earnouts

Earnouts are a contractual arrangement in which part of the purchase price for a company is contingent on the target achieving defined performance milestones after closing. They are commonly used in mergers and acquisitions to bridge valuation gaps when future prospects are uncertain and to align incentives between buyer and seller.

The earnout typically specifies a measurement period, often one to three years, target metrics such as revenue, EBITDA, or net income, and a formula for calculating the payout. Terms may include caps and floors, and the form of payment can be cash, stock, or a mix. Payouts may be subject to an escrow or holdback to support performance verification.

Administration of an earnout is usually handled by a designated manager, committee, or earnout administrator responsible for calculating results, validating data, and resolving disputes. Clear definitions of accounting standards, revenue recognition, and expense treatment are important to prevent manipulation and disagreements.

Valuation and risk considerations include the seller’s exposure to post-closing performance and the buyer’s risk of overpayment or misaligned incentives. Earnouts can complicate integration and governance and may lead to disputes over measurement, control changes, or extraordinary events outside the target’s control.

Accounting and tax treatment vary by jurisdiction. In many places, contingent consideration is recorded at fair value with subsequent changes recognized in earnings. Tax treatment depends on local rules and the transaction structure and may affect when and how much is taxed. Parties should address audit rights, dispute resolution, and how events such as material restructurings affect targets.

Common pitfalls include vague metrics, inconsistent calculations, and insufficient protections against post-closing changes. Careful drafting and clear economics are essential to reduce risk and preserve deal value.