TLDR:
An earn-out is a transaction structure where part of the purchase price in an acquisition is contingent on the target company achieving specific financial or operational performance after closing. Earn-outs bridge valuation gaps between buyers and sellers, allowing transactions to close despite disagreement on what the business will achieve.
Common Earn-Out Structures
Typical structures include: revenue-based earn-outs (additional payments triggered by revenue thresholds over 1-3 years post-closing), EBITDA-based earn-outs (most common in PE deals, tied to profitability metrics), milestone-based earn-outs (specific product launches, customer wins, regulatory approvals—common in pharma and biotech), and hybrid structures combining metrics. Payment can be all-or-nothing (cliff), proportional (linear scaling), or threshold-and-bonus (base payment + upside). Maximum earn-out values typically range from 10-40% of total purchase consideration.
Common Disputes
Earn-outs generate substantial litigation because incentives often diverge post-closing: sellers want maximum measured performance during the earn-out period; buyers running the business may prioritize long-term value over short-term metrics. Common dispute triggers include: buyer changes to business operations or accounting practices reducing measured metrics, expense allocations (corporate overhead, intercompany charges) affecting EBITDA, integration decisions sacrificing earn-out period revenue, and disputes over the calculation methodology. Good earn-out drafting specifies accounting principles, allocation rules, and governance over decisions affecting earn-out metrics.
Drafting Best Practices
Effective earn-out provisions include: clear and objective metrics (avoiding subjective measures), explicit accounting principles and calculation methodology, defined treatment of unusual items and one-time events, restrictions on buyer actions that would unfairly suppress metrics (operating covenants during the earn-out period), seller information rights and dispute resolution mechanism, and acceleration on change of control. Tax treatment matters significantly: earn-out payments are typically taxed as ordinary income or capital gains depending on structure, affecting net seller proceeds. Cross-border earn-outs require careful planning around withholding tax and double-treaty applicability.