What is an earnout, why is it used in PE deals, and what are the classic problems with it?

An earnout defers part of the purchase price, payable only if the business hits agreed post-close targets (revenue, EBITDA, milestones) over a set period. It's used to bridge a valuation gap — the seller believes the hockey stick, the buyer doesn't — so the seller gets paid for performance if it materializes; it also retains and motivates founder-sellers who stay on. Classic problems

• measurement disputes — EBITDA is manipulable, so the definition, accounting policies, and buyer's post-close conduct (cost allocations, integration) all become fight material
• misaligned incentives — the seller optimizes the earnout metric short-term while the buyer runs the business long-term
• integration handcuffs — buyers may covenant to run the business 'consistent with past practice,' delaying synergies. From the buyer's math: an earnout is contingent consideration — model it as an additional use of funds in the year it's likely paid, funded from FCF or equity, and haircut returns accordingly.