You’ve just closed the deal of your career. Your company has acquired a fast-growing boutique agency for $10 million. You’ve paid $6 million upfront. And the remaining $4 million is tied to the agency hitting specific revenue targets over the next two years. On paper, everything looks perfect.
The founder stays on to help with the transition, the team seems motivated and you’re confident the business will thrive under your leadership. But a few months in, things start to go a little pear-shaped.
You’re not seeing the results you expected and the metrics are becoming a source of tension. When you ask why, the founder says that your team is making operational changes that undermine the agency’s ability to hit its targets. What started as a strategic win is turning into a legal and emotional headache.
This is the world of earnouts, i.e. financial tools that can help bridge valuation gaps but come with significant risks if not carefully structured.
In this article, our business acquisition lawyer will explore what earnouts are, how they’re typically used in M&A deals, the legal implications you need to be aware of and how to structure them to avoid costly disputes.
What is an earnout?
An earnout is a contractual arrangement where part of the purchase price of a business is paid after closing, based on the business achieving certain performance targets.
A simple earn out definition is a financial mechanism used in business acquisitions to bridge the gap between what the buyer is willing to pay upfront and what the seller believes the business is worth.
How are earnouts structured in M&A arrangements?
Earnouts in an M&A deal are typically tailored to the nature of the business and the perceived risks. While no two earnouts are identical, they generally include the following components.
Performance metrics
Post earnouts are based on financial targets like revenue, EBITDA or net profit. However, some use non-financial KPIs like customer retention, product development milestones or user growth.
Measurement period
The earnout period can last anywhere from 12 months to five years, though most fall in the 1–3 year range.
Payment mechanics
Earnout payments can be made in cash, shares, or a mix of both – typically on an annual or milestone basis.
Seller involvement
Often, the seller remains in the business for the duration of the earnout period to help hit the agreed targets. On the surface, this seems straightforward. But earnouts legal implications can be far-reaching if things don’t go as planned.
3 risks of disputes over post-sale performance targets
Disagreements over earnouts are among the most litigated issues in M&A.
Here are three major risks to watch for.
1. Expectation management
One of the biggest earnouts watchouts is mismatched expectations. The seller may assume the business will operate “as usual”.
The buyer may intend to restructure or integrate it quickly, potentially compromising performance metrics. Without clear communication, this is a recipe for conflict.
2. Operational control
Sellers often lose operational control once the sale closes. Even if they stay on in a leadership role, their decision-making power may be diluted.
If the buyer cuts spending, shifts strategy or reorganises teams, it could affect performance and earnout payouts. In the worst cases, it can lead to accusations of sabotage.
3. Ambiguous metrics and accounting methods
What constitutes “EBITDA” (Earnings Before Interest, Taxes, Depreciation, and Amortisation) may seem obvious until you’re debating which expenses should be included.
Disputes often arise around accounting principles, revenue recognition or exclusions from certain line items. If the earnout terms aren’t crystal clear, lawyers will inevitably get involved.
How to structure earnouts to avoid legal issues
The key to avoiding earnout drama in your M&A transaction? Solid planning, good faith and airtight contracts.
Here’s how to structure your earnout agreement to minimise risk.
Define your metrics clearly
Be meticulous in defining performance targets. This sounds a lot easier than it actually is.
You’re going to need to spell out how metrics will be calculated, what accounting principles apply and how disputes will be handled. Include sample calculations if necessary. Ambiguity is your enemy.
Outline operational control
Clearly establish who will make key business decisions during the earnout period. If the seller remains involved, what authority do they have.
If the buyer takes over, what obligations do they have to support performance goals? Laying out expectations around control, budget, and strategy helps prevent misunderstandings about what each party can and cannot do after the sale.
Hire an M&A Lawyer
Perhaps the most important step – hire an experienced M&A lawyer. Earnouts are complex financial instruments with major legal implications. A good lawyer will draft clear and enforceable clauses, identify red flags early and protect you in the event of future litigation.
Don’t cut corners here. The cost of legal support is minimal compared to a multi-year lawsuit.
Need a lawyer to assist in your business acquisition?
Whether you’re buying or selling a company, earnouts can be a powerful tool to get a deal over the line, but only when structured correctly.
If you’re navigating earnouts in an M&A or facing challenges with post-sale targets, it’s crucial to get expert advice. Our legal team has years of experience structuring earnouts, resolving disputes, and ensuring transactions are smooth and fair.
From drafting contracts to negotiating performance terms, we’ve got your back. Reach out today to schedule a confidential consultation.
