Earnouts in M&A Deals: Structuring, Protecting, and Resolving Disputes

When a buyer and seller cannot agree on the value of a business, an earnout can bridge the gap. Earnouts tie a portion of the purchase price to the future performance of the business after closing, giving the seller an opportunity to earn additional consideration if the business hits certain performance targets, often based on financial metrics. While earnouts can be an effective tool for getting deals done, they are also one of the most frequently litigated provisions in M&A transactions. A well-drafted earnout provision should address four key areas: how performance is measured, how payments are made, how the seller's interests are protected during the earnout period, and how disputes are resolved.

How Is Performance Measured?

The threshold question in any earnout is what metric will be used to determine whether the targets have been met. The most common metrics are general revenue, gross income, and net operating income (NOI). Each carries different implications for the parties.

Revenue-based earnouts are the simplest to calculate and the most difficult for a buyer to manipulate after closing. Revenue is a top-line number — it reflects total sales without regard to costs, expenses, or accounting judgments. For that reason, sellers often prefer revenue as the earnout metric because it is harder for a buyer to decrease through discretionary spending decisions or expense allocations. The downside is that revenue alone does not reflect the true profitability or health of the business. A company can generate significant revenue and still lose money.

Gross income introduces costs of goods sold into the equation, providing a somewhat more nuanced picture of performance. However, it still excludes operating expenses, overhead, and other costs that affect the bottom line.

Net operating income, or NOI, is generally the best representation of the business's actual performance during the earnout period. NOI accounts for revenue minus operating expenses, giving both parties a metric that reflects how the business is truly performing under the buyer's stewardship. The tradeoff is complexity: NOI-based earnouts require the parties to agree on detailed accounting definitions, including which expenses are included, how overhead is allocated, and whether extraordinary or non-recurring items are excluded. Despite this added complexity, NOI-based earnouts tend to produce the most meaningful and fair measurement of whether the business has achieved the performance the parties contemplated at the time of the deal. However, NOI-based earnouts also provide the greatest opportunity for decisions made by the buyer — such as spending decisions or expense allocation that were not expected by the seller — to result in an earnout being reduced or not paid at all, which can lead to post-closing earnout disputes.

Earnouts can sometimes provide for achievement of certain non-financial performance milestones specific to the seller's business. Non-financial performance milestones commonly include the receipt of regulatory (such as FDA) approval, the issuance of one or more patents, or the launch of a new product. A milestone structure requires the parties to agree on the specific milestones (including what will and what will not satisfy the milestones), the degree of buyer efforts to cause or to cooperate in causing the milestone event to be achieved, and any deadline by which the milestones must be achieved.

Regardless of which metric or milestone is chosen, the earnout provision should clearly define the applicable accounting standards (e.g., GAAP applied consistently with the target company's historical practices), the measurement periods, and any specific inclusions or exclusions from the calculation. For non-financial performance milestones, care must be taken to avoid the use of industry and colloquial terms in defining the milestones — the precise definition of which could later be disputed. Ambiguity in these definitions is one of the leading causes of post-closing earnout disputes.

How Is the Buyer Going to Pay?

Once the parties agree on the performance metric, the next question is the mechanics of payment. The earnout provision should specify the timing, form, and structure of payments with precision.

Timing considerations include when the earnout period begins (typically at closing), how long it lasts (earnout periods commonly range from one to three years), and when payments are due after each measurement period ends. The buyer will typically need time after the close of each measurement period to calculate the earnout — 60 to 90 days is common — and the provision should specify a deadline for the buyer to deliver the earnout calculation to the seller.

The form of payment matters as well. Most earnouts are paid in cash, but some deals provide for payment in buyer stock, a promissory note, or a combination. Sellers should be cautious about accepting non-cash consideration for earnout payments, as it introduces additional risk around valuation, liquidity, and timing.

The structure of the earnout can also vary. Some earnouts are binary, where the full earnout amount is paid if the target is met, and nothing is paid if it is not. Others are tiered or scaled, with partial payments for partial achievement of the targets. Scaled earnouts are generally more favorable to sellers because they reduce the all-or-nothing risk inherent in a binary structure. The parties may also negotiate a cap on the total earnout payments and a floor or minimum threshold below which no payment is owed.

How Do You Protect the Earnout?

From the seller's perspective, one of the greatest risks of an earnout is that the buyer will operate the business after closing in a way that undermines the earnout targets, whether intentionally or through neglect. The seller no longer controls the business, but the consideration to be received by the seller depends on how the business performs. This fundamental tension makes protective covenants critical.

The most important protection is an operating covenant that governs how the buyer will run the business during the earnout period. At a minimum, sellers should seek a covenant requiring the buyer to operate the business in the ordinary course consistent with past practices. Stronger protections might include commitments to maintain certain levels of staffing, marketing spend, or capital investment, or restrictions on the buyer's ability to divert revenue, customers, or key employees away from the acquired business.

Sellers should also consider whether to negotiate restrictions on the buyer's ability to make changes that could affect the earnout calculation, such as changing accounting methods, reallocating overhead, or integrating the acquired business into the buyer's existing operations in ways that make it difficult to measure standalone performance. A provision requiring the buyer to maintain separate books and records for the acquired business during the earnout period can be a valuable safeguard.

Another common protective mechanism is an acceleration clause providing that the full earnout (or a specified portion) becomes payable if certain triggering events occur. Examples include if the buyer sells the business during the earnout period, materially breaches its operating covenants, or takes actions that make it impossible to calculate the earnout.

Buyers, on the other hand, will want flexibility to operate the acquired business as they see fit and to integrate it into their broader operations. Earnout negotiations often involve significant back-and-forth on the scope of operating covenants, and the final terms will depend on the relative leverage and priorities of the parties.

Dispute Resolution

Even with careful drafting, post-closing disputes over earnout provisions are common. The earnout provision should include a clear and detailed dispute resolution process in an effort to avoid costly litigation.

A typical earnout dispute resolution framework begins with the buyer delivering its earnout calculation to the seller within a specified period after the end of each measurement period. The seller then has a review period, usually 30 to 60 days, to examine the calculation and the underlying books and records. The provision should expressly grant the seller access to the buyer's financial records and personnel during this review period.

If the seller disagrees with the buyer's calculation, the seller delivers a written objection specifying the items in dispute and the seller's proposed adjustments. The parties then enter a negotiation period, typically 30 days, to attempt to resolve the disagreements.

If the parties cannot resolve the dispute through direct negotiation, the provision should designate a neutral third-party accounting firm with experience in the industry of the seller's business to serve as the final arbiter. The independent accountant's review is typically limited to the specific items in dispute (rather than a de novo review of the entire calculation), and the accountant's determination is binding on both parties, absent manifest error. The provision should also address how the costs of the independent accountant are allocated. Commonly, each party bears its own costs, or the costs are split based on the relative success of each party's position.

Including a well-defined dispute resolution mechanism in the earnout provision reduces the risk that disagreements will escalate into full-blown litigation, which can be expensive, time-consuming, and distracting for both parties, and is not confidential like arbitration can be. A well-defined dispute resolution mechanism also provides both the buyer and the seller with greater certainty about the process for resolving disputes, which can make the earnout structure more palatable during deal negotiations.

Conclusion

Earnouts can be a powerful tool for bridging valuation gaps and aligning the interests of buyers and sellers in M&A transactions. But they are only as effective as the drafting that supports them. A well-structured earnout provision addresses the measurement metrics, payment mechanics, protective covenants, and dispute resolution with specificity and clarity. Sellers and buyers alike benefit from investing the time and attention upfront to get these provisions right, because by the time a dispute arises, the leverage dynamics and business relationships that shaped the original deal may look very different.

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Andrew Schultheis is a partner in DWT's Seattle office and Dylan Lowe is an associate in the firm's Portland office. For questions or additional insights, please reach out to the authors or another member of our corporate M&A team and sign up for our alerts.