Earnouts: When They Bridge a Gap and When They Create a Dispute

An earnout is useful when buyer and seller disagree about the future and both are willing to let results decide. It is a poor substitute for agreeing on value, and a poorly drafted one is among the most common sources of post-closing disputes. Sellers should treat any earnout as money they may not receive, and negotiate the terms that determine whether they will.

What an earnout is

An earnout makes part of the purchase price contingent on the business achieving defined results after closing. A seller might receive $1.6 million at closing and up to $400,000 more if revenue over the next two years reaches agreed targets.

When an earnout fits

Earnouts address a specific problem: a gap in price expectations caused by uncertainty that only time can resolve. Typical situations include the following.

• Recent growth. Earnings rose sharply last year, and the buyer is unsure the increase will hold.
• A pending event. A large contract is up for renewal, or a new product has just launched.
• Customer concentration. Much of the revenue depends on one account.
• Owner dependence. Customer relationships are personal to the seller, and their transfer is uncertain.
• A temporary decline. The seller believes a weak year was an anomaly, and the buyer is not convinced.

In each case the seller is confident, the buyer is cautious, and the earnout lets the seller be paid for being right.

When it does not fit

SBA-financed acquisitions. SBA rules prohibit seller earnouts in 7(a) change-of-ownership loans. The price must be fixed at closing. Because so many Main Street acquisitions rely on SBA financing, earnouts are less common at this level than owners expect. In those transactions, a seller note, sometimes on standby, is the available tool for bridging a gap.

Businesses the buyer will change substantially. If the buyer plans to merge operations, change pricing or consolidate locations, the acquired company's separate results become difficult to measure.

Sellers who are leaving immediately. An earnout depends on performance the departing seller cannot influence.

The choice of metric

The measure used determines how easily the earnout can be manipulated or disputed.

Revenue is the simplest to measure and the hardest for a buyer to distort. Sellers generally prefer it. Buyers worry that it rewards unprofitable sales.

Gross profit addresses that concern while still excluding most of the buyer's discretionary spending.

EBITDA or net income reflects what the buyer cares about but depends on every expense decision the buyer makes after closing. New salaries, management fees, allocated overhead and accounting changes all reduce it.

Specific milestones, such as renewal of a named contract or retention of listed customers, work well when the uncertainty is narrow.

As a rule, the further down the income statement the metric sits, the more protection the seller needs in the drafting.

Terms that determine whether it pays

A workable earnout answers each of these questions in the purchase agreement.

1. How is the metric defined? Reference the accounting methods the company used before closing, and attach a sample calculation.
2. What is the measurement period? One to three years is typical. Longer periods increase the chance of changes that make measurement unreliable.
3. Is payment all-or-nothing or graduated? A sliding scale that pays proportionally between a floor and a target reduces the incentive to dispute a narrow miss.
4. Is there a cap, and can shortfalls be made up? A catch-up provision lets a strong second year offset a weak first.
5. How must the buyer operate the business? Sellers ask for covenants to run the business consistently with past practice, maintain adequate staffing and working capital, and avoid diverting customers to affiliates.
6. What happens if the business is sold again, the seller is terminated without cause, or the buyer defaults on its bank loan? Acceleration in these events is a common request.
7. What information does the seller receive? Periodic statements and a right to review the records supporting the calculation.
8. How are disputes resolved? Referral of calculation disputes to an independent accountant is faster and cheaper than litigation.

The seller's position after closing

The underlying difficulty is that the seller bears the risk while the buyer holds control. The buyer decides whom to hire, what to spend and which customers to pursue. Even a buyer acting in good faith will make choices that affect the calculation.

For this reason, earnouts work best when the seller remains in a role with real influence over the result, for a period that matches the measurement window. They also work best when they represent a minority of the total price. A common guideline is that a seller should be satisfied with the transaction on the basis of the closing payment alone, with the earnout regarded as additional.

Tax treatment

Earnout payments are generally treated as additional purchase price. If payment is conditioned on the seller's continued employment, however, the IRS may view it as compensation, taxed as ordinary income and subject to payroll taxes. The agreement should be drafted with this distinction in mind, and reviewed by a tax advisor.

Alternatives worth considering

Other structures can address the same uncertainty with less complexity.

• A seller note provides fixed payments and is permitted in SBA transactions.
• A holdback or escrow released when a specific event occurs, such as a contract renewal.
• A retained equity interest, which lets the seller share in future value directly.
• A price adjustment at closing based on trailing results through the closing date.
• A consulting agreement that compensates the seller for specific transition work.

An earnout is one tool among several. It serves both parties when the uncertainty is real, the metric is simple, the period is short and the seller remains involved. When those conditions are absent, a lower fixed price or a different structure is usually the better outcome.

Twelve31 Advisors evaluates contingent structures against fixed alternatives and negotiates the terms that determine what a seller ultimately receives.