When earnouts are used
Earnouts appear most commonly in four situations. Disagreement on future performance: a growth-stage company’s seller projects aggressive growth; the buyer is more conservative. An earnout splits the difference — the seller gets paid more if they are right. Founder-dependent businesses: when a company’s value depends heavily on the founder or key management remaining and continuing to drive growth, an earnout aligns their incentive with business performance post-close. Distressed or uncertain businesses: when the business has material uncertainty (regulatory approval, pipeline product launch, key contract renewal), the earnout allocates risk between parties based on outcome. Private company M&A: earnouts are rare in public company acquisitions (too complex to implement at scale) but common in SME and mid-market private deals.
The disputes that earnouts create
Earnouts are a prolific source of post-closing litigation. The fundamental problem: once a business is acquired, the buyer controls its strategy and operations — creating scope for the buyer to manage the acquired business in ways that reduce earnout payments without technically breaching the contract. Does the buyer direct sales resources away from the acquired business to its own competing products? Does it allocate shared costs to the acquisition that weren’t present pre-deal? Does it pursue integration moves that disrupt the business’s sales momentum? These disputes can be genuine or manufactured, but the frequency of earnout litigation has led sophisticated sellers to negotiate protective provisions: "buyer shall operate the business in the ordinary course," explicit limits on cost allocations, and sometimes a separate management structure during the earnout period.
“An earnout is a bet between parties who disagree about the future. If they agreed, there would be no need for one. If they agree too easily on the structure, somebody has miscalculated.”
What this means for you
Earnouts are a deal structure tool, not a valuation methodology — they allocate risk rather than determine total value. For sellers, the key negotiating points are: choosing metrics that are difficult for the buyer to game (revenue over EBITDA; gross margin over net income); limiting buyer operational control that could affect performance; clear accounting definitions to avoid disputes; and independent arbitration mechanisms if targets are disputed. For buyers, earnouts reduce upfront payment risk on uncertain businesses but create management complexity and relationship strain if targets are missed. The best earnouts are short (1–2 years), use simple unambiguous metrics, and are structured realistically enough that both parties believe they are achievable.