Earnouts & Contingent Consideration

An earnout makes part of the price depend on what happens after closing. It can settle a genuine disagreement about one uncertain outcome, but it will not make an overpriced deal cheap. You still need a case that justifies the total you might pay, the cost of running the earnout, and the limits it puts on how you run the business.

Treat an earnout as a small operating agreement inside the deal. Finance must calculate it, the business must live with it, and counsel must turn the economics into terms that can be enforced. Most of the design work is in the definitions, because the definitions decide what the seller can do to get paid.

Name the uncertainty the earnout shares

Start by stating exactly what the parties disagree about: a product approval, customer retention, a revenue ramp, a contract award, or sustained profitability. Then ask two questions. Will the answer be visible within a sensible period? And can either side significantly influence the measurement?

If the real disagreement is about trust, the quality of the accounts, or your ability to integrate, a contingent payment may magnify the dispute. Consider instead:

• More diligence
• A different perimeter
• A fixed deferred payment
• A lower upfront price
• Stopping the process

Choose a metric that rewards the right behavior

Every metric captures something real and invites a particular distortion. The table shows what each one measures, what can bend it, and the definitions it needs.

Never choose a metric only because it is easy to calculate. A revenue target can reward sales that lose money, which works against the investment thesis. A profit target can discourage the very investment that made the acquisition worth doing.

Write the payment formula and test its edges

Define the measurement period, currency, threshold, cap, and payment date. Then settle the harder points:

• How to interpolate and round between the threshold and the cap
• Whether performance is cumulative, and whether any shortfall or excess carries forward or can be caught up
• How negative results, discontinued products, acquisitions, disposals, and reorganizations affect the number

Hypothetical linear earnout: The buyer pays nothing if qualifying annual revenue is $50 million or less, and a maximum of $20 million at $70 million or more. Between those points, each extra dollar of revenue adds a dollar of payment:

Payment = min($20m, max($0m, (Revenue − $50m) × 1.0))

Qualifying revenue of $48m → $0m
Qualifying revenue of $60m → $10m
Qualifying revenue of $75m → $20m

These inputs are hypothetical, not typical market terms. A cliff, where a large amount becomes payable the moment revenue crosses a line, would create very different incentives near that line. Test the formula at the threshold, just above it, at the cap, and with disputed or restated inputs.

Model the expected payment and the maximum

Show the upfront price, the possible earnout payments, their timing, financing, taxes, and integration costs in one view. Include the maximum payment in liquidity planning, even if you expect to pay less.

A probability-weighted payment is a planning tool. It is not automatically the fair value used in the accounts. Using the example above with hypothetical probabilities, the undiscounted expected payment is $9 million:

Explain where the probabilities come from. Do not present them as more precise than the evidence allows.

Then calculate buyer returns in each operating scenario, using the payment that goes with it. A strong result can raise both cash flow and the payment. A weak result can cut the payment and still leave a bad acquisition. Never show the smaller downside payment as if it were a benefit.

Agree how the business will be run during the earnout

Discuss the integration plan before anyone drafts. If the business will be merged into another product line, a standalone profit target may become difficult to measure.

Agree who controls the decisions that move the metric:

• Pricing and customer allocation
• Hiring and product investment
• Shared services and major restructuring

Identify which actions need the seller's consent or consultation, and what happens if the operating plan changes. Both parties should understand the trade: each protection for the seller removes some of the buyer's freedom to run the business.

Then define how the calculation treats the events that blur it: cross-selling and bundled contracts, transferred customers, foreign exchange and related-party charges, and acquisitions or disposals of businesses. Put worked examples in the agreement's calculation schedule where you can. Examples expose ambiguity faster than abstract definitions.

Hunt for loopholes as the seller's CFO would

Earnout definitions are usually written while both sides want the deal to close. The person who will read them hardest is the seller's CFO in the first year after closing, with millions of dollars riding on each word. In a dispute, the words on the page usually carry more weight than what the buyer meant.

Have finance and counsel test how the definitions reward changes in timing, contracting entity, margins, and returns. Identify actions that increase the payout without creating the intended business value. Then decide which definitions or covenants need to change.

A hypothetical example. Recognition and returns must comply with applicable accounting rules. Counsel and accounting advisers should verify both the contractual definition and the permitted treatment.

Inside the band, each $1 million of measured revenue adds $1 million of payment, so these three moves alone could be worth up to $10 million to the seller.

Sort the moves into three groups. Close the cheap loopholes with a definition, for example a returns adjustment or a margin floor for qualifying contracts. Accept the moves that also create the value you are paying for. For the rest, decide whether a covenant, set-off right, or inspection right is worth the negotiating cost.

The check that matters: send every fix to counsel to draft, then test each identified move against the new wording, because a new exclusion can open a gap of its own.

Keep purchase price separate from pay for staying

A payment that depends on the seller continuing to work in the business can raise different accounting and tax questions from purchase consideration. Ask accounting and tax specialists to review the actual conditions, who receives the payment, the forfeiture terms, and the employment arrangements.

For IFRS reporting, business combination accounting and contingent payments need analysis under the relevant standards. The IFRS Foundation's IFRS 3 materials set out the acquisition accounting framework and related implementation topics. Apply the accounting framework your company uses, rather than assuming every payment belongs in goodwill.

Use retention arrangements for a clear talent goal. Never hide compensation in an earnout just to change how the headline price looks.

Set up measurement and disputes before the first period

The agreement should settle:

• Who prepares the calculation, from which records, and how often
• What inspection rights the other side has
• How long each side has to object, and how objections are resolved
• Who pays the costs of a dispute

Counsel should distinguish an accounting determination from a broader contract dispute and design the process for each.

Set up the ledger and reporting fields before the first measurement period starts. Keep the source data and every approved change to the method. The business should never discover at year-end that it did not capture the customer-level data the calculation needs.

Check the term sheet against this list

• The uncertainty being shared, and why an earnout suits it
• Metric definitions and the order of priority among accounting rules
• Period, threshold, payment curve, cap, and payment timing
• Worked calculations, including edge cases
• Operating commitments and integration assumptions
• Treatment of extraordinary events, acquisitions, and disposals
• Reporting, access, objection, and dispute procedures
• Tax and accounting analysis, with the responsible specialists named
• Security, set-off, acceleration, and other protections where negotiated
• A named administrator after closing, and an executive who owns escalations

Know the five ways earnouts fail

Each of these failures starts in the drafting, so each has a fix before signing.

Continue with deal structure, tax considerations, and integration planning.