What is an earnout and why do acquirers use them?

Full Explanation

In an acquisition for £20M cash at close, an earnout might add: if combined revenue of buyer + target reaches £50M within 2 years, sellers receive an additional £10M. Earnouts align incentives: sellers are motivated to ensure smooth integration and retention (because their exit proceeds depend on post-close performance); buyers reduce upfront risk (if integration fails, they do not pay full price). For sellers, earnouts are a double-edged sword: they provide upside if the business thrives, but also create risk (integration decisions may be out of the seller's hands, depressing earnout achievement). Earnouts commonly fail because: (1) Integration challenges (buyer mismanages, key customers leave), (2) Earnings manipulation (buyer allocates costs differently, reducing target profit), (3) Buyer/seller misalignment on goals. The EARN acronym helps structure defensible earnouts: Explicit (clear metrics, no ambiguity), Agreed (both parties signed-off on targets), Reasonable (achievable but stretching), and Negotiated (specific escrow, payment terms). Earnouts are common in add-on acquisitions (PE buying smaller competitors) where integration risk is material. Sellers should push for: (1) clear, auditable metrics, (2) seller governance (board seat or advisory role), (3) escrow funds held for earnout payment, (4) sunset provisions (if earnout not achieved within 3 years, sellers receive defined percentage).

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