“Navigating the Earnout Game: How to Win in M&A Deals”

### **What is an Earnout and How to Structure One That Works**

An earnout is a performance-based bonus paid out over time, typically after the sale of a business. It is a contractual arrangement where a portion or all of the purchase price is contingent upon the target company achieving certain performance milestones. This structure is commonly used in M&A transactions to bridge valuation gaps, manage risk, and motivate sellers to ensure a smooth transition[2].

#### Key Elements to Consider When Structuring an Earnout

1. **Total Purchase Price**:
– The total amount to be received by the seller, which can be set equal to the seller’s ask or at 70% to 80% of the seller’s ask[1].

2. **Up-Front Payment**:
– A portion of the purchase price paid upfront, reducing the contingent portion.

3. **Contingent Payment**:
– The portion of the purchase price tied to performance milestones, such as revenue growth, customer retention, or EBITDA.

4. **Earnout Period**:
– The duration for which the earnings are measured, typically ranging from one to three years.

5. **Performance Metrics**:
– Specific targets that must be achieved, such as revenue growth or customer acquisition metrics[2].

6. **Measurement and Payment Methodology**:
– How earnings are calculated and paid, including the frequency of payments and corresponding payment triggers[2].

7. **Target/Threshold and Contingent Payment Formula**:
– The formula defining the earnout payment structure, including any thresholds or multipliers[1][2].

#### Types of Earnouts

1. **Performance-Based Earnouts**:
– Incentivize the seller to achieve specific performance targets post-acquisition, such as revenue growth or adjusted EBITDA[4].

2. **Milestone-Based Earnouts**:
– Contingent on the achievement of specific predefined milestones, such as product launches or regulatory approvals[4].

3. **Profit-Based Earnouts**:
– Focus on financial performance metrics like EBITDA, serving as a protective measure for buyers against potential overpayments[4].

#### Benefits of Earnouts

– **Valuation Flexibility**: Earnouts help close valuation gaps by adjusting payments to actual performance[4].
– **Risk Mitigation**: By linking payments to performance, buyers can reduce risk associated with high valuations in uncertain markets[4].
– **Enhanced Seller Commitment**: Sellers have a vested interest in the company’s success, as their earnings depend on meeting specific targets[4].
– **Improved Negotiations**: Earnouts provide a structured framework for contingent payments, benefiting both parties[4].
– **Increased Alignment**: An earnout structure creates a win-win scenario where financial interests of both the buyer and seller align[4].