Earnout Payment Terms: Key Clauses Explained

Earnout agreements tie part of a business's sale price to its future performance. They help bridge valuation gaps, reduce buyer risks, and keep sellers motivated post-sale. However, unclear terms often lead to disputes. Here's what you need to know:

• Payment Models: Fixed earnouts guarantee payments upon meeting targets, while ratchet earnouts reward exceeding them.
• Metrics: Revenue, EBITDA, or milestones like product launches are common. Clear definitions are critical.
• Tax Implications: Sellers prefer capital gains treatment; buyers often seek deductions. Early tax planning is essential.
• Dispute Resolution: Include steps like negotiation, mediation, or arbitration to handle conflicts efficiently.

Well-defined clauses and regular reporting can prevent issues and ensure smooth execution. Clear agreements protect both parties and align incentives.

Earnouts in M&A Explained – Real Life Examples and The Risks Involved

Key Clauses in Earnout Agreements

Earnout agreements hinge on several key clauses that dictate how payments are structured, when they are made, and the conditions that trigger them. These clauses are critical for protecting both the buyer and the seller, minimizing the risk of disputes later. Building on the basics of earnout agreements, let’s take a closer look at the mechanics behind these clauses.

Payment Structure Options

Earnout agreements typically follow one of two payment models: fixed earnouts or ratchet earnouts. In a fixed earnout, the seller is guaranteed a set payment if specific performance goals are met. While this provides clarity and predictability, it doesn’t reward the seller for exceeding expectations. On the other hand, a ratchet earnout ties the payment to performance beyond a set threshold, offering additional rewards for surpassing targets.

Another important decision is whether payments will be made in cash or equity. Cash payments provide immediate liquidity, which is straightforward and risk-free for the seller. However, equity payments can align the seller’s interests with the buyer’s long-term success, though they come with the added risk of market fluctuations.

Earnout Period and Payment Timing

The timing of earnout payments is just as crucial as their structure. Most earnout periods range from one to three years, though industries with longer development cycles, such as biopharmaceuticals or medical devices, may extend up to five years. These longer periods account for the time needed to achieve meaningful performance milestones.

Payments can be structured as annual installments, ensuring regular cash flow, or as a lump sum tied to cumulative performance. For middle-market transactions, earnout payments often represent 10% to 25% of the total purchase price. All payment amounts must be clearly defined in U.S. dollars, with conversion mechanisms in place for businesses operating internationally.

Performance Metrics and Targets

Defining clear and measurable performance metrics is essential to the success of any earnout agreement. Revenue-based metrics are a common choice for businesses with strong sales potential but unpredictable profit margins. However, these may not fully reflect the company’s financial health unless paired with profitability measures like EBITDA or net income, which ensure payments are tied to sustained success.

In many cases, agreements combine financial metrics with operational milestones. For example, product launches, regulatory approvals, or hitting customer acquisition goals may be included alongside revenue or profit targets. Metrics should be realistic, measurable, and grounded in the company’s historical performance to ensure fairness for both parties.

Tax Considerations for Earnouts

Taxes are often a sticking point in earnout agreements, as buyers and sellers usually have opposing preferences. Sellers typically prefer earnout payments to be treated as part of the purchase price, which qualifies for lower capital gains tax rates of 15% or 20% (plus a potential 3.8% net investment income tax). This approach also allows sellers to defer part of their tax liability using the installment sale method. Buyers, however, often favor classifying these payments as compensation income, which provides an immediate tax deduction. Unfortunately, this classification subjects the seller to higher ordinary income tax rates of up to 37%.

The IRS evaluates several factors to determine the correct tax treatment, such as whether the seller provides post-closing services, if payments are proportional to ownership, and whether the seller receives reasonable compensation for additional services. The length of the seller’s post-closing involvement compared to the earnout period can also influence how payments are classified.

To avoid surprises, it’s essential to consult tax advisors early in the process to ensure the transaction documents align with the desired tax outcomes.

Tax Treatment	Seller Impact	Buyer Impact
Purchase Price	15–20% capital gains rate plus potential 3.8% net investment income tax; installment sale deferral available	Must capitalize and amortize over time
Compensation	Up to 37% ordinary income rate; employment taxes; all taxes due in the year of sale	Immediate tax deduction

Milestones and Timelines in Earnout Agreements

Clear milestones and timelines are the backbone of effective earnout agreements. They not only guide when payments are triggered but also define how performance is measured. When crafted carefully, they help avoid disputes and ensure that both parties stay aligned on expectations.

Setting Key Milestones

The success of an earnout agreement hinges on establishing milestones that are clear, measurable, and mutually understood. Financial metrics like revenue thresholds, EBITDA targets, or net income goals are often used. For instance, in Electronic Arts' acquisition of PopCap, the earnout structure required PopCap to achieve specific cumulative EBIT targets within a set period. If they missed the mark, no additional payments were made. This approach minimized financial risk for the buyer while motivating the seller to drive performance.

However, not all milestones need to revolve around financial metrics. Operational goals - such as securing regulatory approvals, launching new products, or hitting customer acquisition targets - can be equally crucial. These should reflect the nature of the business and be objectively measurable. A case involving Fortis Advisors, LLC v. Dematic Corp. highlights the importance of clarity. Here, the lack of a precise definition for "Company Products" led to disputes over sales calculations when newer products were excluded from the earnout metrics.

To set realistic milestones, use a data-driven approach. Analyze past performance, industry standards, and future projections. This ensures that goals are challenging yet achievable. Additionally, account for external factors like market disruptions or regulatory changes to avoid setting up either party for failure.

Creating and Enforcing Timelines

Timelines are just as critical as milestones. They need to balance the seller's motivation with what’s operationally feasible. Most earnout periods last between one and three years, with many deals now favoring two-year terms. The chosen duration should align with the industry’s business cycle and the pace of post-acquisition integration.

Timing matters. As attorney Aaron Hall advises:

"Timeline synchronization ensures the earnout period is neither too brief to capture meaningful results nor excessively long, which may introduce uncertainty and diminish incentive effectiveness".

Industries with longer development cycles, such as pharmaceuticals, may require earnout periods of up to five years. This allows time for milestones like regulatory approvals or clinical trials. In contrast, tech or service-based companies often achieve their goals more quickly. The Glidepath Ltd. v. Beumer Corp. case illustrates this point: post-acquisition investments in long-term projects delayed short-term financial targets, and the courts ultimately sided with the buyer.

Flexibility is key. Including provisions in the agreement to adjust timelines or recalibrate milestones can help address unforeseen circumstances, such as market shifts or regulatory delays. This flexibility ensures that both parties can adapt without derailing the agreement.

Tracking Milestone Achievement

Tracking progress is essential to avoid disputes and ensure transparency. Reliable data sources, clear reporting protocols, and independent audits can help verify whether milestones are met. The agreement should explicitly define how metrics are calculated, where the data comes from, and how it will be reviewed.

Attorney Aaron Hall emphasizes:

"Engaging independent third-party auditors enhances the credibility of data used in earnout agreements by providing unbiased verification of reported metrics".

The importance of clear verification processes is evident in the Chambers v. Genesee Wyoming Inc. case. A disagreement over EBITDA adjustments led to a missed earnout payment. The court ruled in favor of the seller because the agreement explicitly excluded the buyer's adjustments from the calculations.

Detailed documentation is critical. Agreements should outline validation criteria, assign responsibilities, and establish checkpoints. For example, in the 2012 acquisition of FerroKin Biosciences by Shire Pharmaceuticals, a $45 million milestone payment was tied to Phase III trials for deferitazole. When regulatory delays occurred, the court ruled that the delay wasn’t attributable to the regulatory body, and Shire was ordered to make the payment.

These examples highlight the value of thorough documentation and well-defined procedures. By addressing potential pitfalls upfront, both parties can protect their interests and maintain trust throughout the earnout period.

sbb-itb-97ecd51

Dispute Resolution in Earnout Agreements

Even the most well-thought-out earnout agreements can lead to disagreements. In fact, during the first quarter of 2023, earnout disputes in Delaware saw a fourfold increase compared to the previous quarter. This highlights just how important it is to not only draft clear earnout clauses but also to have effective mechanisms in place for resolving potential conflicts. As Vice Chancellor J. Travis Laster put it:

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

Having a clear plan for handling disputes can save both parties time, money, and unnecessary stress, while also preserving the relationship. By using structured methods, conflicts over performance metrics can be addressed more efficiently.

Common Dispute Resolution Methods

When disputes arise, there are several ways to resolve them, each with its own benefits depending on the circumstances and the relationship between the parties.

• Negotiation and Mediation: These are often the most cost-effective and quickest ways to resolve disputes. Negotiation involves direct discussions between the parties, whereas mediation brings in a neutral third party to guide the conversation. Both methods allow the parties to remain in control of the outcome and avoid the formalities of legal proceedings.
• Arbitration: This option strikes a balance between informal resolutions and full-blown litigation. Arbitration is typically faster than court proceedings, keeps matters private, and results in a binding decision. Many earnout agreements include arbitration clauses to streamline the resolution process and avoid the public nature of court cases.
• Litigation: When other methods fail or the case is particularly complex, litigation might be necessary. While it can be expensive and time-consuming, litigation is sometimes the only way to resolve disputes that require formal legal intervention or set important legal precedents.

A tiered approach to dispute resolution is common in earnout agreements. This means starting with negotiation, moving to mediation if necessary, and only turning to arbitration or litigation as a last resort.

Consequences of Non-Compliance

Failing to follow the agreed-upon dispute resolution process can lead to serious financial and legal consequences. Skipping established steps might result in claims being dismissed or additional penalties being imposed.

For instance, parties that bypass agreed procedures may be ordered to cover the opposing side's legal fees and costs. Ignoring notice requirements or skipping mandatory mediation can also weaken a claim, as courts tend to enforce dispute resolution clauses strictly when clear procedures and timelines are outlined.

Not following the proper process can also harm trust and increase costs, even if a party ultimately wins the dispute. Non-compliance can complicate enforcement of judgments or awards, making the resolution process more difficult in the long run.

How to Avoid Disputes

Preventing disputes altogether is always the best strategy, and this begins with clear drafting and proactive communication.

• Define Every Term Clearly: Ambiguity is often at the heart of earnout disputes. Define performance metrics, calculation methods, and operational guidelines with precision. For example, a small tech consulting firm sold for $2 million upfront and a $1 million earnout tied to achieving $300,000 in annual net income over two years succeeded due to clear terms. However, in another case, vague staffing clauses allowed a buyer to reassign key consultants, reducing net income and leading to litigation.
• Ensure Regular Data Sharing and Recordkeeping: Schedule regular financial updates, hold mandatory meetings to discuss decisions impacting earnout performance, and maintain detailed records of all financial and operational activities. Proper documentation can act as critical evidence in resolving disputes and help clarify any misunderstandings about performance metrics.
• Protect the Seller's Interests: Post-acquisition, sellers often face challenges in ensuring the business operates in a way that allows earnout targets to be met. Including covenants that require the buyer to maintain consistent business practices and consult the seller on key operational changes can help address this issue.
• Include Specific Dispute Resolution Steps: Clearly outline the steps for resolving conflicts within the agreement itself. This could include requirements for written notices, mandatory negotiation periods, and defined timelines for each stage of the resolution process.

The importance of these protections was underscored in the SRS v. Valeant case, where the Delaware Court of Chancery ruled that buyers could breach their obligations by taking actions that made earnout targets unachievable - even if those actions were deemed commercially reasonable. This case highlights how essential it is to include robust protections in earnout agreements to minimize disputes.

How to Draft Effective Earnout Agreements

Drafting earnout agreements that work seamlessly requires meticulous attention to detail and clear communication. Experts on platforms like Kumo emphasize that well-defined terms are critical to avoiding disputes and ensuring successful outcomes. Building on the key clauses discussed earlier, crafting an effective earnout agreement hinges on clarity and enforceability from the outset.

Using Clear and Simple Language

Precision is the backbone of any effective earnout agreement. Vague or undefined terms often lead to conflicts. Every term, especially those tied to performance metrics, must be defined with absolute clarity to eliminate ambiguity.

For example, instead of using broad terms like "net revenue", explicitly outline what is included or excluded. If the metric is EBITDA, specify how expenses, depreciation, or other factors are calculated. Including detailed formulas and examples - such as an appendix showing a sample EBITDA calculation - can serve as a helpful reference point for both parties.

This need for precision was underscored in the Fortis Advisors v. Dematic Corporation case. Here, the term "Company Products" was left undefined, leading to a dispute over whether sales of integrated products should count toward the earnout. The court ultimately ruled the term ambiguous and allowed external evidence to clarify its meaning.

Similarly, buyer obligations should be explicitly stated to prevent overly broad interpretations. In Menn v. ConMed Corp., a "commercial best efforts" clause lacked clear criteria, leading the court to interpret it as requiring the buyer to do "essentially everything in its power" to meet the obligations. To avoid such scenarios, agreements should clearly outline the buyer's responsibilities and actions required to support earnout goals.

Regular Compliance Reviews

In addition to clear language, transparency throughout the earnout period is essential. Establishing regular reporting schedules helps keep both parties informed and aligned. Monthly financial reports with detailed breakdowns of performance metrics, coupled with quarterly review meetings, can address potential concerns early.

Sellers should also have audit rights to verify calculations and access relevant documents, such as accounting records or customer contracts. Provisions for third-party audits can further ensure fairness. Early warning systems can be invaluable - if performance metrics fall short, the parties should be notified promptly, with explanations and proposed corrective actions documented.

Maintaining thorough records of financial transactions, operational decisions, and communications is another critical step. These records provide a solid foundation for resolving disputes or validating earnout calculations if disagreements arise.

Checklist for Key Earnout Agreement Elements

Effective earnout agreements cover a variety of components. Here's a breakdown of the most important elements:

Performance Metrics and Targets

• Define clear, measurable metrics (e.g., revenue, EBITDA, customer retention).
• Set achievable targets based on historical data.
• Provide explicit calculation formulas and examples.
• Include adjustment mechanisms for extraordinary events.

Timeline and Payment Structure

• Clearly state the start and end dates of the earnout period.
• Define payment schedules tied to specific milestones or metrics.
• Specify whether payments are cumulative or independent.
• Plan for early termination scenarios.

Operational Controls and Reporting

• Outline the buyer's responsibilities during the earnout period.
• Establish detailed reporting requirements and audit rights.
• Set limits on operational changes that could affect performance.
• Define key employee retention requirements, if applicable.

Dispute Resolution Framework

• Include tiered processes (e.g., negotiation, mediation, arbitration).
• Set clear timelines for resolving disputes.
• Specify which disputes require expert review versus court intervention.
• Define governing law and jurisdiction.

Legal and Tax Considerations

• Address tax implications of earnout payments.
• Include representations and warranties related to calculations.
• Specify escrow arrangements for disputed amounts.
• Plan for scenarios like business sales or restructuring.

Comparison Table: Payment Structures and Metrics

Payment Structure	Advantages	Disadvantages	Best Used When
Fixed Milestones	Clear targets; predictable payments	May not reflect actual performance; all-or-nothing risk	Business has predictable revenue patterns; specific approvals required
Ratchet Structure	Rewards exceptional performance; aligns incentives	Complex calculations; potential disputes over thresholds	High-growth businesses with variable performance
Revenue-Based	Easy to measure; tied to business growth	Doesn't account for profitability; can be manipulated	Service businesses with stable margins
EBITDA-Based	Focuses on profitability; harder to manipulate	Complex calculations; disputes over adjustments	Companies where cost management is critical

Often, combining multiple metrics - like revenue and customer retention - creates a more balanced incentive structure. The goal is to ensure that whatever structure is chosen, it’s documented with the same precision and clarity that defines the rest of the agreement.

Key Takeaways from Earnout Agreements

Earnout agreements can often determine whether a deal thrives or falls apart, and much of this hinges on how well the terms are crafted from the outset. Vice Chancellor J. Travis Laster put it plainly:

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

This quote highlights the importance of getting the details right from the very beginning.

For an earnout agreement to work smoothly, performance metrics must be clearly defined with specific calculations and examples. Vague language like "best efforts" or unclear revenue definitions tends to lead to disputes. Clarity is key.

Payment structures and timelines also need to be transparent. When both parties know exactly when payments are due and what triggers them, potential conflicts can be avoided. This clarity should extend to operational controls, ensuring buyers have clear responsibilities during the earnout period. By removing ambiguity from payment terms and timelines, the groundwork is laid for smoother execution.

Recent data shows a sharp rise in earnout-related disputes. This trend aligns with the increasing use of earnouts - 33% of deals in 2023 included earnouts, compared to 21% in 2022 and 18% in 2021.

Effective agreements also include a tiered approach to resolving disputes, starting with negotiation and moving to arbitration if necessary. Setting strict timelines for each stage of dispute resolution helps prevent drawn-out conflicts. Additionally, agreements should specify which disputes require expert review versus court involvement and include contingency plans in case the designated expert becomes unavailable.

Tax considerations are another critical aspect. Deciding early on how payments will be treated - whether as purchase price adjustments or compensation - can have a major impact on both parties' tax obligations. Addressing these implications upfront avoids unpleasant surprises later and underscores the importance of precise definitions in every term of the agreement.

Regular monitoring and reporting are essential for accountability. By incorporating routine reporting and audit rights, parties can identify and resolve potential issues before they escalate. This proactive approach, paired with thorough record-keeping, lays a solid foundation for addressing any disagreements that may arise.

FAQs

How can I make sure the performance metrics in an earnout agreement are fair and realistic for everyone involved?

To create a balanced and practical earnout agreement, it's essential to establish specific, measurable performance metrics that align with the business's objectives. These might include targets like revenue, EBITDA, or achieving particular milestones. The key is to ensure these goals are realistic, attainable, and within the control of the party expected to meet them.

It's also important to agree on transparent accounting methods and set up a clear dispute resolution process in advance. This helps prevent potential conflicts down the line. Additionally, defining the timeline for evaluating performance and thoroughly documenting all terms can build trust and ensure both parties are on the same page.

What tax considerations should buyers and sellers be aware of with earnout payments, and how can they address them effectively?

Tax treatment of earnout payments can differ based on how they're structured and classified. If an earnout is considered part of the purchase price, it’s typically taxed as capital gains (usually 15-20%). On the other hand, if it’s classified as compensation for services, it’s taxed as ordinary income. The exact tax treatment hinges on the terms set out in the purchase agreement.

To navigate these tax considerations effectively, buyers and sellers should:

• Clearly outline earnout terms in the agreement to align with desired tax strategies.
• Explore options like installment sales or contingent consideration to potentially reduce tax liabilities.
• Work closely with tax professionals to ensure compliance with tax regulations and avoid unnecessary risks.

Thorough planning and precise documentation play a critical role in managing tax obligations and facilitating smoother transactions.

How can you reduce the risk of disputes in earnout agreements, and what are the best ways to resolve them if they arise?

To minimize the chances of disputes in earnout agreements, it’s essential to spell out key details like performance metrics, calculation methods, timelines, and exclusions with precision. Vague or unclear language in these areas often leads to misunderstandings. Adding specific clauses on how disputes will be managed can also go a long way in keeping disagreements from escalating.

When it comes to resolving conflicts, mediation and arbitration tend to be more practical options compared to litigation. They’re typically quicker and less expensive, making them a preferred choice for many. Including these alternative dispute resolution (ADR) methods in the agreement, along with clear deadlines for resolution, can streamline the process. It’s also worth considering provisions for third-party audits or neutral evaluations to maintain transparency and ensure a fair approach throughout.

Related posts

• 5 Earnout Structures for SMB Acquisitions
• Checklist for Avoiding Earnout Agreement Issues
• Legal Remedies for Earnout Breaches in M&A