What is Earnout Clause? Plain English Explanation
Definition
An earnout clause ties part of the purchase price in an acquisition to the future performance of the business. The seller receives additional payments if the business hits certain targets after the sale closes.
Why It Matters in Contracts
Earnouts sound fair in theory but are often structured to benefit the buyer. The buyer controls the business post-acquisition and can make decisions that make it harder to hit earnout targets, effectively reducing the purchase price.
Real-World Example
A founder sells their company for $5 million upfront plus a $3 million earnout if revenue exceeds $10 million in the next two years. The acquiring company reassigns key salespeople, making the target nearly impossible to hit.
What to Watch For
- 🔴Targets that the buyer can manipulate through business decisions
- 🔴Accounting methods that differ from historical practices
- 🔴No obligation for the buyer to operate the business in good faith
- 🔴Earnout tied to metrics the seller cannot influence post-acquisition
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Disclaimer: This glossary entry is for educational purposes only and does not constitute legal advice. Consult a qualified attorney for guidance on your specific situation.