What are earnouts and how do they affect deal pricing?

Full Explanation

Earnouts bridge valuation gaps: buyer and seller disagree on fair value. Solution: buyer pays base price (buyer's estimate), seller gets additional payment (earnout) if targets are hit. Example: seller wants £100M; buyer offers £80M. Earnout structure: £80M upfront + up to £20M earnout if revenue grows 20% annually for 3 years. This aligns seller and buyer incentives: seller stays motivated to support integration and growth; buyer reduces downside risk if projections miss. Earnout mechanics are critical: how are targets defined (revenue, profit, customer retention)? Who controls the operating decisions that affect targets? Disputes are common: seller claims buyer sabotaged growth; buyer claims seller was overly optimistic. For valuations, earnouts affect entry pricing: a deal at £100M base value with £20M earnout potential is really priced at £100M minimum, £120M maximum depending on execution. Financial reporting: the buyer records the earnout as a liability (accrued expense) and adjusts goodwill if targets are hit. For companies considering acquisition, earnouts can be attractive if you're confident in hitting targets: you get certainty of deal (base price) plus optionality (earnout upside). For buyers, earnouts are protective: if post-acquisition performance disappoints, they avoid overpaying.

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