When the Price Is Never Quite Right: Making Earn-Outs Work in M&A
It is not uncommon in M&A transactions that a buyer and seller arrive at the table with very different views on what the business is worth. The seller believes the business is worth more than it has yet to show while the buyer is not willing to pay for potential that has not materialized. That is where earn-outs come in, giving both sides a way to close the deal today and let actual results settle the argument on price. However, where earn-outs are not carefully structured, the downside is that they trade one disagreement for another.
This article walks through the key considerations for buyers, sellers, and their advisors before putting an earn-out in place.
What Is an Earn-Out and Why Does It Matter?
An earn-out is a contingent payment mechanism. A portion of the purchase price is paid only if the target business meets agreed performance targets after closing.
Earn-outs are commonly found in sectors where future value is difficult to pin down at closing. Technology, life sciences, professional services, and founder-led businesses are some examples. They are also a natural fit when the seller will remain involved in running the business post-closing, giving both sides a shared incentive in the outcome.
Earn-out performance metrics can be financial or operational. Some examples include:
• Financial metrics: revenue, EBITDA, or net profit over a defined post-closing period (typically one to three years).
• Non-financial milestones: customer retention rates, regulatory approvals, product launches, or the successful integration of key personnel.
The Earn-Out Paradox: Alignment and Conflict at the Same Time
At its core, an earn-out is an alignment mechanism, giving buyer and seller a shared stake in what happens next. The seller is motivated to perform while the buyer avoids overpaying for results that never materialize. In theory, risk is shared. However, the earn-out period can introduce a fundamental tension that many parties underestimate at signing. The buyer takes control of the business at closing but the seller’s payout depends on what the buyer does with it.
This is where earn-out disputes tend to arise. After closing, a buyer may integrate the business, reallocate resources, or shift strategic priorities. None of those decisions are necessarily wrong. However, these decisions can have the effect of moving the goalposts for the seller and making the earn-out targets harder, or impossible, to achieve.
This is where earn-out disputes tend to arise. After closing, a buyer may integrate the business, reallocate resources, or shift strategic priorities. None of those decisions are necessarily wrong. However, these decisions can have the effect of moving the goalposts for the seller and making the earn-out targets harder, or impossible, to achieve.
Careful drafting can mitigate this tension, but it cannot substitute for an upfront conversation about what the buyer intends to do with the business after closing.
Getting the Drafting Right: Where Deals Go Wrong
Ambiguity is the leading cause of earn-out litigation. The earn-out formula should be specific enough that an independent third party such as an accountant, an arbitrator, or a court can apply it without guessing at the parties’ intent. Key drafting considerations include:
• Define the metrics precisely. If the earn-out is tied to “revenue,” the agreement should specify what is included and excluded, which accounting standards apply, and how intercompany transactions are treated. An example calculation attached as a schedule can be informative.
• Address the buyer’s post-closing obligations. Most earn-out agreements include a covenant requiring the buyer to operate the business with “reasonable efforts” or “in the ordinary course.” These are negotiated standards and their scope should be understood by both sides.
• Set realistic and measurable targets. Earn-out targets that were optimistic at the time of signing or that no longer make sense after a market shift are a recipe for frustration. Parties should test their assumptions carefully.
• Include dispute resolution mechanisms. Specifying a process for resolving disagreements over earn-out calculations, whether through an independent accountant for calculation disputes or arbitration for broader factual or legal disagreements, can avoid litigation and preserve the business relationship.
Protecting the Seller: The Earn-Out Is Only Worth What the Buyer Will Pay
From the seller's side of the table, an earn-out is only as good as the buyer's ability and willingness to pay. If the buyer's financial circumstances change, or the buyer disputes whether targets were met, collection can become a real challenge. Sellers should negotiate appropriate protections from the outset. Common examples include:
• Escrow or holdback arrangements, where funds are held by an agent and released upon satisfaction of agreed conditions.
• Parent guarantees, where the buyer is a subsidiary or acquisition vehicle.
• Security interests over the target's assets or shares.
Buyers, on the other hand, will typically seek set-off rights: the ability to reduce earn-out payments to satisfy indemnity claims or post-closing purchase price adjustments. These rights are commercially reasonable, but their scope must be clearly defined to prevent them from becoming a tool for withholding legitimate payments.
A Tax Note Worth Paying Attention To: The Reverse Earn-out
How an earn-out is structured can have meaningful tax consequences and the choice between a traditional and reverse earn-out can be one of the most consequential tax planning decision that parties will make. Tax planning should be integrated into the earn-out structuring discussion from the outset and not treated as an afterthought.
Under a traditional earn-out, post-closing payments tied to performance are generally treated as income to the seller and taxed at full marginal rates (though exceptions may exist, such as applying the “cost recovery method” which may allow capital gains treatment on a share sale if certain narrow conditions are met).
By contrast, a reverse earn-out, where the full purchase price is paid at closing and reduced if targets are not met, is generally treated as a capital gain to the seller and carries a more favourable tax rate. That said, the tax benefit comes with a trade off as the seller must recognize the full purchase price in the year of sale, which can create a potentially higher tax liability upfront. If the purchase price is ultimately adjusted downward, the seller may be able to claim a capital loss on the shortfall, though the utility of that loss will depend on whether the seller has capital gains to apply it against.
What This Means for Buyers and Sellers
Whether an earn-out creates value or conflict depends almost entirely on how it is negotiated and drafted. The parties who fare best are those who go into the process with clear expectations, a candid conversation about post-closing control, and experienced legal and financial advisors at the table.
The practical takeaways:
• For sellers: scrutinize the buyer’s post-closing obligations carefully. Understand what the buyer can and cannot do with the business during the earn-out period. Take care to ensure your protections are realistic and not simply aspirations.
• For buyers: be precise about the metrics and realistic about what you can commit to. Vague covenants to “use reasonable efforts” are not a substitute for a clear operational plan.
• For both parties: treat the earn-out as an ongoing relationship and not a transaction that ends at closing. The earn-out period will test the working relationship between buyer and seller and the agreement needs to be built with that in mind.
The Bottom Line
Done well, an earn-out can save a deal that would otherwise fail and create real value for both sides. Done poorly, it defers the valuation disagreement rather than resolving it and sets the stage for a dispute that is often more costly than the gap it was meant to bridge.
An earn-out rewards preparation. The parties who invest the time to get the structure right are far better positioned to benefit from it.
Loopstra Nixon’s Business Law Group advises buyers, sellers, and founders on the full range of transaction structuring and negotiation, including earn-out arrangements, purchase price mechanics, and post-closing risk allocation. For more information, please contact the authors or a member of the team.