An “earn-out” is a contingent‐payment mechanism commonly used in mergers and acquisitions to bridge valuation gaps and share future‐performance risk between buyer and seller. Instead of paying the full purchase price at closing, the buyer pays a base amount up front and defers a portion of the consideration—often 10–50% of the total—to be “earned” only if the acquired business meets specified post-closing targets.
Key Purposes
- Bridging Valuation Disagreements: When a seller and buyer place different values on future growth of the acquired company, they can agree to defer part of the purchase price as a reasonable alternative to a “cash deal”.
- Alignment of Incentives: By tying compensation to metrics (e.g., revenue, EBITDA, user growth, regulatory milestones), earn-outs motivate sellers and management to stay engaged through the transition and possibly for longer.
- Allocation of Risk: Paying less up front and deferring the balance effectively is an option on future success; the seller may obtain additional upside for hitting targets but risks foregoing guaranteed cash if performance falters.
Typical Structure
- Length: 1–5 years post-closing
- Deferred Amount: 10–50% of total purchase price
- Use of Multiplier: that can be calculated via a multiplier/ratchet (e.g., 5× every $1 of EBITDA above a $2 M hurdle)
- Use of Performance Metrics: financial (revenue, gross profit, EBITDA, net income) or non-financial (clinical-trial milestones, patent filings, customer retention)
- Accounting Controls: An “earn-out schedule” should dictate which GAAP/IFRS policies apply, how opening‐balance errors get corrected, and which one-time items are excluded from Adjusted EBITDA
- Compensation: Cash is usually the preferred method of being compensated.
Ideal Core Contractual Components
- Precise Metric Definitions: It is best to use crystal-clear formulas for each target (e.g., “Adjusted EBITDA” = net income + D&A + certain add-backs)
- Covenants on Buyer to Protect the Seller: The buyer should be obligated to run the business in “good faith” or use “commercially reasonable efforts” not to sabotage earn-out performance.
- Seller Rights to Protect Itself: If the seller is not retained in the management of the acquired company, then the seller will require a combination of information and inspection rights, board or advisory seats, and retention of key managers.
- Escrow or Holdbacks: Minimum earn-out amounts may be held in escrow to guarantee payment if targets are met.
- Dispute Resolution: The usual suspects: appraisal, mediation, arbitration, and/or litigation.
Advantages of Using Earn-Outs
- Alignment of purchase price with actual performance.
- Reduction of overpayment risk for buyers and rewarding sellers for upside.
- Overcome valuation differences without forcing one side to concede.
- Smooths ownership transition and preservation of key talent.
- Deferment of a portion of the seller’s tax liability until earn-out payment is actually received.
Pitfalls & Limitations
- Manipulation of Risk: Buyers may front-load expenses (R&D, marketing, headcount) to depress metrics. Likewise, sellers may do the opposite by sacrificing long-term health for short-term earn-out gains.
- Overly Rigid Plans: Earn-outs assume the post-closing business follows the expected plan without a mechanism for amending the earn-out under unanticipated situations—major strategic pivots can render targets obsolete or unfair.
- External Factors May Arise: Anyone remember the Covid shutdown?
Best Practices for Drafting: Clients Read Your Attorney’s Work!
- Definitions: Every term and adjustment must be precisely defined from hurdle metrics to allowable add-backs.
- Accounting Methodology: Determine up-front what accounting policies apply how opening‐balance errors get fixed.
- Buyer Covenants: Buyer must not try to screw you over. One example stems from an unnecessary restructuring.
- M&A Terminology Must Be Understood By Everyone: At closing, no one should be asking “did we properly explain cap multipliers, ring-fence set-off rights, and articulate minimum/maximum payments?”
- Dispute Resolution: No one likes planning for a divorce at the wedding but it is reality. My favorite provision is to require the businesspeople try to resolve the dispute before the attorneys (and their fees) are involved. When it comes to arbitration, I would refer to this blog post because the options are greater than you think: Effective Use of Arbitration Clauses – Seidman Law
Earn-outs have unlocked deals that otherwise would not have happened because they fairly share reward and risk between the parties. But only when everyone is speaking the same language. Fuzzy drafting or misaligned incentives turn them into magnets for post-closing conflict, which is why the next blog post will dive into greater detail into why earn disputes occur.
David Seidman is the principal and founder of Seidman Law Group, LLC. He serves as outside general counsel for companies, which requires him to consider a diverse range of corporate, dispute resolution and avoidance, contract drafting and negotiation, and other issues. In particular, he has a significant amount of experience in hospitality law by representing third party management companies, owners, and developers.
He can be reached at david@seidmanlawgroup.com or 312-399-7390.
This blog post is not legal advice. Please consult an experienced attorney to assist with your legal issues.
Photo Credit: What is an Earnout? | A Simple Model
