Earn-Outs in M&A Explained: Contingent Consideration

Key takeaways

An earn-out defers part of the purchase price and makes it contingent on the target hitting agreed performance targets after completion — usually over one to three years. It exists for one reason: the buyer and seller cannot agree on value, because the seller is pricing growth the buyer will not pay for upfront. The earn-out lets the seller prove the forecast and get paid only if it materialises
The metric is the entire negotiation. A revenue earn-out is hard to manipulate but rewards growth that may be unprofitable; an EBITDA earn-out aligns with value but is the most disputed number on the income statement, because the buyer who now controls the business can suppress it with cost allocations; a milestone earn-out — a regulatory approval, a contract win — is binary and clean to verify but lumpy
The structural flaw is a control problem: after completion the buyer runs the business, but the seller's payment depends on how it performs. The buyer has a direct incentive to manage the earn-out down — defer revenue, load group overhead, invest for the long term at the expense of the measured period — which is why earn-outs are among the most litigated clauses in private M&A and why the protective covenants matter more than the formula
Under IFRS 3, contingent consideration is fair-valued at acquisition and a liability-classified earn-out is remeasured through the income statement each period — but if the payment is conditional on the seller staying employed, it is not consideration at all: it is post-combination remuneration, expensed against earnings. Misjudging that line restates the deal economics, which is exactly why it is tested

An Earn-Out Exists Because the Price Could Not Be Agreed

A buyer and a seller sit across a £40m gap. The buyer values the business at £100m on its current £10m of EBITDA — ten times earnings. The seller wants £140m, because next year EBITDA will reach £14m, and fourteen times the current number is what the future is worth. Both are looking at the same business and pricing two different things: the buyer prices what exists, the seller prices what is coming.

An earn-out resolves that standoff by refusing to resolve it. Instead of settling on a number, the parties agree the buyer pays £100m now and a further amount later — but only if the growth the seller promised actually arrives. The disagreement about the future is converted from a price the buyer has to pay today into a bet the seller has to win tomorrow. The seller keeps the upside it believes in; the buyer stops paying for a forecast it does not.

That makes an earn-out the natural sibling of the pricing mechanics that fix a deal price, and the most useful way to see it is against them.

It Prices the Future, Where Locked-Box and Completion Accounts Price the Present

The locked-box and completion accounts mechanisms both answer the same narrow question: what is the business worth on the day it changes hands, given the cash and working capital it holds. They argue over a balance sheet that already exists. An earn-out argues over a balance sheet that does not exist yet — the one the business will produce in a year or two — and that single difference changes the entire risk profile.

A completion-accounts dispute is bounded: the numbers are real, the period is closed, an expert can rule on them. An earn-out dispute is open-ended, because the thing being measured is still being created by the buyer who has an interest in how it turns out. Pricing the present is an audit; pricing the future is a wager on a game one side now referees.

The phrase that matters: "the seller is being paid on a business it no longer controls" This is the fault line under every earn-out. At completion the seller hands over the keys, and from that moment the buyer decides how the business is run — what it spends, where revenue is booked, how group costs are allocated, whether it invests for next year or harvests for this one. Yet the seller's final payment depends on the very number those decisions move. Every protective covenant in an earn-out exists to constrain a buyer who is being asked not to act in its own short-term interest. Read the earn-out clause and you are reading a negotiation over control, not over price.

Hold that control problem in view, because it decides which metric the parties are willing to write the cheque against — and the metric is where the real negotiation happens.

The Metric Is the Whole Fight: Revenue, EBITDA or Milestone

An earn-out is only as good as the number it pays on, and there are three families of number, each trading measurability against alignment with value. Choosing one is not an accounting preference — it decides who can game the structure and how hard.

Metric	Measurability	Manipulation risk	Aligns with value?	Where it fits
Revenue	High — top line is hard to distort	Seller-side: chase low-margin sales to hit the number	Weak — rewards growth even if unprofitable	Early-stage, pre-profit, or where margin is stable
EBITDA	Low — the most judgement-laden line on the P&L	Buyer-side: cost allocations, overhead, investment timing	Strong — it is what the multiple was paid on	Established, profitable businesses
Milestone	Highest — binary, objectively verifiable	Lowest — it either happened or it did not	Depends — value of the event must be pre-agreed	Pharma approvals, key contract wins, regulatory clearances

Revenue is clean to measure but pays for the wrong thing: a seller staying on can flood the top line with discounted, loss-making sales that hit the earn-out target and damage the business the buyer just bought. EBITDA fixes the alignment — it is the number the multiple was applied to — but it reopens every argument that a Quality of Earnings exercise ever had, now with the buyer controlling the inputs. Milestones sidestep both problems by being binary, but only suit businesses whose value turns on discrete events.

Insider tip The metric maps directly onto who is more likely to cheat, and the covenants follow the cheat. On a revenue earn-out the buyer drafts protections against the seller stuffing the channel — quality-of-revenue tests, clawbacks on returns, minimum-margin floors. On an EBITDA earn-out the seller drafts protections against the buyer suppressing the number — frozen accounting policies, a bar on allocating group overhead into the target, agreed treatment of capex and bonuses. Naming which side the covenants are defending against, given the metric, is what tells an interviewer you understand an earn-out as an incentive system rather than a formula.

A Worked Earn-Out: How the £40m Gap Gets Bridged

Return to the £100m-versus-£140m standoff and structure the bridge. The buyer pays £100m at completion. The earn-out pays a multiple of the EBITDA growth above the current £10m baseline, capped so the buyer never pays more than the seller's own £140m number.

1. Baseline and upfront: £100m for £10m EBITDA. The buyer pays ten times the current, proven earnings on day one. Everything above this is contingent — the seller has been paid for the present, not the forecast.

2. The formula: 10× the EBITDA growth above £10m. For every £1m of EBITDA the business adds above the baseline in the earn-out year, the seller earns a further £10m — the same multiple the buyer paid upfront, so growth is valued consistently.

3. The cap: £40m. The earn-out cannot exceed £40m, which is reached at £14m of EBITDA (10 × £4m of growth). The cap means the buyer's total outlay tops out at exactly the seller's £140m ask — the buyer never pays more than the seller's own valuation, only confirms it.

4. The outcome splits the bet. Hit £14m and the seller collects the full £40m for a £140m total — the forecast is vindicated and paid. Stall at £10m and the earn-out is zero, the deal settles at £100m, and the buyer is proved right. The forecast risk sat with the seller the entire time.

That is the mechanism working as intended: the buyer pays for growth only when it appears, and the seller is rewarded for being right. The problem is that the number deciding all of it — earn-out-year EBITDA — is produced by a business the buyer now runs, and a single accounting decision can move it.

Common mistake Assuming the formula determines the payout. It does not — the inputs to the formula do, and the buyer controls them. Suppose the business genuinely earns £14m, but the buyer allocates £2m of group head-office cost into the target during the earn-out year. Measured EBITDA falls to £12m, the growth above baseline drops from £4m to £2m, and the earn-out collapses from £40m to £20m. A £2m bookkeeping allocation has just saved the buyer £20m. This is why the earn-out schedule freezes accounting policies and bars group cost allocations — and why an earn-out without those covenants is a trap dressed as a price.

£20m The earn-out swing from a single £2m cost allocation — half the contingent payment erased by an accounting choice the buyer controls. The 10× multiple that makes the structure fair on the way up also magnifies every manipulation on the way down, which is why the covenants matter more than the formula

The Control Problem Is Why Earn-Outs Are Litigation Magnets

The £20m swing is not a loophole; it is the structure. An earn-out asks the buyer to run, for one to three years, a business in a way that maximises a payment to someone else — and no amount of goodwill survives that incentive. The buyer wants to integrate the target, cut duplicated cost, invest for the long term and book revenue where it suits the group; every one of those rational acts can depress the earn-out number. The seller, conversely, wants the business ring-fenced and harvested for short-term metrics, whatever that does to its health after the earn-out ends.

So the earn-out schedule becomes a charter of operating constraints. It typically requires the business to be run in the ordinary course and substantially as before, freezes the accounting policies used to compute the metric, bars the buyer from allocating group costs into the target or diverting its revenue elsewhere, restricts integration that would distort the measure, and gives the seller information rights to audit the calculation. The better drafted these are, the smaller the fight — but they can never be complete, because no contract can anticipate every operating decision over three years.

Insider tip The single most contested word in an earn-out is "ordinary". A covenant to run the business "in the ordinary course" is meant to stop the buyer gaming the metric, but it also handcuffs the buyer from doing the very things it bought the business to do — restructure, integrate, reinvest. A sophisticated buyer narrows the covenant to specific prohibited acts rather than a vague good-faith standard, because a vague standard is an open invitation to litigate. A seller wants the opposite: the broadest possible duty of good faith, because it catches conduct the specific list missed. Where that line settles tells you who had the leverage in the deal.

The IFRS 3 Trap: When an Earn-Out Is Not Price but Pay

The accounting carries a distinction that changes the deal economics, and it catches candidates who treat an earn-out as obviously part of the price. Under IFRS 3, contingent consideration is measured at fair value at the acquisition date and included in the cost of the acquisition. Where it is classified as a liability, it is remeasured to fair value each period, and the movement runs through the income statement — so as the target outperforms and the expected earn-out rises, the buyer books a charge against its own earnings for a payment it is happy to make.

The trap sits one step deeper. If the earn-out is conditional on the seller remaining employed — paid only if the founder stays and forfeited if they leave — it is not consideration at all. Accounting standards treat a payment contingent on continued employment as remuneration for post-combination services, expensed over the service period rather than added to the price of the business. A £30m "earn-out" that the founder forfeits by resigning is, in substance, a £30m retention bonus, and it lands on the P&L as cost, not on the balance sheet as goodwill.

P&L Where an employment-linked earn-out lands — expensed as remuneration, not capitalised as deal consideration. The same £30m sits in completely different places depending on a single clause about whether the seller can walk away with it, which is why structuring the forfeiture condition is a deliberate accounting choice, not a detail

That technical line is why an earn-out is never just a number bolted onto the price — its structure decides whether it is price or pay, and the answer reshapes both the buyer's reported earnings and the seller's tax. Which is the same reason it is one of the cleaner ways an interviewer separates candidates who have read about deals from those who have priced one.

How This Is Tested: "How Would You Bridge a Valuation Gap?"

The question rarely names the earn-out; it describes the standoff — a seller who wants more than the buyer will pay — and asks how to close it. An earn-out is one answer among several, and the strong candidate names the alternatives before reaching for it: a vendor loan note, where the seller lends part of the price back and is repaid with interest; rollover equity, where the seller reinvests into the deal and shares the future as an owner rather than a creditor; or plain deferred consideration, a fixed sum paid later and certain, contingent on nothing.

The earn-out is the right tool only when the gap is specifically about future performance the seller can influence and the buyer doubts. The weak answer stops at "use an earn-out". The strong answer picks the metric and defends it.

Interview framing Asked how you would structure the bridge, start by locating the disagreement: if it is about whether the forecast growth is real, an earn-out fits; if it is about the founder staying motivated, rollover equity fits better, because it makes them an owner rather than a counterparty. Then choose the metric and justify it from the manipulation risk — milestone if the value turns on a discrete event, because it is binary and unarguable; EBITDA if it is an established profitable business, but only with frozen accounting policies and a bar on group cost allocations, because otherwise the buyer controls your number; revenue only if margins are stable, because otherwise the seller chases unprofitable sales. Close on the covenant that polices it and the cap that bounds the buyer's downside. Naming the cost-allocation risk and the "ordinary course" covenant unprompted is what signals you have seen an earn-out fought over, not just defined.

The Verdict: An Earn-Out Is a Bet, Not a Bridge

An earn-out is sold as a clever way to align a buyer and seller who disagree on value. It is more honest to call it what it is: a failure to agree a price, deferred into a future dispute. The disagreement does not get resolved at signing — it gets postponed, relabelled as a performance target, and handed to a buyer who now controls the outcome and a seller who can only watch and audit. The alignment is real on the way up and adversarial the moment the metric softens.

That does not make it wrong, but it sets the rule for using it. An earn-out is at its best when the metric is binary and outside the buyer's control — a regulatory approval, a named contract — because then there is nothing to manipulate and little to dispute. It is at its worst on an EBITDA target after the seller has left, because the seller is then being paid on a number the buyer produces and has every incentive to shrink. Between those poles, the quality of the earn-out is the quality of its covenants, not the elegance of its formula. A clean formula on weak covenants is a lawsuit with a payment schedule attached.

Careers: An Associate Models the Earn-Out and Then Polices It

On a live deal the earn-out is not the lawyers' clause the deal team watches from a distance — it is a number the associate owns twice. First in the model: the earn-out is a contingent line in sources and uses and a future cash outflow that has to be probability-weighted into returns, because an earn-out the seller hits is real money leaving the LBO in year two. Then in the deal itself: the associate builds the EBITDA bridge the earn-out is measured against, helps draft the accounting-policy schedule that freezes it, and — once the business is owned — defends the firm's calculation when the seller's advisers audit it a year later.

That second job is where the misalignment becomes someone's actual week. The seller will read every cost allocation as an attempt to suppress their payment, and the associate is the one reconciling the management accounts to the earn-out definition line by line. The clause that looked like a formula at signing is, by the earn-out date, a forensic accounting exercise with millions riding on the answer.

Anyone can say an earn-out "pays the seller if the business performs" — that is the brochure. The judgement is knowing what it is for: that it does not resolve a price disagreement, it defers one, and it hands the deciding number to the side with the incentive to shrink it. The metric you choose decides who can cheat, the covenants decide whether they can, and the IFRS line decides whether it is price or pay. Reading the schedule that way — as an incentive system the buyer now controls — is the difference between someone who has seen a deal and someone who has seen a glossary.

Take Your Preparation Further

An earn-out sits on top of the pricing and diligence machinery, so read it alongside the pieces it plugs into. Start with Locked-Box vs Completion Accounts, since an earn-out is the same pricing problem extended into the future, then Quality of Earnings, because the EBITDA an earn-out pays on is the same number a QoE normalises. For the gap an earn-out bridges, the EV-to-Equity Bridge sets the price it adjusts, and Management Equity covers rollover, the alternative when the goal is to keep the founder invested. For where the contingent payment lands, the LBO model, and for where the clause sits in the timeline, The M&A Process.

For the process map this mechanism plugs into, download our free M&A Process Cheat Sheet, and for the full set of PE interview questions and model answers — including how to reason about deal structuring under pressure — see the PE Interview Masterclass.

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Earn-Outs: How a Contingent Price Bridges a Valuation Gap — and Why It Usually Just Defers the Fight