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Earnout

What is an Earnout?

An Earnout is a contractual agreement in mergers and acquisitions (M&A) where the seller of a company receives additional future compensation based on the business achieving specific performance targets after the deal closes.

In simple terms, part of the payment is delayed and conditional — the seller "earns" it only if the company does well post-acquisition.

Why Use an Earnout?

Earnouts help bridge valuation gaps between buyers and sellers. If the buyer isn’t fully convinced the business is worth the price the seller wants, an earnout lets them:

  • Pay less upfront.
  • Reward the seller if the company meets or exceeds expectations later.
  • Reduce the buyer’s risk if the company underperforms.

How an Earnout Works?

  1. The buyer and seller agree on:
  • Performance metrics (e.g., revenue, EBITDA, profit, user growth).
  • Time frame (typically 1–3 years).
  • Payout structure (fixed amounts, percentages, or bonuses).

  1. After the deal closes, the acquired company operates under the buyer.

  2. If the agreed metrics are achieved, the seller receives the earnout payment.

Example

A tech company is acquired for ₹100 crore:

  • ₹70 crore paid upfront.
  • ₹30 crore earnout based on hitting ₹50 crore in annual revenue within 2 years.

If the company hits the revenue target, the seller gets the ₹30 crore. If not, they may get nothing or a partial amount.

Benefits of Earnouts

1. For Buyers:

  • Risk Mitigation: Reduces the chance of overpaying.
  • Incentivizes Performance: Keeps key founders or managers motivated.
  • Cash Flow Friendly: Smaller upfront capital outlay.

2. For Sellers:

  • Higher Potential Payout: Can earn more if the business grows.
  • Shows Confidence: Demonstrates belief in the company’s future performance.

Risks and Challenges

  1. Disputes Over Metrics
    Performance targets can be subject to interpretation or manipulation.

  2. Lack of Control
    Sellers may have less influence over operations post-acquisition, affecting performance.

  3. Complex Structuring
    Earnouts can become legally and financially complicated.

  4. Trust Issues
    Misalignment between buyer’s management goals and seller’s earnout goals can lead to conflict.

Best Practices for Structuring an Earnout

  • Use clear, measurable metrics.
  • Define calculation methods in detail.
  • Set reasonable timelines (usually 1–3 years).
  • Outline dispute resolution mechanisms.
  • Decide on seller’s involvement post-deal.