Buyers and sellers sometimes agree on a business opportunity but disagree about its future financial performance. The seller may expect growth. The buyer may hesitate to pay at closing for earnings that have not occurred. An earnout provides a way to connect additional purchase consideration with future results. However, the concept alone does not resolve the disagreement. The parties must establish earnout performance terms that clearly define how the additional consideration becomes payable.

Select the Right Performance Measure

The parties must first determine what performance will trigger the earnout. Common measures include revenue, gross profit, EBITDA, customer retention, or specific operational milestones. Each measure creates different incentives and risks.

Revenue provides a relatively straightforward measurement. However, revenue growth does not necessarily produce greater profitability. EBITDA connects payment more closely with earnings. Yet post-closing expense decisions may directly affect the calculation. At the measurement level, the selected metric should reflect the economic assumptions underlying the transaction.

Establish the Measurement Period

The earnout must specify when measurement begins and ends. A shorter period provides earlier resolution but offers less time for expected growth to develop. A longer period provides more time for performance but expose the seller to additional post-closing uncertainty. The appropriate period depends on the business, performance metric, growth assumptions, and seller’s continuing involvement.

Define the Calculation

Ambiguous formulas create opportunities for disagreement. The agreement should explain thresholds, payment percentages, maximum payments, and any minimum performance requirements. Accounting policies also require careful definition when financial measures determine the payment. Within the calculation, the parties should address unusual expenses, acquisitions, allocations, and changes in accounting practices. The agreement should also establish procedures for reviewing calculations and resolving disputes.

Consider Who Controls Performance

After closing, the buyer generally controls the company. That control creates significant considerations when buyer decisions affect the seller’s earnout. The buyer may change pricing, staffing, marketing, capital spending, or other operating policies. Integration with another company may further affect revenue and expenses. Given this shift of control, sellers should negotiate appropriate operating protections and information rights before closing.

Determine How and When Payment Occurs

The agreement should clearly define payment timing after the company achieves the required performance. Payments may occur annually, periodically, or after the entire measurement period. The parties should also address the buyer’s creditworthiness and any appropriate payment protections. Tax treatment requires separate consideration because the structure may affect the character and timing of income.

Align the Earnout With the Transaction

Effective earnout performance terms should connect the seller’s additional consideration with measurable post-closing results. The M&A advisor should negotiate the economic framework before attorneys convert those terms into definitive agreements. Accounting and tax advisors should also review provisions affecting financial measurements and tax treatment. A well-designed earnout does not eliminate uncertainty. It defines how the parties will measure, allocate, and compensate for that uncertainty.