Earn-Out Provisions in Contracts Explained
What Is an Earn-Out?
An earn-out is a contractual provision where part of the purchase price in an acquisition is paid later, contingent on the acquired business hitting specified performance targets after closing. It bridges the gap when buyer and seller disagree on valuation.
For example, a buyer might pay $8 million at closing with an additional $2 million payable if the acquired business reaches $5 million in revenue within two years.
How Earn-Outs Are Structured
- Performance metrics — Revenue, EBITDA, gross profit, customer retention, or product milestones
- Measurement period — Typically 1-3 years after closing
- Payment schedule — Lump sum at period end or incremental payments tied to periodic targets
- Accounting methods — The agreement should specify which accounting standards and principles govern the calculations
Common Pitfalls
- Buyer control problems — After closing, the buyer controls the business and could make decisions that undermine earn-out targets (reducing marketing spend, reassigning staff, merging operations)
- Vague metrics — Ambiguous definitions of revenue or profit can lead to disputes over whether targets were actually met
- No acceleration on change of control — If the buyer resells the business, the earn-out could become meaningless without an acceleration clause
- Offset provisions — Some buyers try to offset indemnification claims against earn-out payments
Protective Provisions to Consider
- Require the buyer to operate the business in the ordinary course during the earn-out period
- Define precise accounting methodologies and dispute resolution procedures
- Include acceleration clauses if the buyer sells, dissolves, or materially changes the business
- Establish an independent arbitration process for earn-out disputes
When to Consult a Lawyer
Earn-out disputes are among the most litigated provisions in M&A transactions. Consider retaining experienced M&A counsel to draft or review earn-out terms, especially regarding metric definitions and buyer conduct obligations.
This article is for informational purposes only and does not constitute legal advice. Consult a licensed attorney for guidance specific to your situation.