What is an earnout and how does it work in M&A?

  • Posted by: Frédérique Pardon

An earnout is a deal structure in M&A where part of the purchase price is paid after closing, contingent on the acquired business hitting agreed performance targets. It bridges the gap between what a buyer is willing to pay today and what a seller believes the business is worth. The sections below break down how earnouts work, when they make sense, and how to avoid the disputes they can trigger.

How does an earnout payment get calculated?

An earnout payment is calculated by measuring actual post-closing performance against pre-agreed targets and applying a formula to convert that performance into a cash payment. The formula typically multiplies the achieved metric by a fixed rate, or pays a set amount for each milestone reached within a defined period.

The most critical design decision is choosing the right performance metric. Common options include:

  • Revenue: Straightforward to measure, but easier for a buyer to influence through pricing decisions or channel shifts
  • EBITDA: Reflects profitability, though it can be affected by post-acquisition cost allocations
  • Gross profit: A middle ground that captures top-line growth while filtering out some cost manipulation risk
  • Non-financial milestones: Product launches, regulatory approvals, or customer retention rates, common in tech and life sciences deals

The payment structure itself can be linear (a percentage of every euro above a threshold), tiered (different rates at different performance levels), or binary (full payment if a milestone is hit, nothing if it is not). Each approach has different risk profiles for both sides, and the choice should reflect how predictable the target business’s performance actually is.

When do buyers and sellers agree to use an earnout?

Buyers and sellers agree to use an earnout when there is a genuine valuation gap that neither side can close through negotiation alone. This typically happens when a seller’s projections are optimistic, the business has limited trading history, or future value depends heavily on events that have not yet occurred.

Several deal situations make earnouts particularly common:

  • Early-stage or high-growth companies where most of the value is in future potential rather than current earnings
  • Founder-led businesses where the seller’s continued involvement is essential to realising that potential
  • Deals in uncertain markets where macro conditions make it hard to agree on a fair multiple
  • Acquisitions with pending milestones such as regulatory approvals, contract renewals, or product launches

From a buyer’s perspective, an earnout reduces upfront risk and aligns the seller’s incentives with post-closing performance. From a seller’s perspective, it offers a path to a higher total price, provided the business performs as expected. The structure only works, however, when both sides genuinely believe the targets are achievable and measurable.

What are the most common earnout structures in M&A deals?

The most common earnout structures in M&A deals are revenue-based earnouts, EBITDA-based earnouts, and milestone-based earnouts. Each serves a different purpose and suits different types of businesses and deal contexts.

Revenue-based earnouts

Revenue earnouts are the simplest and most widely used. The seller receives additional payments if the business hits revenue targets over one to three years post-closing. They work well when revenue is easy to track and both parties trust that the buyer will not artificially suppress it through pricing changes or product decisions.

EBITDA-based earnouts

Profitability earnouts tie payments to EBITDA or gross profit. They give buyers more protection against a seller chasing revenue at the expense of margins, but they introduce complexity around how costs are allocated post-acquisition. Sellers need to negotiate carefully to ensure the buyer cannot load the acquired entity with costs that reduce the earnout payout.

Milestone-based earnouts

Milestone earnouts are common in sectors like biotech, software, and professional services, where value creation is tied to specific events rather than financial run rates. A payment might be triggered by a regulatory approval, a signed enterprise contract, or a product reaching general availability. These structures work best when the milestone is binary, clearly defined, and outside the buyer’s ability to delay or obstruct.

What risks do earnouts create for sellers?

Earnouts create significant risks for sellers because, after closing, the buyer controls the business and therefore controls many of the factors that determine whether targets are met. A seller who accepts an earnout is effectively betting on a future they no longer manage.

The most serious risks include:

  • Operational interference: A buyer may change pricing, redirect resources, or restructure the business in ways that make the earnout targets harder to hit, even if those decisions make strategic sense for the combined entity
  • Accounting disputes: Revenue recognition policies, cost allocation, and intercompany charges can all affect the earnout metric in ways that were not anticipated at signing
  • Integration decisions: If the acquired business is merged into the buyer’s operations quickly, isolating the performance of the original entity for earnout measurement becomes difficult or impossible
  • Delayed payment or non-payment: Buyers may dispute calculations, leading to costly and time-consuming disagreements that can drag on for years

Sellers should treat every earnout as a negotiation that continues after closing. The protections built into the deal agreement are the only real safeguard once the transaction is complete.

How can earnout disputes be prevented in the deal agreement?

Earnout disputes can be prevented by defining the measurement mechanics with extreme precision in the deal agreement, leaving as little room for interpretation as possible. Most disputes do not arise from bad faith; they arise from ambiguity that both sides interpreted differently at the time of signing.

Practical protections to include in the agreement:

  • Accounting definitions: Specify exactly how the earnout metric will be calculated, including which accounting standards apply and how any post-acquisition cost allocations will be treated
  • Operational covenants: Require the buyer to operate the business in a way that gives the earnout a fair chance, such as maintaining the existing sales team, not redirecting key customers, or preserving the product roadmap
  • Reporting rights: Give the seller access to monthly or quarterly financial reports during the earnout period, along with the right to audit the calculation
  • Dispute resolution mechanism: Agree in advance on an independent expert or arbitration process to resolve disagreements quickly, rather than defaulting to litigation
  • Acceleration clauses: Include provisions that trigger full earnout payment if the buyer sells the business, merges it, or takes actions that make measurement impossible

The more specific the agreement, the less room there is for a dispute to develop. Vague language around “reasonable efforts” or undefined accounting terms is where most earnout litigation originates.

What’s the difference between an earnout and a deferred payment?

The key difference between an earnout and a deferred payment is conditionality. A deferred payment is a fixed amount that will be paid at a future date regardless of performance. An earnout is a variable amount that is only paid if the business meets specific targets after closing.

A deferred payment is essentially a financing arrangement. The buyer owes the seller a defined sum, and the only question is timing. It carries no performance risk for the seller, though it does carry credit risk if the buyer’s financial position deteriorates before the payment date.

An earnout, by contrast, is inherently uncertain. The seller may receive the full amount, a partial amount, or nothing at all, depending on how the business performs. This makes earnouts more complex to negotiate and more contentious to administer, but also more useful when there is a genuine disagreement about future value.

In practice, some deals combine both structures: a portion of the price is deferred on a fixed basis, while another portion is contingent on performance. This gives the seller more certainty on a baseline amount while preserving upside if the business outperforms.

How Greyt helps with earnouts and M&A deal structuring

Earnouts are one of the most technically demanding elements of any M&A transaction. Getting the structure right requires financial modelling, accounting expertise, and a clear view of how post-closing operations will affect the metrics that trigger payment. That is exactly where we add value.

When we support clients through M&A transactions, we work from a CFO perspective across the full deal lifecycle through our M&A expert advisory services:

  • Deal structuring: We help define earnout metrics, thresholds, and formulas that are realistic, measurable, and defensible from both sides of the table
  • Financial due diligence: We validate the assumptions behind projected performance, so both buyers and sellers enter the earnout period with a shared understanding of what the numbers mean
  • Agreement review: We identify ambiguous language and accounting definitions that could create disputes later, before the deal is signed
  • Post-closing support: We help track performance against earnout targets and flag issues early, so problems can be resolved before they escalate

Our five-phase M&A methodology runs from financial due diligence and deal evaluation through strategy, evaluation, transaction execution, and post-deal integration, covering every stage where earnout risk can emerge. Whether you are a founder preparing for an exit, a CFO evaluating an acquisition, or a private equity team managing a portfolio transaction, we bring the financial discipline to make the deal work, not just close.

If you are navigating an M&A process and want a clear view of how to structure or evaluate an earnout, get in touch with our team.

Frequently Asked Questions

How long do earnout periods typically last, and what duration should sellers push for?

Earnout periods most commonly run between one and three years post-closing, though deals in sectors like biotech or SaaS can extend to five years when value depends on long-cycle milestones. Sellers generally benefit from shorter periods, since the longer the earnout runs, the more exposure they have to buyer-driven operational changes that can affect performance. As a rule of thumb, the earnout period should be long enough to capture a meaningful performance cycle but short enough that the seller retains some leverage in the relationship.

Can a seller negotiate protections if the buyer integrates the acquired business too quickly?

Yes, and this is one of the most important protections a seller can push for. The deal agreement should include explicit covenants restricting how quickly the buyer can merge the acquired entity into its own operations, particularly if that integration would make it impossible to isolate the earnout metric. Some agreements include a standalone operation clause requiring the buyer to maintain the business as a separate unit for the duration of the earnout period, along with acceleration provisions that trigger full payment if integration happens ahead of schedule.

What happens to the earnout if the acquiring company is sold or changes ownership before the earnout period ends?

This scenario is a significant risk for sellers and must be addressed explicitly in the deal agreement before signing. Without a specific clause, a change of control at the buyer level can leave the earnout in legal limbo, with no guarantee the new owner will honour the original terms. Well-drafted agreements include an acceleration clause that triggers full earnout payment upon a subsequent sale, merger, or change of control of the buyer, ensuring the seller is not left exposed by events entirely outside their control.

Is an earnout ever a red flag, and when should a seller walk away from one?

An earnout can be a red flag when it is being used by the buyer to shift all valuation risk onto the seller rather than bridge a genuine disagreement. If the upfront payment is very low and the majority of the deal value sits in the earnout, the seller should scrutinise whether the targets are realistically achievable under the buyer's control. Sellers should also be cautious when the buyer resists including operational covenants or audit rights, as this often signals an unwillingness to give the earnout a fair chance.

How should founders who are staying on post-acquisition think about earnout targets versus their employment terms?

Founders who remain with the business after closing need to ensure their employment terms and earnout obligations are clearly separated and do not conflict. A buyer may set aggressive earnout targets while simultaneously limiting the founder's authority to make the decisions needed to hit them, which creates a frustrating and often unwinnable position. Founders should negotiate for clearly defined decision-making authority, adequate budget, and a direct link between their operational autonomy and the metrics they are being held accountable for during the earnout period.

What are the tax implications of receiving an earnout payment, and do they differ from the upfront consideration?

The tax treatment of earnout payments can differ meaningfully from the upfront purchase price, and this varies depending on jurisdiction, deal structure, and how the earnout is characterised — for example, whether it is treated as additional sale proceeds or as compensation income. In some cases, payments received by a selling founder who remains employed may be reclassified as employment income rather than capital gains, which carries a significantly higher tax rate. Sellers should engage a tax adviser early in the negotiation process to model the after-tax value of different earnout structures before agreeing to terms.

What financial records and reporting systems should a seller have in place before entering an earnout period?

Sellers should ensure their financial reporting systems are robust, well-documented, and capable of producing the specific metrics defined in the earnout agreement before the deal closes. This means having clean management accounts, a clear revenue recognition policy, and ideally a financial model that maps actual performance to the earnout formula in real time. Gaps in reporting infrastructure discovered after closing are difficult to fix and can leave the seller unable to effectively challenge a buyer's earnout calculation, even when the underlying performance supports a higher payment.

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