Definition - What does Earnout mean?
An earnout is a financing arrangement for the purchase of a business in which the seller finances a portion of the purchase price, and payment of this amount is contingent on achieving a predetermined level of future earnings. An earnout is often used to bridge a valuation gap. The seller only gets paid if the predetermined level of future EBITDA or other financial targets are achieved.
Divestopedia explains Earnout
Say a seller has a valuation expectation of $15 million, but the buyer thinks a purchase price of $12 million is more appropriate. The gap of $3 million might be bridged by an earnout. The seller could get paid $1 million per year only if a certain EBITDA target is achieved in each of the next three years following the sale.
An earnout can be negotiated, as it is simply another contractual term of the deal. That being said, an earnout will typically range between 10% to 50% of the total purchase price, and will usually not extend past three years.
Earnouts can be negative for sellers if they are not properly defined at the letter of intent stage and/or properly managed throughout the earnout period. While they can produce a higher total purchase price, they are often used by sophisticated buyers to put the risk of future performance back on the seller. They are particularly challenging to measure if the acquired company will be integrated with the buyer's operations during the earnout period. Integration makes it harder to define whether the additional EBITDA was contributed by the acquired company, or as a result of synergies from working within the buyer's overall operations.