ends. Some sophisticated structures include interim payments based on quarterly performance, providing sellers with more regular earnout income streams.

Performance monitoring requires ongoing collaboration between buyers and sellers. Sellers often retain rights to access financial information, participate in business planning discussions, and receive regular performance updates. This ongoing relationship must be carefully managed to avoid conflicts while ensuring accurate earnout calculations.

The practical success of earnouts often depends on maintaining the target company’s operational independence during the earnout period, with existing management playing a key role in sustaining business performance. Buyers who immediately implement significant operational changes risk disrupting the business performance that earnout payments depend upon.

The measurement period and ongoing obligations typically extend into the post closing phase, requiring both parties to remain engaged and aligned after the transaction is finalised. Earnouts can also facilitate a smooth transition during post-acquisition integration, helping to align interests and maintain stability as the acquired company becomes part of the buyer’s organisation.

Pros and Cons of Earnouts for Buyers

From a buyer’s perspective, earnouts offer compelling advantages while introducing specific risks that require careful management.

Advantages for buyers begin with significant risk mitigation. Rather than paying full consideration upfront based on seller projections, earnouts ensure buyers only pay premium valuations if the business actually delivers promised performance. By holding back part of the purchase price and tying payments to future results, earnouts help reduce the buyer’s risk of overpaying or underestimating the business’s potential. This protection proves particularly valuable when acquiring high-growth companies with limited operating histories or businesses entering new markets with uncertain prospects.

Cash flow management represents another major buyer advantage. Earnouts reduce the initial capital outlay required for acquisitions, preserving buyer resources for operational investments, additional acquisitions, or unexpected challenges. This improved cash flow flexibility can make the difference between completing strategic acquisitions and passing on attractive opportunities.

Earnouts also provide built-in seller motivation. When significant portions of the purchase price depend on post-completion performance, sellers typically remain highly engaged in ensuring business success. This alignment often results in smoother transitions, better customer retention, and more effective knowledge transfer than traditional acquisition structures.

However, earnouts introduce administrative complexity that buyers must manage effectively. Ongoing earnout calculations require dedicated resources, sophisticated accounting procedures, and regular communication with sellers. Many factors must be considered when designing an effective earnout arrangement, including performance metrics, payment schedules, and dispute resolution mechanisms. These administrative burdens can prove costly and time-consuming, particularly for buyers managing multiple acquisitions simultaneously.

Integration challenges present another significant consideration. Buyers may find their integration plans constrained by earnout requirements, as significant operational changes could disrupt the metrics used for earnout calculations. The success of the earnout often depends on the buyer’s strategy for managing the acquired business, as their operational approach and management skills can directly impact performance outcomes. This limitation can delay achieving acquisition synergies or implementing optimal operational structures.

Dispute resolution becomes a recurring concern with earnout arrangements. Despite careful documentation, disagreements over earnout calculations, business performance factors, and buyer conduct during earnout periods frequently arise. These disputes can consume substantial management time and legal resources while damaging relationships with the former business owners who may remain a key employee of the business.

Earnouts may also limit buyer flexibility in business development decisions. Strategic pivots, market exits, or significant investment changes could impact earnout metrics in ways that create conflicts with sellers. Buyers must carefully consider how earnouts might constrain future strategic options.

Pros and Cons of Earnouts for Sellers

Sellers face a different risk-reward calculation when considering earnout structures, with potential for higher overall consideration balanced against increased uncertainty and ongoing business exposure.

The primary seller advantage lies in valuation optimisation. When sellers have strong confidence in future business performance, earnouts can deliver total consideration significantly exceeding what buyers would pay upfront. This upside potential often makes earnouts attractive for sellers of high-growth businesses or companies with strong market positioning.

Earnouts also provide sellers with continued participation in business success and more control. Rather than walking away from a business they’ve built, sellers can benefit from future growth while transferring operational responsibilities to buyers. Further, sellers will retain more control over the business post-completion, as usually the SPA will (1) limit what the buyer can do with the target business during the earnout period, and (2) grant the seller more rights, such as the right to veto certain decision.

Tax planning opportunities may favor earnout structures in certain situations. Depending on jurisdiction and individual circumstances, spreading sale proceeds across multiple years through earnout payments can provide tax advantages compared to receiving full consideration at completion. Clearly defined payment criteria in the SPA can influence the tax treatment of contingent payments, directly impacting the seller’s interest in optimising the structure for favorable tax outcomes. However, tax planning requires careful coordination with qualified advisors.

Risk retention represents the most significant seller disadvantage. Unlike traditional sales where sellers receive full consideration at completion or a portion is deferred but guaranteed, earnouts leave sellers exposed to business performance risks they may no longer have complete control over. Market downturns, buyer mismanagement, or operational challenges can significantly reduce earnout payments regardless of the business’s pre-sale performance. When a seller’s retirement or future plans depend on the business’s ongoing success and decisions made by others, such a situation can create considerable stress and strain on relationships.

Loss of control creates ongoing seller vulnerability. Once completion occurs, buyers effectively gain operational control while sellers retain financial exposure through earnout arrangements. This misalignment can prove frustrating when sellers disagree with buyer decisions that impact earnout performance but lack authority to influence business operations.

Earnout calculations can become sources of significant disputes. Even with detailed SPAs, disagreements over performance measurements, accounting treatments, and buyer conduct frequently arise. Sellers may find themselves investing substantial time and legal fees pursuing earnout payments they believe they’ve earned.

Cash flow uncertainty presents practical challenges for sellers. Unlike immediate consideration payments, earnout income streams remain uncertain until performance periods conclude. In many cases, payments are contingent on a future event, such as achieving specific financial thresholds like EBITDA targets or other conditions only determinable at a later date. This uncertainty can complicate sellers’ financial planning, investment decisions, and retirement strategies.

Bridging Valuation Gaps with Earnouts

Earnouts are a strategic tool for bridging valuation gaps that often arise during M&A negotiations. A valuation gap occurs when the buyer and seller have differing views on the target company’s future performance, leading to disagreements over the appropriate purchase price. This is especially common when the company’s future revenue or profitability is uncertain, or when information asymmetries exist between the parties.

By linking a portion of the purchase price to the achievement of specific targets, earnouts offer a practical way to resolve these differences. The earnout clause in the share purchase agreement sets out the precise milestones—such as revenue, EBITDA, or other performance metrics—that must be met for the seller to receive additional earnout payments. This approach allows the buyer and seller to share both the risks and rewards associated with the target company’s future performance.

Earnout arrangements are particularly effective in situations where the company’s future is difficult to predict, or where the buyer lacks full visibility into the business’s operations. By making part of the purchase price contingent on future results, earnouts help to mitigate risk for the buyer while giving the seller the opportunity to benefit from the company’s growth and success. This structure also facilitates a smoother transition, as both parties remain invested in the target company’s ongoing performance.

Ultimately, earnouts bring clarity and flexibility to the purchase agreement, enabling buyers and sellers to bridge valuation gaps and move forward with confidence—even in the face of uncertainty.

What to Include in the SPA if You Are the Buyer

Buyer protection in earnout arrangements depends heavily on comprehensive SPA provisions, including essential earnout clauses, that address performance measurement, business operations, and dispute resolution mechanisms.

Performance measurement provisions must establish precise calculation methodologies. The SPA should specify exactly which accounting standards apply, how performance metrics will be calculated, and what adjustments may be made for extraordinary items. Vague performance definitions create opportunities for disputes and potential earnout overpayments.

Business operation clauses should preserve buyer flexibility while maintaining earnout integrity. Key provisions include requirements that buyers operate the business in the ordinary course during earnout periods, restrictions on significant operational changes without seller consent, and guidelines for how integration activities will be managed without disrupting earnout calculations.

Financial reporting and access provisions ensure transparency while protecting buyer interests. The SPA should establish reporting schedules, specify what financial information sellers may access, and create procedures for seller review of earnout calculations. However, these access rights must be balanced against buyer needs for operational confidentiality.

Dispute resolution mechanisms require careful structuring to provide efficient conflict resolution. Many successful earnout SPAs include expert determination procedures for calculation disputes, with qualified accountants making binding decisions on earnout amounts. This approach often proves faster and less expensive than traditional litigation while providing specialised expertise. In cross border transactions, it is especially important to address the need for neutral legal frameworks and efficient dispute resolution systems to manage international legal and jurisdictional considerations.

What to Include in the SPA if You Are the Seller

Seller protection in earnout arrangements requires comprehensive SPA provisions that preserve earnout value while providing meaningful recourse when buyers fail to meet their earnout obligations.

Performance measurement protections must prevent buyer manipulation of earnout calculations. Critical provisions include requirements that buyers maintain separate accounting for earnout calculations, specifics on the accounting method to be used, and definitions of key terms. such as the ‘earnout conditions’ that must be met for payments to be made. Without these protections, buyers might inadvertently or deliberately reduce earnout payments through accounting modifications.

Business operation covenants should ensure buyers maintain business performance potential. Key provisions require buyers to operate the business with reasonable commercial efforts, maintain adequate staffing levels, continue marketing and business development activities, and avoid actions that could materially impair earnout performance. These covenants help ensure earnout failures result from genuine market conditions rather than buyer neglect.

Information access rights enable sellers to monitor earnout progress and identify potential issues. The SPA should provide sellers with regular financial reports, access to relevant business records, and rights to discuss business performance with key managers. However, these rights must be structured to avoid interfering with buyer operations or creating confidentiality risks.

Security and guarantee mechanisms provide additional earnout payment protection. Depending on buyer creditworthiness and earnout amounts, sellers might negotiate parent company guarantees, personal guarantees by the directors or shareholders of the buyer entity, or other security interests to ensure earnout payment capability.

Dispute resolution procedures should favor efficient earnout calculation reviews. Many seller-favorable SPAs include expert determination rights, allowing sellers to trigger independent reviews of earnout calculations by qualified professionals.

Change of control provisions address situations where buyers themselves become acquisition targets. If the buyer is sold during the earnout period, sellers should retain earnout rights against the new owner or receive accelerated earnout payments. Without these provisions, seller earnout rights might become effectively worthless following buyer changes of control.

When discussing valuation and payment calculations, it is essential to determine the fair market value of the earnout right or business. This ensures that any earnout payments or acceleration provisions are based on an objective and transparent valuation formula in the SPA.

For tax planning and sale proceeds, sellers should consider whether business asset disposal relief (BADR) may apply to the gain or the earnout right itself, potentially reducing capital gains tax liability.

Regarding tax implications, the classification of contingent payments as income or capital gains will affect income taxes owed by the seller. Clear contractual guidance in the SPA is crucial to ensure the intended tax treatment and minimise unexpected tax liabilities.

Conclusion: Making Earnouts Work for Bridging Valuation Gaps in Your M&A Transaction

Earnouts represent powerful tools for bridging valuation gaps and aligning buyer-seller interests in M&A transactions. However, their success depends entirely on careful structuring, comprehensive documentation, and realistic expectations from both parties.

The key to earnout success lies in balancing competing interests while maintaining practical implementability. Buyers need protection from overpayment risks and operational flexibility, while sellers require meaningful upside potential and protection from buyer misconduct. Achieving this balance requires sophisticated legal drafting, realistic performance targets, and commitment to ongoing collaboration.

As M&A markets continue evolving, earnouts will likely become increasingly sophisticated tools for managing transaction risks while optimising deal outcomes. Success will favour parties who approach earnouts with clear objectives, comprehensive planning, and realistic expectations about both opportunities and challenges.

Malcolm Zoppi is a specialist M&A solicitor with extensive experience in complex acquisition transactions. He regularly advises buyers and sellers on earnout structures, deal negotiations, and post-completion matters across various industries and transaction sizes.