Drafting Earnout Provisions That Actually Work

Few provisions in a purchase agreement generate more post-closing litigation than the earnout. Intended to bridge valuation gaps between buyers and sellers, earnouts frequently become the source of disputes over accounting methodologies, operational decision-making, financial reporting and contractual interpretation. The irony is that most of these disputes are entirely foreseeable and, with careful drafting, largely avoidable.

In addition to commercial and operational considerations, poorly drafted earnouts may create unintended accounting and tax consequences that materially alter the economics the parties believed they had negotiated.

Although no agreement can eliminate every disagreement arising from a contingent payment structure, practitioners can significantly reduce litigation risk by anticipating the issues most likely to arise after closing. An earnout should not merely describe how additional consideration is calculated. It should function as a road map for resolving the practical questions that inevitably arise once the buyer assumes control of the business.

Define Financial Metrics with Precision

Parties commonly argue over how revenue, EBITDA (earnings before interest, taxes, depreciation and amortization) or other metrics are measured. Common issues include which generally accepted accounting principles (GAAP) methods apply, whether practices must be consistent with the target's past practice, how intercompany charges and overhead are allocated, the effect of acquisitions after closing and the treatment of one-time items. For instance, many earnout disputes begin with a deceptively simple question: What exactly does "EBITDA" mean? Although EBITDA is a commonly used financial metric, there is no universally accepted definition. Whether stock-based compensation, management fees, integration costs, restructuring charges, purchase accounting adjustments or extraordinary expenses are included or excluded can materially affect the earnout calculation. 

Rather than relying on generic references to "GAAP" or "consistent with past practice," practitioners should define each adjustment expressly. Where appropriate, the agreement should establish an explicit hierarchy, specifying whether historical accounting principles control over GAAP in the event of inconsistency. Attaching an illustrative earnout calculation as an exhibit can further reduce ambiguity by demonstrating precisely how the parties intend the formula to operate.

Earnouts may also be tied to nonfinancial operational milestones tied to events, approvals, launches, retention, integration or operational performance rather than revenue, EBITDA, net sales or margin. Such milestones need to be approached in a similar manner. Parties may disagree about whether a milestone was achieved. Examples include what qualifies as satisfying "regulatory approval," "trial enrollment," "commercial launch" or "user or customer adoption" milestones. Here, it is imperative to think about and specify how partial or late achievement is treated under such provisions. Again, the best way to avoid disputes is to carefully define any nonfinancial operational milestones and make the milestones objective and auditable. Precision during drafting is invariably less expensive than expert testimony after closing.

Carefully Balance Operational Flexibility

Perhaps the most heavily negotiated aspect of an earnout is the buyer's ability to operate the acquired business during the earnout period. This is even more complicated when sellers stay on to help run the business following the deal.

Sellers frequently seek affirmative covenants requiring the buyer to operate the business in a manner consistent with historical practice or refrain from taking actions that could reduce the likelihood of achieving the earnout targets. Buyers, by contrast, often resist operational restrictions that could interfere with post-closing integration or broader business strategy.

Neither extreme is ideal.

Excessively restrictive covenants may prevent buyers from realizing anticipated synergies, implementing operational efficiencies or responding to changing market conditions. Conversely, broad grants of discretion may invite allegations that the buyer intentionally depressed performance to avoid paying contingent consideration.

Rather than attempting to regulate every business decision, practitioners should focus on identifying the limited categories of actions that are genuinely material to the earnout calculation. Tailored covenants frequently provide greater certainty than broad standards that require the parties to litigate what constitutes "commercially reasonable efforts" or "good faith."

Address the Scope of Buyer Discretion

Many purchase agreements provide that following closing, the buyer retains sole discretion over the operation of the business. Although commercially understandable, such provisions do not always eliminate post-closing disputes.

Courts are often asked to reconcile broad contractual grants of discretion with implied duties of good faith and fair dealing. Accordingly, practitioners should expressly address whether the buyer may prioritize its broader corporate interests, integrate the acquired business with existing operations, allocate shared expenses, discontinue product lines or redirect personnel during the earnout period.

The more clearly the agreement allocates decision-making authority, the less likely the parties will need to ask a court to supply contractual terms after the fact.

The Implied Covenant Is Not a Drafting Substitute

Many earnout disputes ultimately invoke the implied covenant of good faith and fair dealing. Sellers argue that the buyer manipulated operations to defeat the earnout. Buyers respond that the agreement granted them complete operational discretion.

The implied covenant, however, is not intended to rewrite agreements or provide protections the parties chose not to negotiate.

Practitioners should resist the temptation to rely on generalized concepts of good faith where specific contractual language can allocate the relevant risks directly. If the parties intend to require minimum operational efforts, preserve certain business lines or prohibit specified actions during the earnout period, those obligations should appear expressly in the agreement rather than being left to implication.

Contractual precision remains the most effective mechanism for reducing litigation risk.

Expert Determination or Arbitration?

Dispute resolution provisions deserve the same level of attention as the earnout itself.

Many agreements provide that accounting disputes will be resolved by an independent accounting firm acting as an expert rather than as an arbitrator. This distinction is significant.

Expert determination is generally well suited for disputes involving mathematical calculations, accounting principles or the application of agreed financial methodologies. It is considerably less effective when disputes require witness testimony, document discovery or determinations regarding contractual intent and alleged misconduct.

Practitioners should therefore distinguish between accounting disagreements and broader contractual disputes. Purchase agreements often benefit from bifurcated dispute resolution provisions under which calculation disputes are submitted to an accounting expert while issues involving contractual interpretation, fraud, breach of covenant or bad faith proceed through arbitration or litigation in the agreed forum.

Attempting to resolve every earnout dispute through a single mechanism frequently creates unnecessary procedural complications.

Tax Considerations Should Inform Earnout Drafting

Earnouts are frequently negotiated as commercial solutions to valuation uncertainty, but they also present significant tax planning considerations. Tax consequences can differ materially depending on how contingent consideration is structured and whether the transaction is treated as an asset acquisition, a stock acquisition or partnership transaction.

Among other issues, practitioners should consider whether earnout payments constitute additional purchase price or may instead be characterized, in whole or in part, as compensation for future services. This distinction carries significant consequences for both buyers and sellers. Amounts treated as purchase price generally preserve capital gains treatment for sellers, whereas payments characterized as compensation may be subject to ordinary income tax, employment taxes and applicable withholding obligations.

The risk of recharacterization may be heightened where earnout recipients are continuing employees, particularly if payments are conditioned on continued employment, forfeited upon termination or otherwise resemble incentive compensation rather than contingent purchase consideration. Although continued employment provisions are often commercially justified, counsel should carefully evaluate, in coordination with the relevant tax return preparers, whether the overall structure appropriately reflects the parties' intended tax treatment.

Practitioners should also consider the timing of income recognition, buyer's basis adjustments, purchase price allocation under Internal Revenue Code Section 1060 in applicable asset acquisitions, and interaction between contingent consideration and installment sale reporting where relevant. Earnouts that are open-ended and uncapped may warrant making certain elections to not have the installment rules apply to such deferred consideration due to how basis is allocated. Cross-border transactions may present additional withholding and treaty considerations that warrant early involvement from tax advisors.

Tax planning should not be viewed as a post-signing exercise. Decisions regarding earnout mechanics, payment conditions and drafting often influence the tax consequences as much as the negotiated economics themselves. The parties should take care to set forth the agreed tax treatment of an earnout in the transaction documents so that expectations are aligned. Close coordination between transaction counsel and tax advisors during the drafting process can substantially reduce the likelihood of unintended tax outcomes long after the transaction has closed. 

Conclusion

Earnouts remain valuable tools for bridging valuation gaps, particularly in founder-led businesses, high-growth companies and transactions involving uncertain future performance. Yet they continue to generate a disproportionate share of post-closing disputes.

The common thread in most earnout litigation is not commercial misconduct but contractual ambiguity.

By carefully defining financial metrics, allocating operational discretion, articulating the parties' expectations regarding post-closing conduct, addressing the tax implications of contingent payment structures and selecting dispute resolution mechanisms that correspond to the nature of potential disagreements, practitioners can substantially reduce the likelihood that an earnout will become the most heavily litigated provision in the purchase agreement.

The best earnout provisions are not those that predict every future disagreement. They are the ones that provide clear answers before those disagreements arise.

For more information, please contact the authors or your Holland & Knight relationship attorney.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.