Earnouts formally called contingent consideration, is a mechanism used in M&A whereby, in addition to an upfront payment, future payments are promised to the seller upon the achievement of specific milestones (i.e., achieving specific EBITDA targets). The purpose of the earnout is to bridge the valuation gap between what a target seeks in total consideration and what a buyer is willing to pay.

Types of earnouts

Earnouts are payments to the target that are contingent on satisfying post-deal milestones. Most commonly the target achieving certain revenue and EBITDA targets. Earnouts around the achievement of non-financial milestones such as winning FDA approval or winning new customers.
A 2017 study conducted by SRS Aquion looked at 795 private-target transactions and observed:
64% of deals had earnouts and revenue milestones.
24% of deals had earnouts had EBITDA or earnings milestones.
36% of deals had earnouts had some other kind of earnout metric (gross margin, achievement of sales quota, etc.)

Prevalence of earnouts
The prevalence of earnouts also depends on whether the target is private or public. Only 1% of public-target acquisitions include earnouts1 compared with 14% of private-target acquisitions2.
There are two reasons for this:
Information asymmetries are more pronounced when a seller is private. It is generally more difficult for a public seller to materially misrepresent its business. Then it is for a private seller because public companies must provide comprehensive financial disclosures as a basic regulatory requirement. This ensures greater control and transparency. Private companies, particularly those with smaller shareholder bases, can more easily hide information and prolong information asymmetries during the due diligence process. Earnouts can resolve this type of asymmetry between the buyer and seller by reducing the risk for the buyer.
The share price of a public company provides an independent signal for the target’s future performance. This sets a floor valuation which in turn narrows the range of realistic possible purchase premiums. This creates a valuation range that is usually far narrower than that observed in private target negotiations.

Earnout in M&A example
Sanofi’s 2011 acquisition of Genzyme illustrates how earnouts can help parties reach an agreement on valuation issues. On February 16, 2011, Sanofi announced it would acquire Genzyme. During negotiations, Sanofi was unconvinced of Genzyme’s claims that prior production issues around several of its drugs were full, and that a new drug in the pipeline was going to be as successful as advertised. Both parties bridged this valuation gap as follows:
Sanofi would pay $74 per share in cash at closing.
Sanofi would pay an additional $14 per share, but only if Genzyme achieved certain regulatory and financial milestones.
In the Genzyme deal announcement press release (filed as an 8K the same day). All the specific milestones required to achieve the earnout were:
Approval milestone: $1 once FDA approved Alemtuzumab on or before March 31, 2014.
Production milestone: $1 if at least 79,000 units of Fabrazyme and 734,600 units of Cerezyme were on or before December 31, 2011.
Sales milestones: The remaining $12 would be paid out contingent on. Genzyme achieving four specific sales milestones for Alemtuzumab (all four are in the press release).