An earnout is a contractual provision in an acquisition where a portion of the purchase price is contingent on the acquired company achieving specific future performance milestones. This mechanism bridges valuation gaps between buyers and sellers by tying a percentage of the total consideration to measurable outcomes such as revenue targets, EBITDA thresholds, or customer retention rates over a defined period, typically one to three years post-acquisition.
Why It Matters
Earnouts solve one of the most common dealbreakers in M&A transactions: disagreement over company value. When a seller believes their business is worth $10 million based on projected growth while the buyer will only pay $7 million based on current performance, an earnout structure can close the gap. The buyer pays $7 million upfront and commits to an additional $3 million if specific metrics are achieved. This reduces risk for buyers who might otherwise walk away from promising but unproven businesses, while giving sellers the opportunity to capture full value if their projections prove accurate. For angel investors, earnouts are particularly relevant when exiting portfolio companies that show strong potential but lack the track record to command premium valuations.
Example
A SaaS company generates $2 million in annual recurring revenue when acquired. The buyer offers $8 million upfront plus an earnout of $4 million if the company reaches $5 million ARR within 24 months. The founder stays on to drive growth, confident in the company's trajectory. After 18 months, the company hits $5.2 million ARR, triggering the full earnout payment. The seller ultimately receives $12 million total consideration. Had the company only reached $4 million ARR, the earnout might have been prorated to $2 million, resulting in $10 million total. This structure aligned incentives: the buyer reduced upfront risk while the seller had clear motivation to continue building the business post-acquisition.