An earn-out makes part of the purchase price dependent on future performance.
It may help bridge a difference between the seller’s expectations and the buyer’s view of risk. It may also create disagreement after closing because the company’s ownership, strategy, and operating decisions have changed.
The legal and tax structure requires qualified professional advice. The business terms also require careful operating analysis.
What is being measured?
Earn-outs may be based on:
- revenue;
- gross profit;
- operating profit;
- EBITDA;
- cash flow;
- customer retention;
- product launch;
- regulatory approval;
- another milestone.
Each measure creates different incentives and risks.
Revenue may be easier to measure but may encourage low-margin sales. Profit may better reflect value but can be affected by cost allocation and investment decisions.
Who controls the result?
After closing, the buyer usually controls the company.
The seller should understand whether the buyer may:
- change pricing;
- reduce marketing;
- move customers;
- add central costs;
- change accounting policies;
- combine operations;
- delay investment;
- replace management;
- transfer employees;
- discontinue products.
If these decisions affect the earn-out, the agreement needs clear protections and definitions.
Define the calculation
The transaction documents should address:
- accounting standards;
- revenue recognition;
- cost allocation;
- intercompany charges;
- extraordinary items;
- acquisitions or disposals;
- budget responsibility;
- currency;
- customer transfers;
- reporting frequency;
- audit and inspection rights.
The calculation should not depend on terms that remain undefined.
Understand the operating role
The seller may be required to remain involved.
Clarify:
- position;
- authority;
- reporting line;
- time commitment;
- employment terms;
- termination consequences;
- decision rights;
- access to information.
A seller cannot reasonably be accountable for a result without meaningful influence over the decisions that produce it.
Consider payment risk
The buyer’s future ability to pay matters.
Review:
- who owes the earn-out;
- whether payment is guaranteed;
- security;
- subordination;
- financing restrictions;
- set-off rights;
- consequences of a later sale;
- treatment in insolvency.
Plan for disagreement
The documents should define:
- calculation process;
- review period;
- information rights;
- objection procedure;
- independent expert process;
- court or arbitration forum;
- allocation of dispute costs.
A good earn-out agreement does not assume that the parties will always agree.
Decide whether complexity is justified
An earn-out may be appropriate when future performance is genuinely uncertain and both parties accept the continued relationship.
It may be inappropriate when the seller needs a clean exit, the buyer expects major integration, or future performance will be heavily influenced by decisions outside the seller’s control.
The amount written into the agreement is not the same as cash received at closing. Sellers should evaluate both the potential upside and the practical path to payment.