Earnouts in Business Acquisitions: Preventing Post-Closing Disputes
Why an earnout can solve one problem and create another
A buyer and seller may agree on the value of a business but disagree about how much of that value is proven. An earnout bridges the gap by tying additional purchase price to performance after closing. The challenge is that the buyer often controls the business during the measurement period. Unless the agreement anticipates that shift in control, a payment formula that appears straightforward can become the center of a costly dispute.
Define the metric before debating the percentage
Revenue, gross profit, EBITDA, customer retention, and product milestones each measure different things. The agreement should define the chosen metric, the measurement period, accounting policies, permitted adjustments, and treatment of unusual transactions. Terms such as “net revenue” or “ordinary course” are not self-executing. The parties should test the formula against realistic scenarios before signing.
Address who controls performance
After closing, the buyer may change pricing, staffing, marketing spend, accounting systems, or the allocation of shared expenses. Those decisions can affect the earnout even when made for legitimate business reasons. Sellers may seek operating covenants, restrictions on shifting revenue, or standards governing integration. Buyers may resist commitments that prevent them from managing the acquired business. The contract must state the negotiated balance rather than assume an implied obligation will solve the problem.
Make the numbers auditable
Reporting deadlines, access to supporting records, a period to object, and an independent accountant or other neutral for defined accounting disputes can prevent disagreement from escalating. The agreement should distinguish disputes over calculations from claims that a party breached an operating covenant; they may require different procedures and remedies. Also address offsets, acceleration, termination of employment, and what happens if the acquired business is sold again.
The practical takeaway
An earnout should be drafted as an operating system, not just a purchase-price line item. Parties benefit from modeling best-case and worst-case outcomes, assigning responsibility for records, and documenting the circumstances under which payment can be reduced or withheld. Early attention to these details helps preserve the commercial compromise that made the deal possible.
Worked earnout example
Assume a seller receives $4 million at closing plus up to $1 million if the acquired business reaches $5 million in annual revenue. If the buyer later shifts customers to an affiliate or changes revenue-recognition policies, the parties may disagree over whether the target was met. The agreement should specify accounting principles, affiliate transactions, permitted adjustments, reporting, and dispute resolution before closing.
Drafting from both sides
Sellers often seek reporting access, anti-diversion covenants, and protection against changes designed to defeat the earnout. Buyers need flexibility to integrate operations and avoid open-ended operational restrictions. A negotiated covenant and an independent accounting-dispute mechanism are generally more useful than leaving those issues to later litigation.
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This article is general information, not legal advice. The outcome depends on the facts and applicable law.
