Earnouts in PE Deals — Structuring Guide

When a buyer and seller cannot agree on price, an earnout bridges the gap. The buyer pays a base purchase price at closing and additional consideration if the business achieves specified post-close financial targets. In the 2025-2026 deal environment, where the bid-ask spread remains wide, earnouts have become an increasingly common structuring tool.

When Earnouts Are Used

Earnouts are most common in situations where future performance is genuinely uncertain:

High-growth companies: A SaaS business growing 40% annually may be worth 15x revenue if growth continues, but only 8x if it decelerates. An earnout lets both parties share the risk.
Founder-dependent businesses: If the founder is leaving post-close and customer relationships are concentrated, the buyer is uncertain about revenue retention.
Turnaround situations: The seller believes their recent operational improvements will drive margin expansion. The buyer wants to see proof before paying for it.
Regulatory uncertainty: If a pending regulatory approval could significantly impact the business, an earnout defers payment until the outcome is known.

How Earnouts Are Structured

Key structural elements include:

Metric selection: The most common metrics are revenue, EBITDA, and gross profit. Revenue is preferred by sellers because it is harder for the buyer to manipulate post-close. EBITDA is preferred by buyers because it captures profitability.
Measurement period: Typically 1-3 years post-close. Shorter periods favor sellers (less time for buyer interference); longer periods give the buyer more protection.
Threshold and cap: Earnouts usually have a minimum threshold (no payment below $X in EBITDA) and a maximum cap (no payment above $Y). Some structures use a linear interpolation between threshold and cap.
Payment timing: Earnout payments are typically made within 60-90 days after the measurement period ends and financials are audited.

A simplified example: Base purchase price of $400M. Earnout of up to $100M, payable if trailing twelve-month EBITDA exceeds $55M within 24 months of closing. If EBITDA reaches $50M, no earnout. If EBITDA reaches $60M, full $100M is payable. Linear interpolation between $55M and $60M.

The Seller's Dilemma

Sellers face a fundamental problem with earnouts: once the deal closes, the buyer controls the business. The buyer can take actions that depress earnout metrics:

Accelerating expenses: Loading costs into the earnout measurement period to suppress EBITDA.
Revenue diversion: Shifting revenue to other entities or deferring contracts past the measurement period.
Changing accounting policies: Altering revenue recognition or expense capitalization practices.
Operational interference: Making management changes, restructuring sales teams, or altering pricing strategies.

To protect against these risks, sellers negotiate covenants requiring the buyer to operate the business in the ordinary course during the earnout period. Some agreements include specific protections such as maintaining headcount, preserving pricing, and requiring seller consent for material operational changes.

The Buyer's Challenge

Buyers face their own complications:

Integration constraints: Operating the business in "ordinary course" during the earnout period can delay necessary integration activities and synergy realization.
Accounting complexity: Earnout liabilities must be marked to fair value on the balance sheet under ASC 805. Changes in the estimated earnout payment flow through the P&L as non-cash adjustments, creating earnings volatility.
Dispute risk: Earnout disputes are among the most litigated issues in M&A. Approximately 30-40% of earnouts result in some form of dispute.

Modeling Earnouts

When building a financial model that includes an earnout, consider:

Probability-weighted scenarios: Model the earnout payment under base, upside, and downside scenarios. Assign probabilities to each and calculate the expected value.
Discount rate: The earnout payment is uncertain and deferred. Discount it at a rate reflecting the risk — typically higher than the cost of equity.
IRR impact: Include the earnout payment in your sources and uses. A $100M earnout paid in year 2 changes the equity check at closing and affects the return timeline.
Tax treatment: Earnout payments may be treated as additional purchase price (capital) or compensation (ordinary income) depending on structure. The tax characterization affects the seller's net proceeds.

Best Practices for 2026

Given the current market environment:

Keep it simple: The more complex the metric, the more likely a dispute. Revenue or gross profit over a 12-18 month period is the cleanest structure.
Independent accounting: Specify that earnout calculations will be reviewed by an independent accounting firm, with binding arbitration for disputes.
Milestone-based alternatives: Instead of financial metrics, some deals use operational milestones (product launches, customer renewals, regulatory approvals) that are binary and harder to dispute.
Acceleration provisions: Include acceleration triggers for events like a change of control during the earnout period, ensuring the seller is not disadvantaged by a quick flip.