Earnout provisions are among the most creative and, simultaneously, the most litigated structures in M&A transactions. When a buyer and seller cannot agree on purchase price because they disagree about the future performance of the business, an earnout can bridge the gap—allowing the seller to receive additional consideration if the business achieves agreed-upon milestones after closing. In theory, it aligns the interests of both parties around a shared outcome. In practice, earnouts require extraordinarily careful drafting and a clear-eyed understanding of the risks on both sides.
How Earnouts Work
In a typical earnout structure, the buyer pays a baseline purchase price at closing, with an additional payment (or series of payments) contingent on the business achieving specific financial or operational milestones during a defined post-closing period. The milestones might be revenue-based, EBITDA-based, or tied to a specific business event—such as the renewal of a major contract or the receipt of specific regulatory approval. The earnout period commonly ranges from one to three years, and the contingent payment can represent anywhere from a modest supplement to the base price to a substantial portion of the total deal consideration.
Where Earnout Disputes Come From
The majority of earnout disputes arise from one of three sources: (1) ambiguity in the definition of the earnout metric, (2) the buyer’s post-closing business decisions that affect the earnout calculation, or (3) disputes about accounting methodologies used to measure performance. A seller who negotiated an earnout based on “revenue” may discover at the measurement date that the buyer and seller had fundamentally different understandings of what revenue means—and the purchase agreement did not specify. A seller running a business unit post-closing who finds that the buyer has allocated overhead costs in a way that reduces reported EBITDA may cry foul, but if the purchase agreement did not restrict how the buyer could operate the business or allocate expenses, the seller may have limited recourse.
Drafting Earnouts That Actually Work
From a buyer’s perspective, the key to an earnout that does not end in litigation is precision at the drafting stage. The earnout metric should be defined with specificity—not just “revenue” or “EBITDA,” but revenue or EBITDA calculated in accordance with a specific accounting standard, with specific inclusions and exclusions enumerated. The buyer’s obligations with respect to operating the business during the earnout period should be clearly stated—whether that means a best-efforts obligation, a specific operating covenant, or simply a commitment not to take actions designed to frustrate the earnout.
Dispute resolution mechanisms specific to the earnout calculation should also be included—typically a procedure by which either party can challenge the earnout statement and submit disputed items to an independent accountant for resolution. This is cheaper, faster, and less destructive than litigation.
When Earnouts Make Sense (and When They Don’t)
Earnouts are most effective when the valuation gap arises from a genuinely uncertain future event—a pending product launch, a regulatory approval, a major customer contract under negotiation—rather than from fundamental disagreement about the baseline value of the existing business. They are least effective when the seller is expected to remain involved in running the business post-closing, because the post-closing relationship between buyer and seller is inherently tense and the potential for perceived interference in earnout-related decisions is high.
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