Earn-Outs Without Regret: Protecting Future Payouts When Control Changes Hands
Earn-out arrangements are built around a simple commercial premise: bridge a valuation gap by tying part of the purchase price to future performance. The execution demands precision. These structures must function through the buyer's operational decisions, integration plans, accounting policies, and reporting processes long after the seller has stepped away from day-to-day control. Getting that alignment right is not just a drafting exercise; it is a judgment call.
At the strategic level, earn-outs align incentives around post-closing growth. At the document level, they turn on metrics, covenants, reporting requirements, and dispute mechanics. The following are key issues to pay attention to when structuring these provisions.
Choosing the Right Metric: Revenue, EBITDA, or Milestones
The foundation of any earn-out is the performance metric. Different metrics suit different businesses and deal dynamics.
Points that typically deserve close attention:
Revenue-based. Straightforward to track and less subject to cost allocation games, but exposed to pricing pressure, discounts, customer churn, and channel shifts.
EBITDA or profit-based. Harder for the buyer to manipulate through revenue recognition alone, but vulnerable to internal cost shifting, overhead allocations, and changes in corporate accounting policy.
Milestone-based. Product launches, customer wins, regulatory approvals, or integration targets work well where financial metrics will be noisy or heavily influenced by buyer behavior beyond the seller's control.
The metric should reflect what the seller can reasonably influence post-closing while giving the buyer comfort that payment correlates to actual value creation. Absent that alignment, disputes become inevitable.
Buyer Covenants: Operational Support and Non-Sabotage
Even a perfectly chosen metric fails if the buyer can undermine it through resource allocation or integration decisions. Earn-out agreements typically include covenants to address this.
Key protections to consider:
Resource commitments. Minimum staffing levels, marketing spend, R&D budget, or sales support dedicated to the earn-out business for the measurement period.
Non-diversion. Restrictions on shifting key customers, products, or personnel away from the earn-out calculation base.
Good-faith efforts. A covenant to operate the business in a manner consistent with achieving the earn-out targets, measured against the buyer's own internal planning at closing.
These provisions do not handcuff legitimate business decisions. They ensure the buyer cannot achieve the earn-out targets on paper while starving the business of what it needs to succeed in reality.
Integration and Reorganization Protections
Post-closing integration often disrupts earn-out calculations. Products get merged into larger units, revenue streams are reallocated, and standalone P&L visibility disappears.
To preserve the original economics, agreements commonly address:
Allocation methodology. How revenue and expenses will be attributed when the target business is integrated into a larger division or product line.
Business unit continuity. Rules for calculating performance if the standalone entity dissolves, including pro rata allocation of shared costs and preservation of customer-specific tracking.
Substitution protections. If the core business is materially altered (rebranded, sunsetted, or replaced), how the earn-out adjusts to reflect equivalent economics.
The goal is to make integration a neutral event for the earn-out calculation, not an opportunity to rewrite the math.
Reporting, Verification, and Baseline Alignment
Earn-outs live or die on data quality and access. Without structured transparency, sellers lack the information needed to assess or enforce their rights.
Essential mechanics include:
Reporting obligations. Detailed, time-bound reports (monthly or quarterly) showing the earn-out metric calculation, with supporting schedules for revenue recognition, cost allocations, and adjustments.
Agreed baseline. Attaching representative pre-closing financials or an illustrative calculation as an exhibit, with future reporting required to follow the same methodology and classifications absent mutual written change.
Verification rights. Access for an independent accountant to review underlying records where there is a good-faith dispute, typically with cost-shifting if underpayment exceeds a threshold.
Deductions and adjustments should mirror the treatment in pre-sale financial statements. Where possible, certifications tie back to the attached exhibit, creating a stable reference point.
Disputes: Expert Determination vs. Litigation
Even well-drafted earn-outs can lead to disagreements over metrics, adjustments, or compliance with covenants. A clear dispute framework prevents these from derailing the entire relationship.
Common approaches:
Escalation ladder. Internal resolution first (CFO to CFO), then senior executives, before formal proceedings.
Expert determination. Binding resolution of accounting or methodology disputes by a neutral expert (often a Big 4 firm or industry specialist), with narrow scope to avoid scope creep.
Interim payments. Partial payments during disputes, with true-up or holdback resolved later.
Carve-outs. Separating accounting disputes (expert) from covenant breaches or integration issues (arbitration or court).
The process should be fast, specialized, and predictable—favoring commercial resolution over years of litigation.
Role, Termination, and Acceleration Triggers
Earn-outs often intersect with the seller's ongoing employment or consulting role, creating additional complexity.
Points to address explicitly:
"For cause" definitions. Narrow definitions that cannot be used to circumvent earn-out obligations.
Acceleration on termination. Whether payments accelerate (pro rata or otherwise) if the seller is terminated without cause during the earn-out period.
Double-trigger protections. Ensuring change of control or material breach by the buyer preserves earn-out economics.
These terms prevent the buyer from using personnel decisions as a backdoor way to avoid contingent payments.
Bringing Strategy and Mechanics into Alignment
Earn-outs bridge valuation gaps while aligning seller and buyer around post-closing performance. They only deliver on that promise when the strategic design and operational mechanics work together.
For founders and CEOs contemplating a sale or major transition, and attorneys thinking through the practical business aspects of deal documentation, the priority is clarity on objectives—guaranteed economics vs. leveraged upside, tolerance for buyer discretion, verification needs—and ensuring the metric, covenants, reporting, and dispute provisions are calibrated accordingly. Thoughtful alignment at the drafting stage minimizes the risk that operational reality undermines the economics of the deal.
