Checklist for Avoiding Earnout Agreement Issues

Earnout agreements are used in M&A deals to balance buyer and seller interests by tying part of the purchase price to future business performance. While they can help bridge valuation gaps, they often lead to disputes. Here's a quick guide to avoid common issues:

• Define Scope Clearly: Specify what’s being acquired, which metrics apply (e.g., revenue or EBITDA), and how new products or services are treated.
• Set Realistic Metrics: Use measurable, clear performance targets like revenue, EBITDA, or milestones. Align metrics with business goals.
• Ensure Accounting Consistency: Maintain consistent accounting practices pre- and post-acquisition to avoid skewed results.
• Outline Payment Terms: Define payment triggers, timelines, and ceilings. Use tiered structures and include acceleration clauses for events like changes in control.
• Add Dispute Resolution: Include mediation, arbitration, or third-party audits to handle conflicts without litigation.
• Protect Sellers: Provide transparency through regular updates, financial access, and safeguards against harmful buyer actions.
• Set Operating Rules: Ensure buyers maintain normal operations and avoid impairing earnout performance.

Quick Comparison of Earnout Structures:

Structure Type	Key Features	Pros	Cons
Revenue-Based	Tied to top-line sales growth	Simple, harder to manipulate	Ignores profitability
EBITDA-Based	Reflects operational earnings	Focuses on efficiency, profitability	Complex, prone to disputes
Milestone-Based	Based on specific achievements	Clear, objective targets	May not reflect overall business
Hybrid	Combines multiple metrics	Balances growth and efficiency	More complex to manage

Key Tip: Use clear, detailed agreements to align expectations, reduce disputes, and ensure fairness for both parties.

How to Structure an Earn Out and Avoid Big & Expensive Mistakes

Define Business Scope and All Parties

When structuring an earnout agreement, clarity is everything. You need to spell out exactly what’s being acquired and who’s responsible for what. This level of detail helps avoid misunderstandings or disputes down the road.

Define the Acquired Business

Start by explicitly defining the business being acquired. Vague descriptions make it difficult to measure performance later. Be clear about which parts of the business will influence the earnout. For example, if the company includes both software and consulting services, but the earnout only applies to software revenue, the agreement must state that clearly.

Operational restrictions are another key point. Buyers often want full control to run the business as they see fit, but sellers need transparency about any changes that could affect their earnout payments. The agreement should outline what the buyer can and cannot do that might impact the business’s performance or financials.

You also need to address how new products or services introduced during the earnout period will be handled. For instance, if a new product line is launched, the agreement should specify whether revenue from that product counts toward the earnout and under what conditions.

A great example of detailed scope definition comes from the LeMaitre Vascular transaction in June 2020. Their earnout was tied to the sale of a specific product over three calendar years (2021, 2022, and 2023). They used an "all or none" threshold for each year, with a catch-up payment based on total unit sales if minimum thresholds were surpassed.

Consistency in accounting practices is just as important. The financial metrics used to measure earnout performance must remain consistent between the pre-closing and post-closing periods. This includes how you handle things like intercompany transactions, depreciation, amortization, and acquisition-related costs. Without this consistency, the numbers could get skewed, leading to disputes.

By nailing down these details, you create a solid foundation for measurable performance metrics in the agreement.

List All Parties Involved

It’s equally important to identify every party involved in the earnout agreement. This includes buyers, sellers, guarantors, parent companies, and subsidiaries. Clearly define each party’s role to ensure everyone knows their responsibilities.

For instance, outline who the final decision-makers are and what seller approvals are required for key operations. This helps streamline decision-making and avoids unnecessary delays.

Communication is another critical piece. Sellers should receive regular updates on the business’s performance and any changes that might influence their earnout payments. The agreement should specify how often these updates will occur, what kind of information will be shared, and in what format.

If guarantors are involved, their responsibilities need to be documented as well. For example, individual sellers might personally guarantee certain aspects of the earnout, or a parent company might back the buyer’s payment obligations. Clearly outlining these relationships ensures there’s no confusion about accountability during the earnout period.

Set Performance Metrics and Measurement Methods

After defining the business and identifying the key parties involved, the next step is to establish clear performance metrics. These metrics are essential for avoiding disputes and ensuring that all parties are on the same page. Without a clear way to measure performance, disagreements could arise and drag on for years.

Define Financial and Performance Metrics

The backbone of any earnout agreement is selecting the right financial metrics. Studies indicate that 50%-80% of earnouts rely on either EBITDA or revenue as their primary metric. Each option has its strengths, depending on the business's specific needs.

Revenue-based targets are straightforward and focus on top-line performance. They’re less prone to manipulation through accounting adjustments. This makes them ideal for businesses with steady income streams or when short-term growth is a priority.

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a measure of operational performance, offering a clearer view of how efficiently the business is running. It’s a suitable choice when operational improvements are the focus rather than just boosting sales. However, calculating EBITDA can be more complex, often requiring detailed accounting definitions.

Net income targets take a broader view, reflecting overall profitability. While this metric provides a complete financial picture, it can be influenced by external factors like tax rate changes or interest expenses, which may be beyond the seller's control.

"When structuring an earnout, emphasizing revenue retention as a performance metric can provide several benefits." - Ashley-Kincaid

In addition to financial metrics, operational milestones can be valuable. These could include launching a new product, completing a major project, or hitting specific client retention rates. For businesses in specialized fields like CPA firms, metrics like client retention, revenue growth, and profitability are particularly relevant.

Often, the most effective earnout agreements use a mix of metrics. This balanced approach incentivizes both growth and operational efficiency while maintaining minimum performance standards.

It’s essential to align these metrics with the long-term goals of both the buyer and seller. For example, if the buyer’s focus is on market expansion, revenue-based metrics may be most appropriate. On the other hand, if operational efficiency is the goal, EBITDA or net income targets might work better.

The next step is to clearly define how these metrics will be calculated to ensure consistency.

Document Calculation Methods and Adjustments

Once the metrics are chosen, it's crucial to document exactly how they’ll be calculated. This clarity helps prevent disputes. Spell out the methods for calculating key metrics like EBIT, adjusted EBITDA, gross profit, profit before tax, revenues, and operating cash flow.

Start by ensuring accounting consistency. The same accounting principles and methods used before the deal should continue during the earnout period. This includes practices like depreciation, amortization, inventory valuation, and revenue recognition.

Adjustment mechanisms are also key for handling unforeseen events. Define criteria for adjusting calculations to account for extraordinary circumstances such as natural disasters, pandemics, or regulatory changes. These adjustments ensure that earnout payments reflect the business's true performance rather than external factors.

Earnout formulas should also include provisions to address major market shifts. For example, if regulatory changes impact an entire industry, the earnout calculation should account for these broader effects. This ensures fairness in how performance is measured.

Strategic changes during the earnout period must also be addressed. The agreement should specify how calculations will be adjusted if the buyer makes significant changes, such as merging with another company, adding new product lines, or altering the business model.

"Earn-out provisions offer a compromise in M&A deals, tying part of the purchase price to future performance and addressing valuation differences between buyers and sellers." - Osborne Clarke

To prevent manipulation of metrics, include safeguards in the agreement. For instance, you might restrict certain expenses, limit intercompany charges, or require seller approval for major operational changes that could impact the calculations.

Finally, outline the timing and reporting requirements. Specify when performance will be measured, who will prepare the calculations, and what supporting documents will be needed. Regular reporting helps maintain transparency and allows potential issues to be addressed early.

Whenever possible, use objective criteria for any target adjustments. By relying on measurable triggers rather than subjective negotiations, you can reduce disputes and ensure clarity for both parties. This way, everyone knows exactly when and how adjustments will occur.

Set Payment Terms and Dispute Resolution

Once performance metrics are established, the next step is to outline earnout payments and a clear dispute resolution process. This ensures both parties have a reliable and transparent framework for handling earnout payments.

Set Payment Amount and Triggers

Determine an earnout amount that reflects the deal's risk and the seller's level of involvement. Typically, earnouts account for 10%–25% of the purchase price, though they can sometimes stretch to 25% of the total deal value. The goal is to strike a balance - motivating the seller without overburdening the buyer.

Payment triggers should be based on measurable and objective criteria to avoid disputes. Avoid vague terms like "reasonable efforts" or "best practices." Instead, use specific metrics that are clear and immune to interpretation.

A tiered payment structure can help reduce risks. For example, instead of requiring a single revenue target, you could set multiple thresholds: $3,000,000 in revenue might trigger a partial payment, $4,000,000 a larger payment, and $5,000,000 the full amount. This approach offers flexibility and minimizes the risk of narrowly missing a target.

To protect the buyer, establish a payment ceiling that aligns with the business's projected valuation. This ensures earnout payments remain proportional to the company's actual performance. Sellers should also clarify whether the earnout serves as essential compensation or a bonus on top of an appealing deal.

Acceleration clauses are another important consideration. These clauses protect sellers in case the buyer is acquired during the earnout period, ensuring the seller isn't disadvantaged by operational changes.

Lastly, set realistic targets. While challenging goals can keep sellers motivated, overly ambitious ones may have the opposite effect, potentially harming business performance.

Set Payment Process and Timeline

A detailed payment process is key to avoiding confusion and disputes. Start by defining specific measurement periods. While annual assessments are common, businesses with seasonal trends or rapid growth may benefit from quarterly or monthly evaluations.

Outline clear timelines for calculations and reviews. For instance, buyers might have 30–60 days to calculate earnouts, while sellers could have 15–30 days to review the figures. Payment deadlines should also be explicit, with finalized amounts paid within a set timeframe - commonly 10–30 days - and stated clearly in U.S. dollars (e.g., $1,500,000.00).

Transparency is crucial. Require supporting documents for calculations, and for more complex or high-value earnouts, consider third-party verification by an independent accountant.

Include provisions for partial payments when undisputed amounts can be identified, even if disagreements persist. To encourage timely payments, agreements often include interest on late payments, calculated as the prime rate plus 1%–2%.

Add Dispute Resolution Methods

Even with careful planning, disputes over earnouts can arise. Having a clear resolution process in place can save time, money, and relationships. Tools like mediation, arbitration, or third-party audits are effective for resolving disagreements.

Mediation is often the best starting point, as it is quicker and less expensive than arbitration or litigation. It also helps maintain professional relationships. For example, you might require mediation to begin within 30 days of a dispute being raised, with costs split equally between both parties.

If mediation doesn't resolve the issue, binding arbitration is a viable next step. Arbitration tends to be faster than court proceedings, and it’s helpful to specify that arbitrators should have relevant expertise in accounting or the industry to properly assess earnout calculations.

For technical disputes, expert determination by an independent accountant with M&A experience can be a simpler and more cost-effective solution. Some agreements specify that a "Big Four" accounting firm - one with no prior ties to either party - will make the final call on accounting methods, even if broader contractual disputes require arbitration later.

Interim relief provisions can also be valuable, ensuring that ongoing operations remain unaffected during disputes. These might include temporary measures to prevent operational changes that could skew earnout calculations.

Finally, set clear time limits for raising disputes - typically 30–90 days after earnout calculations are received. After this period, calculations should be considered final. Specify who will bear the costs of dispute resolution, whether it’s the losing party or another agreed arrangement, and include governing law provisions to determine which state's laws will apply (commonly Delaware or New York).

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Set Operating Rules and Seller Protections

Operating rules during the earnout period play a crucial role in minimizing disputes and ensuring both parties are clear on their obligations. These rules are designed to prevent actions that could negatively impact earnout performance.

Set Operating Rules for the Earnout Period

While the buyer needs flexibility to manage the business, that flexibility shouldn’t come at the seller’s expense. It’s essential to establish rules that protect both sides while maintaining operational efficiency. A good starting point is requiring the buyer to run the business in line with its historical practices. For instance, if the company has consistently spent $500,000 annually on marketing, the agreement could stipulate that similar spending levels are upheld during the earnout period.

To safeguard key operations, agreements can also include minimum spending thresholds. For example, if the business typically maintains $1,200,000 in working capital, the buyer could be required to sustain this level throughout the earnout period. Additionally, limiting corporate overhead charges can help ensure that earnout calculations aren’t artificially reduced.

Defining decision-making authority is another critical step. Actions that could impact earnout metrics - such as major strategic decisions or significant expenditures - should require seller consent or advance notice. Maintaining historical accounting methods is another safeguard that ensures consistency in financial reporting.

By laying down these operational rules, both parties can move forward with a framework that protects the seller’s interests while allowing the buyer to manage the business effectively.

"Earnouts work best if you go with the business, if you're going to continue to run it then you want to be very careful to negotiate as much as you can in the purchase agreement about how that earnout is going to work."

• Brett Cenkus, Right-Brained Business Lawyer and Business Consultant

Add Seller Protections

In addition to operating rules, sellers benefit from protections that ensure fairness and transparency during the earnout period. One key safeguard is access to detailed financial information. Sellers should receive monthly or quarterly financial statements - such as profit and loss reports and balance sheets - within 30 days of the end of each period.

Sellers should also have the right to inspect financial records, conduct audits, and review supporting documents, provided they give reasonable notice. These measures promote transparency and help sellers verify that earnout calculations are accurate.

Another important protection is consent rights for significant business decisions. While buyers typically handle day-to-day operations, sellers should retain a say in major actions that could significantly affect earnout performance. As Brett Cenkus explains:

"Include successful provisions that say things like, to the extent buyer takes an action that should reasonably be deemed as impeding the ability of the seller to earn the earnouts owed."

• Brett Cenkus, Right-Brained Business Lawyer and Business Consultant

Non-impairment clauses are another safeguard, preventing buyers from deliberately taking actions that could harm earnout performance. Under Delaware law, buyers are generally expected to act in good faith and avoid actions aimed at undermining an earnout, though they are not obligated to maximize performance unless explicitly stated in the contract.

Change of control protections are also worth considering. If the buyer is acquired during the earnout period, clauses that trigger immediate payment of the earnout can shield the seller from unfavorable changes in management or strategy. The Cephalon case from April 30, 2024, highlights how courts examine customized earnout terms, including decision-making authority and clearly defined obligations, to guide the structuring of effective protections.

If the seller remains involved in the business post-transaction, it’s essential to clearly define their role and authority. Provisions should also prevent the buyer from removing the seller or significantly altering their position without cause.

Lastly, the agreement should address the possibility of operational changes initiated by the buyer. If such changes - like restructuring the sales team or shifting the product mix - materially impact the business, earnout targets may need to be adjusted to reflect these new circumstances. This ensures that both parties remain aligned, even as the business evolves.

Define Acceleration Events and Mutual Commitments

Acceleration events and mutual commitments outline specific conditions for immediate earnout payments and establish clear responsibilities for both buyers and sellers. These provisions act as safeguards for sellers while providing buyers with a structured framework during the earnout period.

Acceleration Events Explained

Acceleration events are designed to ensure that sellers are compensated fairly when unforeseen circumstances disrupt the earnout arrangement. These events typically call for immediate payment and are triggered by specific situations.

Change of control is one of the most frequent triggers. If the buyer is acquired by another company during the earnout period, the new owner may shift priorities or strategies, potentially harming the seller's ability to meet earnout targets. In such cases, the earnout often becomes due immediately, either at a pre-agreed amount or based on projected performance.

Material breach by the buyer is another key trigger. For instance, if the buyer violates critical contractual terms - such as failing to allocate agreed-upon resources or making unauthorized business changes - the seller can demand immediate payment. This provision protects sellers from intentional actions that could undermine earnout performance.

Sale of the business or significant assets during the earnout period also qualifies as an acceleration event. If the buyer sells the acquired company or a large portion of its assets, the original earnout structure may no longer hold, justifying immediate payment to the seller.

Termination of key personnel can also activate acceleration clauses. If the buyer dismisses essential employees or operating shareholders critical to achieving earnout targets, the seller is protected from the negative impact of such decisions.

Other common triggers include regulatory actions and buyer insolvency or bankruptcy. Government restrictions or financial distress on the buyer’s part can jeopardize earnout goals, warranting immediate resolution.

For these clauses to work effectively, precision in their drafting is crucial. Ambiguous language can lead to disputes, while clearly defined triggers provide certainty for both parties. Each event should be described in detail to minimize room for misinterpretation, complementing the mutual commitments discussed below.

Mutual Commitments and Representations

In addition to acceleration events, mutual commitments ensure that both parties act fairly and transparently during the earnout period. Representations and warranties clarify these obligations, helping to maintain trust and minimize disputes.

Good faith and commercially reasonable efforts are central to these commitments. The buyer is expected to operate the business in a way that supports earnout targets while allowing for necessary adjustments. This ensures the seller isn’t disadvantaged by lack of effort or transparency.

Financial support commitments are another safeguard. They ensure that the buyer provides adequate resources to the business, preventing situations where withholding capital might artificially lower performance.

Expense exclusions are particularly relevant when earnout calculations rely on metrics like EBITDA. Sellers often negotiate to exclude certain overhead costs from these calculations, reducing the risk of manipulated outcomes through creative accounting.

Management retention clauses protect key employees essential to earnout success. These provisions prevent buyers from removing critical personnel without justified reasons during the earnout period.

Information sharing is another important aspect. Buyers are typically required to provide sellers with regular updates, such as financial statements and performance data. This transparency helps sellers track progress toward earnout targets and ensures accountability.

In some cases, escrow arrangements may also be included. Here, the buyer deposits the anticipated earnout amount into an escrow account, offering sellers additional security. While not always practical, escrow provisions can strengthen the seller's position in case of disputes.

As Vice Chancellor J. Travis Laster of the Delaware Court of Chancery aptly observed:

"An earn-out often converts today's disagreement over price into tomorrow's litigation over the outcome."

Given this reality, detailed mutual commitments are essential for reducing the likelihood of disputes and ensuring a smoother earnout process. When both parties have clear expectations and potential conflicts are addressed upfront, the chances of success increase significantly.

Use Comparison Tables for Quick Reference

Comparison tables are a practical tool for evaluating earnout structures and protections. They allow both buyers and sellers to quickly compare options, making it easier to ensure that no critical details are overlooked.

Compare Earnout Structures

Each earnout structure comes with its own set of strengths and weaknesses. Here's a quick breakdown of the key differences:

Structure Type	Key Features	Advantages	Disadvantages
Revenue-Based	Payment is tied to top-line sales growth	Easy to track and verify	Ignores profitability; buyer controls pricing and costs
EBITDA-Based	Payment depends on earnings before interest, taxes, depreciation, and amortization	Reflects operational performance; aligns with profitability	Complex calculations; potential for accounting disputes
Milestone-Based	Payment triggered by achieving specific milestones (e.g., product launches, regulatory approvals, customer acquisitions)	Clear, objective targets	May not reflect overall business health; encourages narrow focus
Hybrid Structure	Combines multiple metrics (e.g., revenue and EBITDA thresholds)	Balances various performance factors; reduces reliance on a single metric	More complex; potential for conflicting incentives

Summary of Operating Rules and Protections

Clear operating rules and protections are crucial for earnout success. Without them, fewer than 60% of earnout deals result in full payment.

Protection Category	Buyer Duties	Seller Rights	Common Disputes
Operational Control	Maintain normal business operations and adhere to established business plans	Input on major decisions; veto power over actions that could harm the earnout	Disputes over operational restrictions, budgeting, or staffing
Financial Transparency	Provide regular financial updates and earnout-related data; allow audits	Access to financial records; independent calculation verification	Delays in reporting; disagreements over calculation methods
Good Faith Obligations	Operate the business to support earnout goals; avoid actions that reduce payments	Protection against intentional manipulation; recourse for bad faith actions	Ambiguity in defining "good faith" versus valid business decisions
Resource Commitments	Allocate agreed-upon budgets, staffing, or capital investments	Assurance of adequate business support during the earnout period	Conflicts between buyers' flexibility and sellers' need for consistency

One widely recommended practice is to use negative covenants instead of rigid affirmative ones. Rather than requiring buyers to take specific actions, agreements should focus on prohibiting actions that could intentionally reduce earnout payments. This method provides buyers with the flexibility to operate the business while protecting sellers from manipulation. These comparisons underscore the importance of carefully structuring earnout arrangements to ensure clarity and fairness for both parties.

Conclusion: Key Points for Avoiding Earnout Problems

Earnout agreements can help bridge valuation gaps, but they require careful planning to avoid costly conflicts. With about 14% of private deals and 71% of biopharmaceutical transactions incorporating earnout structures, getting these agreements right is essential for a successful outcome.

To steer clear of earnout pitfalls, focus on clear metrics, defined triggers, and strong dispute resolution mechanisms. Ambiguity in performance definitions is a common source of conflict, often derailing transactions. Experts emphasize the importance of setting precise performance targets, payment structures, and timelines to keep both parties aligned and reduce the risk of disputes.

A great example of this principle is Electronic Arts' acquisition of PopCap. The earnout structure in this deal required PopCap to meet specific EBIT targets over a set period, with clearly defined thresholds. This approach minimized immediate financial risk for the buyer while incentivizing growth for the seller.

Clear payment triggers, calculations, and dispute protocols are equally important. Buyers need detailed reporting requirements to monitor key financial metrics tied to earnout triggers, which helps reduce disagreements over calculations.

Beyond metrics and payment terms, operating rules and seller protections play a critical role. Buyers often want operational flexibility, while sellers need safeguards to prevent actions that could unfairly impact the earnout. Including provisions that protect sellers from harmful changes - without overburdening the buyer - helps strike a fair balance.

The Genzyme-Sanofi case is a cautionary tale about vague performance definitions. When milestones were not clearly outlined, disputes escalated to legal action, ultimately damaging the deal's value. This highlights the importance of precise definitions and serves as a reminder to incorporate robust contractual mechanisms.

Finally, a strong framework should include acceleration events and dispute resolution processes. Planning for scenarios like a future sale of the business or significant operational changes - and having clear steps to resolve disagreements before they escalate - are essential for a solid earnout agreement.

The success of an earnout ultimately depends on alignment. Agreements must be structured so both parties benefit from growth while maintaining clear and fair boundaries.

FAQs

What are common issues with earnout agreements, and how can they be prevented?

Earnout agreements often run into hurdles like vague performance goals, uncertain timelines, and unclear dispute resolution terms, which can create conflicts and slow things down. To avoid these pitfalls, it’s crucial to include:

• Well-defined performance metrics: Clearly outline measurable objectives and specify how success will be assessed.
• Specific timelines: Establish achievable deadlines for milestones and resolving disputes.
• Detailed conflict resolution plans: Provide a clear process to address disagreements efficiently.

Working with seasoned professionals during the drafting phase can significantly reduce risks and ensure the post-transaction process goes more smoothly.

How can performance metrics be defined to ensure clarity and prevent disputes in an earnout agreement?

To minimize disputes in an earnout agreement, it’s crucial to use performance metrics that are clear, measurable, and objective. Metrics like revenue or EBITDA are popular choices because they are relatively easy to track and verify. Be sure to specify the exact targets, the measurement period, and the accounting standards or methods that will be used.

Additionally, clearly define which revenue streams or costs will be included and how they will be calculated. When both parties agree on realistic and transparent metrics from the start, it helps align expectations and reduces the chances of misunderstandings or conflicts during the earnout period.

How can sellers protect themselves during the earnout period, especially regarding financial transparency and business operations?

To safeguard their interests during the earnout period, sellers should make sure the agreement outlines clear financial reporting standards, audit rights, and defined performance benchmarks. These elements are crucial for tracking outcomes accurately and keeping disputes to a minimum.

Sellers might also want to negotiate provisions that allow them to monitor or approve major operational changes that could influence performance outcomes. Regular financial updates and independent audits can further enhance transparency and build trust, making conflicts less likely during this critical period.

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