Earnouts: paying for a forecast
Pay for today's earnings now, and for the seller's forecast only if it is delivered.
- Separate the headline price from the expected price
- Calculate a straight-line earnout payout from actual EBITDA
- Find the probability at which an earnout offer beats a rival cash bid
- Find the EBITDA that earns a set share of the earnout
The intuition
You are selling your car and swear it does 50 miles to the gallon. The buyer does not believe you. So you agree: they pay $10,000 now, and another $2,000 in a year if the car really does 50. If it does 45, they pay part of it. You get your price if you are right; they pay it only if you are.
An earnout does the same in a company sale. The seller prices next year's EBITDA; the buyer prices last year's. The buyer pays for last year upfront and promises more, the earnout, if next year's number arrives.
Headline price = upfront + the maximum earnout. Expected price = upfront + probability × maximum. The seller announces the first; the buyer underwrites the second.
Why it works
- The conventions here: one earnout, measured on next year's EBITDA. Nothing is paid below a threshold, the full amount at or above the target, and a straight line in between. Expected values use one probability of hitting the full target and nothing otherwise. No discounting.
- The buyer pays the high price only when it is cheap. If the earnout pays in full, EBITDA is higher, so the headline price is a lower multiple of the new EBITDA.
- A straight line beats a cliff. All-or-nothing invites a fight over the last dollar of EBITDA; a line makes every dollar worth the same to both sides.
- The seller carries the risk on a number the buyer controls. After closing, the buyer decides pricing, hiring, capex and cost allocation, all of which move EBITDA. Earnouts are among the most disputed clauses in private M&A.
- Against a rival all-cash bid, the earnout offer wins in expectation only if the seller's confidence beats the breakeven probability, and even then many sellers take the certain cash.
| Upfront: 50 × 8 | 400 |
| Headline: 400 + 80 | 480, or 9.6x |
| Expected: 400 + 40% × 80 | 432, or 8.64x |
| EBITDA comes in at 57: (57 − 51) ÷ (60 − 51) | 66.7% earned, so 53.3 paid |
| Rival cash bid of 440: (440 − 400) ÷ 80 | 50% breakeven probability |
| EBITDA for half the earnout: 51 + 50% × 9 | 55.5 |
The formulas
What gets announced.
What the buyer underwrites.
How far along the line EBITDA got.
The confidence needed to prefer the earnout.
Run the line backwards.
Worked example
Add the whole earnout for the headline, and the probability-weighted earnout for the expected price.
See it move
Same company and the same offer. Change the multiple paid upfront, the chance of hitting the target, where the threshold and target sit, and what EBITDA actually does.
- Raise the chance of hitting the target. The expected price climbs toward the headline; the headline does not move.
- Raise actual growth. Nothing is paid until EBITDA passes the threshold, then the payout rises in a straight line until it is capped.
- Raise the threshold or the target. The same actual EBITDA earns less of the earnout, or the same.
- Raise the upfront multiple. Every price grows, but the breakeven probability against the rival does not move.
Run it backwards
Same company, reversed: a rival offers more cash and no earnout. How confident must the owners be of hitting the target to prefer the earnout offer?
The earnout offer is worth upfront + probability × maximum. Set that equal to the cash bid: the probability is the gap between the two upfront amounts divided by the maximum earnout.
Expectation is not the whole answer. Certain cash carries no risk of a dispute over how EBITDA was measured, so sellers often want a probability well above breakeven.
Traps
Say it in the interview
“What is an earnout, and when would you use one?”
Check yourself
4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.
Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.
- Headline = upfront + maximum; expected = upfront + probability × maximum.
- Payout = maximum × (EBITDA − threshold) ÷ (target − threshold), capped.
- Breakeven probability = (rival bid − upfront) ÷ maximum.
- The buyer controls the number; define it tightly.