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Mergers & Acquisitions · Deal Terms
An earnout makes part of the price depend on how the business performs after closing. It can bridge a valuation gap, but only if the metric, the accounting and the buyer's obligations are written so precisely that there is little left to argue about.
What an earnout is
An earnout is a deferred, conditional payment: the seller receives additional purchase price if the business hits defined targets during a set period after closing.
Earnouts appear when the buyer and seller see the business's future differently. The seller points to a strong pipeline or a recent growth spurt; the buyer is unwilling to pay today for results that have not happened. Splitting the price into a fixed amount at closing and a contingent amount later lets the deal close without either side conceding the point.
The difficulty is that the people measuring the result after closing are the buyer's people. The buyer controls the books, the staffing and the strategy, and has an economic reason to see a lower number. The seller has every reason to suspect that decisions are being made with the earnout in mind. Good drafting reduces that tension; poor drafting all but ensures a dispute.
Paul works on earnouts for both sides as part of the firm's M&A services for buyers and sellers, usually alongside the client's accountant, who models the numbers while the firm builds the contract language.
Choosing the yardstick
There is no universally right metric. The choice depends on what the seller can influence after closing and how the buyer plans to run the business.
| Metric | Why parties choose it | Where disputes arise |
|---|---|---|
| Gross revenue | Simple to measure and hard to manipulate through cost allocation | Buyer may argue revenue was bought through discounting; seller may argue sales were redirected to other buyer entities |
| Gross profit | Reflects pricing discipline as well as volume | Cost of goods definitions and inventory accounting |
| EBITDA or net income | Closest to the value the buyer actually receives | Overhead allocations, management fees, integration costs and accounting changes |
| Customer or contract milestones | Ties payment to a specific event, such as renewal of a major account | Whether the milestone was met on the stated terms, and what counts as a renewal |
| Unit or volume targets | Useful where pricing is set by the buyer | Product definitions and returns |
Whichever metric is chosen, the agreement should define it in words and, ideally, attach an illustrative calculation using the business's historical figures.
Drafting essentials
Accounting
State the accounting principles, and whether they must be applied consistently with the seller's historical practice. Say which items are excluded, such as one-off integration costs or charges imposed by the buyer's group.
Conduct
Sellers ask for commitments to run the business in the ordinary course, maintain staffing or a separate profit center, and not divert customers. Buyers resist anything that limits their right to manage. The compromise is usually a good-faith operating standard plus a short list of specific prohibitions.
Visibility
The seller should receive periodic statements, supporting detail on request, and the right to have an accountant review the calculation within a defined window.
Acceleration
If the buyer sells the business, merges it away or breaches key covenants during the earnout period, the agreement can require the earnout to be paid, in full or at a set amount, rather than leaving the seller to chase a new owner.
When numbers are disputed
Even a carefully drafted earnout can produce a disagreement. The question is whether it is resolved quickly and cheaply or through full litigation. A tiered process usually works best: the buyer delivers its calculation, the seller has a fixed period to object in writing with reasons, the parties negotiate for a short period, and anything still unresolved goes to an independent accountant whose decision on the numbers is final.
That accountant's role should be limited to calculation questions. Arguments about whether the buyer breached an operating covenant are legal questions and are usually sent to court or to arbitration. New Jersey enforces arbitration clauses, but the clause must clearly explain that the parties are giving up the right to go to court; the firm's page on mediation and arbitration covers those choices.
New Jersey contracts also carry an implied covenant of good faith and fair dealing. It can help a seller where a buyer acts in bad faith to defeat the earnout, but it is not a substitute for clear express terms, and its reach depends heavily on the facts and the agreement's wording.
Before you agree
Tracking earnout reporting after closing is part of the post-merger integration work the firm handles for clients.
Questions
It is part of the purchase price that is paid later, and only if the business meets agreed performance targets after closing. The seller receives a fixed amount at closing and the possibility of more. Earnouts are used most often when buyer and seller disagree about how the business will perform, or when much of its value depends on the seller's continued involvement.
It depends on what the seller can still influence and how the buyer will operate the business. Revenue is easier to measure but ignores costs; earnings-based measures are closer to real value but are more exposed to accounting choices and overhead allocations. Many deals settle on revenue or gross profit to reduce argument, with careful definitions either way.
The buyer generally controls the business after closing, which is why sellers negotiate operating covenants. Without them, the seller may have to rely on the implied covenant of good faith, which is harder to prove. Specific commitments, such as keeping the business as a separate unit or not moving key customers elsewhere, give the seller firmer ground.
Well-drafted agreements send disputes about the calculation to an independent accountant after a short negotiation window, and send disputes about breach of covenants to arbitration or court. Without a defined process, a disagreement over a single year's number can turn into expensive litigation. Agreeing the procedure in advance is one of the most valuable parts of the drafting.
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