Earn-outs in PE deals

An earn-out is a deal structure where part of the purchase price for a company is deferred and paid later, contingent on the acquired company hitting agreed performance targets. Instead of paying the seller 100% of the price at closing, the buyer pays, say, 80% upfront and 20% in year 2 or 3 if revenue, EBITDA, or a specific milestone is achieved. Earn-outs are common in M&A where buyer and seller cannot agree on price, where the business depends heavily on the founder continuing to operate it, or where the target has uncertain near-term performance. They are particularly common in PE acquisitions of founder-owned businesses, where the seller is staying on to run the company post-deal and has meaningful influence over whether the earn-out pays out.

That is the textbook answer. Here is what actually happens.

Why earn-outs exist

Earn-outs solve a specific problem: the buyer and seller disagree about what the business is worth, and one side is not willing to take the other's valuation on faith.

The seller believes the business is worth $100m based on growth they expect over the next 2 years. The buyer is willing to pay $80m for what they can see today but needs proof of the growth before paying more. The earn-out bridges the gap: $80m at close, plus up to $20m more if specific milestones are hit.

From the seller's perspective, the earn-out is optional optionality. If the business performs as they believe, they get the full $100m. If it does not, they keep the $80m and the buyer keeps the risk of overpayment.

From the buyer's perspective, the earn-out is a hedge. They only pay the incremental $20m if the business actually demonstrates the performance the seller claimed. The buyer's risk is contained.

In theory, both sides should be happy.

In practice, earn-outs are one of the most litigated structures in M&A.

The structural components

Every earn-out has four moving parts.

The metric. What triggers payout. Common choices are revenue, EBITDA, specific milestone achievements (FDA approval, customer contract signing), or some combination. Each has pros and cons.

Revenue is simplest to measure but creates perverse incentives (the seller can discount aggressively to hit revenue targets, sacrificing margin).

EBITDA better aligns with profitable growth but creates arguments about add-backs and cost allocations.

Milestone achievements (common in healthcare and tech deals) are binary and less ambiguous.

The target. What level of the metric triggers payout. Usually structured as a range: partial payout at a threshold, full payout at a higher number, with linear scaling in between. The precise calibration of this range is where negotiation happens.

The period. Over what time frame the performance is measured. Typical earn-out periods are 1-3 years. Longer periods increase uncertainty for both sides. Shorter periods favor the buyer, because the business has less time to demonstrate the claimed growth.

The protections. What the buyer does, or does not do, during the earn-out period. Sellers want commitments that the buyer will not actively harm the business's ability to hit targets. Buyers want freedom to run the combined entity. This is where most disputes start.

The classic failure mode

A founder sells her company to a PE firm for $60m at close plus up to $15m earn-out based on EBITDA growth over the next 2 years. She stays on as CEO.

Year 1 goes fine. The business grows as expected.

Year 2 starts slowly. The PE firm's operations team comes in and insists on implementing their standard cost-cutting playbook: new ERP system, headcount changes, renegotiating vendor contracts. These investments are necessary for the long-term plan but they increase short-term costs and disrupt operations.

EBITDA falls short of the earn-out target by $3m.

The founder argues that the PE firm's operational interventions caused the shortfall. The PE firm argues that the shortfall was driven by factors outside their control and that the standard ops playbook is part of running the business normally.

The earn-out agreement has a "no material adverse operational change" clause, but the threshold for triggering it is ambiguous. The founder did not hit her target. The PE firm does not pay the earn-out.

The founder sues. The litigation drags on for 18 months. The founder eventually settles for a fraction of the earn-out in exchange for releases and waivers.

This pattern is so common that sophisticated seller-side lawyers now push for extensive protective covenants during earn-out periods. Sophisticated buyer-side lawyers resist them. The negotiation consumes a lot of deal-closing energy.

Why PE firms like earn-outs

From the PE buyer's perspective, earn-outs are useful in several scenarios.

Founder-dependent businesses. The business is heavily reliant on the founder's relationships, reputation, or operational involvement. An earn-out keeps the founder engaged during the critical transition period and aligns their interest with the business continuing to perform.

Pre-acquisition performance uncertainty. The company has just won a big contract, or is about to launch a new product, or is pending a regulatory approval. The earn-out lets the buyer avoid paying for uncertain value until it materialises.

Valuation gap bridging. The seller insists on a price the buyer cannot justify based on demonstrated performance. An earn-out lets both sides walk away feeling they won.

Tax and working capital arbitrage. In some jurisdictions, earn-outs have tax advantages for the buyer (deductibility of the contingent consideration) and the seller (capital gains treatment if structured right). Not tax advice, but this is often a factor.

Why sellers push back on earn-outs

From the seller's perspective, earn-outs are often seen as worse than a simple lower price.

The seller is giving up certainty for uncertainty, and the uncertainty is largely controlled by the buyer. The buyer decides how to run the business during the earn-out period. The buyer decides what to spend on capex, new hires, sales and marketing. Each of those decisions affects the earn-out metric, and the buyer has economic interest in reducing the earn-out payment.

The seller is often still working in the business during the earn-out, but as an employee or minority shareholder, not as an owner. Their incentives are misaligned, their authority is reduced, and their relationships with the new ownership team are new.

Experienced sellers (repeat entrepreneurs, private-company veterans) negotiate earn-outs down hard or avoid them entirely. First-time sellers (founders of a single business) are more willing to accept them, and are more often disappointed by the outcome.

The structural mismatch

Here is the underlying tension in most earn-out disputes.

The seller's goal during the earn-out period is to maximise the specific metric the earn-out is measured against, regardless of the long-term implications for the business.

The buyer's goal during the earn-out period is to optimise the long-term business value, which may require short-term investments that depress the earn-out metric.

Both goals are reasonable. They are also directly opposed.

A well-structured earn-out tries to align them, but perfect alignment is not achievable. Every earn-out contains some residual mismatch.

This is why earn-outs work best when: - The founder does not care deeply about the earn-out payment (they are already wealthy) - The metric is hard to manipulate by buyer-side interventions - The earn-out period is short (1-2 years max) - The business is stable and not undergoing significant transformation

The 2025/2026 picture

Earn-outs are increasingly common in the current market because the bid-ask gap between PE buyers and private-company sellers has widened.

In 2021, cash-at-close deals were common because buyers had plentiful cheap debt and sellers had plentiful exits. Today, buyers have more expensive debt and less certainty, while sellers have been watching valuations drift down and are not willing to accept the new normal.

Earn-outs bridge that gap, for better and worse. The "better" is that they let deals happen that would not otherwise happen. The "worse" is that they embed future disputes into deals, and the coming 18-24 months will produce a lot of earn-out litigation.

What to watch for in an earn-out deal announcement

When you see a PE deal announcement that mentions "contingent consideration" or "earn-out", the useful questions are:

What percentage of total deal value is in the earn-out? 10-20% is normal and digestible. Above 30% suggests the buyer and seller disagreed significantly on valuation.

What is the metric? EBITDA-based earn-outs with significant add-back flexibility are bad for sellers. Revenue-based earn-outs are simpler but create perverse incentives. Milestone-based earn-outs are cleanest.

Who is staying on? If the founder is staying on as CEO during the earn-out, the structure is roughly aligned. If the founder is leaving immediately, the earn-out is much harder to hit.

What protections does the seller have? Covenants around not changing the business materially, maintaining existing comp structures, preserving customer contracts. The stronger these protections, the better for the seller.

The closing take

Earn-outs are a common deal tool, and they work well in some scenarios and badly in others. They are particularly common in PE acquisitions of private companies because the valuation gaps between buyer and seller are wide, and both sides want a mechanism that lets them walk away feeling they got a fair deal.

The mechanism is fair in principle. The execution is where it gets messy. Most earn-out disputes come down to judgment calls about whether the buyer's operational decisions during the earn-out period were "normal course of business" or "material adverse changes".

If you are a founder considering a PE offer with an earn-out, the practical advice is: discount the earn-out by 30-50% when comparing to cash-at-close deals. In the actual outcomes of most earn-outs, you get less than modelled. Factor that in up front.

For other PE deal structures that come up in founder-owned company acquisitions, see dividend recapitalisations, sale-leasebacks, and the rest of the toolkit. For the bigger picture of how PE firms approach private-company acquisitions, start with what is private equity.