Earnout Structures: Bridging the Valuation Gap

An earnout is a deal mechanism where part of the purchase price is deferred and becomes payable only if the acquired business meets specified performance targets after the transaction completes. It sounds elegant: seller gets upside if the business performs as promised; buyer pays less upfront if it does not. In practice, earnouts are among the most contentious provisions in any SPA and generate a disproportionate share of post-completion disputes. Use them with eyes open.

When Earnouts Are Used

Earnouts typically arise when buyer and seller cannot agree on value — specifically, when the seller's valuation is based on future performance that the buyer is unwilling to pay for upfront.

The most common situations:

Seller projects strong near-term growth. The business has been growing at 25% annually and the seller expects this to continue. The buyer is sceptical and will not pay a multiple that assumes the growth materialises. An earnout allows the seller to capture that value if they are right.

Key person risk. The seller is also the key operator, and the buyer wants financial incentive to ensure the seller remains engaged and committed for a defined transition period after completion.

Sector volatility. In industries where revenue can swing significantly year-to-year — project-based businesses, government contract-dependent businesses — an earnout allows the buyer to smooth their risk exposure.

Early-stage businesses. Where the business has limited historical EBITDA but strong contracted or ARR-based revenue, an earnout pegged to future ARR or revenue milestones bridges the gap between historical and forward value.

How Earnout Periods Work

The typical earnout period in Malaysian mid-market transactions is one to three years post-completion. The first twelve months post-close are usually the most contentious, because this is the period when integration decisions, budget allocation, and management changes occur — all of which affect the earnout metric.

Earnout periods longer than three years become increasingly difficult to manage. The seller has usually transitioned out of their management role, the business has been integrated (or not), and attributing performance to the original business as a standalone unit becomes artificial.

The earnout is typically measured annually or semi-annually, with payments made following delivery of audited or agreed management accounts for the period.

Financial Metrics Used in Earnouts

The choice of earnout metric is arguably the most important drafting decision. Each metric has different risks for seller and buyer:

Revenue. Easy to measure, hard to manipulate (relative to EBITDA). Sellers prefer revenue-based earnouts because the buyer cannot inflate costs to reduce EBITDA. Buyers are more cautious — revenue growth without margin expansion does not create value for them.

EBITDA. The most common metric for Malaysian transactions. Provides a reasonable proxy for cash generation. The problem: the buyer now controls the business and makes decisions that affect EBITDA — pricing, staffing, investment, which costs are allocated to the acquired entity. This creates structural conflict.

Customer metrics. For SaaS or subscription businesses: Annual Recurring Revenue (ARR), Net Revenue Retention (NRR), or customer count. These are cleanly measurable and relevant to how the buyer values the business, but require careful definition (what counts as ARR? how are upgrades and downgrades treated?).

Gross profit. A compromise between revenue and EBITDA — reflects revenue performance but excludes overhead allocation decisions that are within the buyer's control.

Risks for Sellers

The fundamental risk for a seller in an earnout is this: after completion, the buyer controls the business. They set the budget, the pricing, the cost structure, the investment decisions, and who gets hired or fired. All of these decisions can directly affect the earnout metric.

Specific risks:

Cost allocation. The buyer may allocate shared group costs — IT infrastructure, HR, legal fees — to the acquired entity, increasing its cost base and reducing EBITDA. The earnout should specify exactly which costs can and cannot be allocated.

Revenue reallocation. If the buyer has existing customers who buy products the acquired entity used to sell, those customers may be "migrated" to the buyer's direct contracts, reducing the acquired entity's revenue count.

Underinvestment. The buyer has no incentive to invest in the acquired business during the earnout period if the investment costs reduce short-term EBITDA. This can set up a difficult conversation in year two or three.

Management interference. Instructions from the new parent that the seller believes harm performance — requiring different suppliers, changing pricing policy, requiring headcount reductions — can make the earnout effectively unreachable.

Risks for Buyers

Seller interference. If the seller remains as CEO or key operator during the earnout period, they may take actions to maximise the earnout metric at the expense of long-term business health. Aggressive revenue recognition, deferring maintenance capex, not investing in people — all of these improve short-term EBITDA while harming long-term value.

Management distraction. Sellers focused on hitting earnout targets may not be focused on integration or strategic alignment. The earnout becomes an adversarial dynamic within what should be a cooperative transition.

Underpaying for a strong outcome. If the earnout is structured incorrectly and the business significantly outperforms, the total consideration paid can end up below what the seller would have accepted for an outright sale. This rarely matters commercially but can damage the relationship.

Drafting Considerations

The quality of earnout drafting is what separates a workable mechanism from a dispute waiting to happen. Key provisions:

Accounting policies. The SPA must specify: will earnout be calculated under MFRS? Under a consistent accounting policy with the seller's historical approach? Who prepares the earnout accounts — buyer or seller? Who reviews them?

Control provisions. The seller needs operational protections during the earnout period. These typically take the form of a negative covenant list — actions the buyer agrees not to take without seller consent that would materially affect the earnout metric (restructuring the entity, changing the pricing model, significant lay-offs, new cost allocations above a threshold).

Dispute resolution. Specify how earnout disputes are resolved. Escalation to senior management, then to an independent accountant (typically a Big Four firm) appointed by mutual agreement, is a common mechanism. Litigation over earnout calculation is slow and expensive — an independent expert determination clause resolves disputes faster.

Non-compete alignment. If the seller receives a lower upfront price in exchange for an earnout, ensure they also have a reciprocal non-compete — there is little point in structuring an earnout for a seller who then competes against the acquired business.

Alternatives to Earnouts

Before committing to an earnout, consider whether the same commercial objective can be achieved through:

Seller loan note. The seller receives a fixed deferred payment (a "loan note") payable at a set date, regardless of performance. This is simpler, avoids the governance conflict, and is more seller-friendly — but does not give the buyer the performance protection they wanted.

Locked-box mechanism. All value accretion after a reference date is fixed, and the price adjusts for known items only. Reduces uncertainty without requiring ongoing performance monitoring.

Staged payment with conditions. The deferred payment is contingent on specific, binary events (the seller staying for 12 months post-close; a key customer renewing their contract) rather than a continuous financial metric. Simpler and less contentious than a full earnout.

Price adjustment at completion. Complete accounts-based price adjustment at the completion date for working capital, net debt, and EBITDA — resolves historical uncertainty without deferring price into future periods.