Exploring earnouts and their use in SF acquisitions

Yale Case. By: Robin Mohapatra / Niel Wyma / A. J. Wasserstein

This Yale case analyzes how earnouts are used in ETA and SF transactions. Earnouts are mechanisms that make part of the purchase price contingent upon future performance, for example, linking extra payments to revenue or EBITDA growth. They can be powerful tools to bridge valuation gaps between buyers and sellers, but they are also complex and can lead to serious misalignments if poorly structured.

An earnout is a contractual clause that allows a seller to receive additional consideration after closing if specific milestones are achieved. In ETA deals, earnouts are often used to reconcile differing expectations about the target’s future performance: sellers tend to be optimistic, while buyers and investors are more cautious.

For instance, a seller claiming future growth might accept an earnout instead of being paid upfront for uncertain results. In this way, earnouts serve as an elegant compromise, allowing a transaction to close when parties disagree on valuation.

However, in SF acquisitions, the dynamic is different from traditional PE deals. Legacy management usually steps aside and a first-time CEO takes over, which raises control, incentive, and trust issues that can complicate earnout execution.

1/ Alternatives to earnouts

The authors recommend that ETA buyers explore simpler substitutes before turning to earnouts:

1. Escrows: part of the purchase price is held by a third party to protect against breaches of warranties or hidden liabilities. Safe but not performance-related.
2. Seller Notes: deferred payments with interest that act like subordinated loans. They bridge financing gaps but offer no upside.
3. Rolled Equity: the seller keeps an ownership stake, aligning incentives with the buyer’s success, though it may lead to governance frictions.

Often, a well-structured acquisition combines these instruments, for instance, a mix of escrow for warranties, a seller note for deferred payment, and a small earnout tied to performance.

2/ Why buyers and sellers use earnouts

Buyers’ motives:

• Close deals faster: Earnouts can bridge valuation gaps when negotiations stall.
• Share risk: They protect buyers from overpaying if projections fail to materialize.
• Reduce upfront cash needs: Earnouts act as contingent seller financing.
• Defer payment: Buyers benefit from the time value of money since most earnouts don’t accrue interest.

Sellers’ motives:

• Potential upside: Earnouts act like “free options” that reward strong future performance.
• Tax advantages: Taxes are often deferred until the earnout is paid.
• Boost headline price: Sellers can claim a higher “sale value,” even if much of it is contingent.
• Confidence in new leadership: Sellers may trust the incoming CEO to grow the company and make the earnout achievable.

3/ Best practices for earnout design

To avoid disputes and unintended consequences, earnouts must be crafted carefully. The case highlights several best practices:

1. Choose the right trigger metric: Common options are revenue, gross profit, or EBITDA. Each has pros and cons. For example, revenue targets may encourage sellers to chase unprofitable sales, while EBITDA-based targets can create tension if the buyer makes post-close investments that temporarily reduce profit.
2. Define the payment currency: Earnouts can be paid in cash, equity, or seller notes. Equity promotes alignment but adds governance complexity; notes delay cash outflows but add debt-like features.
3. Set an appropriate duration: Shorter periods (12–24 months) reduce uncertainty and conflict. Longer periods can create friction as market conditions and management strategies evolve.
4. Plan funding in advance: Even contingent payments require preparation. CEOs should model full payout scenarios to ensure liquidity and avoid breaching debt covenants when the earnout becomes due.

4/ Pitfalls and misalignments

Earnouts are not risk-free. The authors identify 4 major pitfalls:

1. Buyer–seller misalignment: Different time horizons and control expectations often lead to conflict.
2. Hidden costs and legal disputes: Earnouts are “agreements to sue later,” as one saying goes. Monitoring and enforcing them can consume time, money, and goodwill.
3. Unclear operational control: Sellers with ongoing influence may resist new strategies that could jeopardize their earnout.
4. Weak dispute resolution procedures: Vague or subjective earnout language almost guarantees future litigation.

ETA entrepreneurs should include clear governance terms, objective metrics, and predefined arbitration processes to manage these risks.

5/ Common misconceptions

The case also debunks several myths:

• “Earnouts are free.” False: every dollar paid to the seller reduces capital available for growth or debt repayment.
• “They don’t affect valuation.” They do; if the earnout is likely to be paid, it increases the effective multiple.
• “A bigger business means the earnout was worth it.” Not necessarily: growth may have occurred anyway, making the earnout a hidden overpayment.
• “They’re easy to operationalize.” In reality, measuring and agreeing on results is complex and often leads to tension.

6/ Real case example

The case closes with the experience of Jacobo Vera Artazcoz, founder of Arcadio Investments, who used an earnout to acquire Libnova, a Spanish SaaS firm. The earnout helped him close the deal without overpaying for optimistic projections. However, defining fair metrics (moving from EBITDA to ARR) proved difficult, and the seller’s emotional attachment to the business led to post-close friction. His key lesson: plan the separation terms as carefully as the partnership itself.

Conclusion:

Earnouts can be valuable tools for bridging valuation gaps and facilitating deals in the ETA world, but they come with significant complexity. They require disciplined design, transparent communication, and strong legal structures.

SF entrepreneurs should use earnouts sparingly, only when simpler alternatives fail, and treat them as temporary bridges, not permanent solutions. A well-crafted earnout can make a deal happen; a poorly structured one can turn a partnership into a prolonged dispute.

Read the full case in: https://som.yale.edu/sites/default/files/2025-09/Exploring%20Earnouts%20and%20Their%20Use%20in%20Search%20Fund%20Acquisitions.pdf