Earnouts bridge valuation gaps — and create most of the post-closing disputes in middle-market deals. Here’s how to draft them to close the deal and avoid the courtroom.
Why earnouts exist
Earnouts — contingent purchase-price payments tied to post-closing performance — bridge the gap between what a seller believes the business is worth and what a buyer is willing to pay today. They are most common when (1) the target’s trajectory is uncertain, (2) the seller projects aggressively, or (3) the seller’s continued involvement is critical to hitting the projection. In Florida middle-market deals we see earnouts in roughly 30–40% of transactions in the $5M–$50M value range, concentrated in services, healthcare, technology, and specialty manufacturing.
Earnouts also generate a disproportionate share of post-closing litigation. The ABA’s most recent Private Target M&A Deal Points Study shows earnout-related disputes account for roughly 15–20% of all post-closing claims despite appearing in a minority of deals. The good news: most earnout litigation traces to avoidable drafting problems, not genuine disagreements about fact.
The five drafting decisions that matter most
1. Pick a metric the business actually tracks
Revenue is the cleanest. EBITDA is more common but introduces dozens of adjustment decisions. Gross profit, customer count, and product-specific metrics can work. Avoid metrics the target does not currently track or that rely heavily on post-closing accounting choices. If the target’s books close on a 45-day lag and have historically required 15+ adjustments per quarter, an EBITDA earnout is an invitation to dispute.
2. Define the metric in one place, exhaustively
An earnout schedule should define every term used in the metric. ‘Revenue’ should specify gross vs. net, returns, chargebacks, affiliated-party sales, discontinued products. ‘EBITDA’ should list every permitted add-back and every prohibited one. Where reasonable minds may differ, pick a definition and stick to it — don’t leave decisions to post-closing discretion.
3. Specify the measurement period
One-year earnouts produce less dispute than three-year earnouts. Every additional measurement period adds exposure to buyer operating decisions and macro changes. If a longer earnout is commercially necessary, consider annual payment gates rather than a single three-year cliff.
4. Define operating covenants
The most common source of earnout litigation is an ambiguous operating covenant. Sellers accuse buyers of running the business to depress the earnout; buyers argue they’re running it per their own reasonable judgment. Either specify the covenant concretely (maintain product mix, preserve customer accounts, maintain specified headcount, operate in ordinary course) or specify who has discretion and what good faith means in that discretion. Do not leave a half-sentence ‘shall operate in good faith’ as the only standard.
5. Preordain dispute resolution
Most earnout disputes are math disputes, not legal disputes. Route them to a neutral accountant under expedited procedures — not to state court. A well-drafted dispute clause names the accounting firm (or a method for selection), sets a timeline, and specifies the firm’s decision as binding subject to limited arbitration review.
Seller-favorable techniques
- Cumulative targets: meet total target over the period, not year-by-year, so one bad quarter doesn’t kill the payment.
- Catch-up provisions: exceeding year two’s target can retroactively pay year one’s shortfall.
- Interim payments: trigger a portion at each milestone rather than all at the end, reducing buyer’s incentive to delay accounting.
- Acceleration on change of control: if the buyer sells the business before the earnout ends, the earnout pays at full value.
- Specified operating covenants protecting product mix, personnel, and customer accounts.
- Seller-selected measurement standards for key accounting choices.
Buyer-favorable techniques
- EBITDA-based metrics with adjustments favoring the buyer (e.g., no add-back for seller’s post-closing compensation).
- Caps on earnout payments, often 20–40% of the upfront purchase price.
- Set-off rights against pending indemnity claims.
- Milestones requiring buyer approval to count (new product launches, new regions).
- Best-efforts language rather than specified operating covenants.
- Dispute resolution in a specific Florida circuit court with mutual consent to personal jurisdiction.
Tax treatment notes
Earnouts are generally treated as installment sale proceeds under § 453 of the Code, but the interest component (imputed if not stated) is taxed as ordinary income. Sellers often prefer to structure the earnout as a capital payment tied to performance metrics rather than as deferred compensation, which would be taxed at ordinary rates. Florida residents enjoy no state tax on the gain portion, but federal characterization still controls.
A Florida-specific wrinkle: the seller-consulting overlap
Florida deal structures often combine an earnout with a post-closing consulting agreement for the seller. The IRS has challenged allocations where a consulting agreement looked like a disguised purchase price, so structure consulting compensation at a genuine market rate and tie it to deliverables, not to the passage of time alone. Where an earnout and a consulting agreement overlap, coordinate carefully so neither triggers the other.
Frequently asked questions
Frequently asked questions
What is an earnout?
A post-closing contingent purchase price payment tied to the target business’s performance during a defined period after closing. Earnouts bridge valuation gaps between what buyers will pay and what sellers expect.
How long do earnouts typically last?
One to three years is most common in middle-market deals. Shorter periods produce less dispute; longer periods are sometimes needed for valuation gap bridging.
What metrics are used?
Revenue and EBITDA are the two most common. Revenue is cleaner; EBITDA is more common because it more closely approximates the valuation multiple used upfront. Customer-count, gross-profit, and product-specific metrics are occasionally used in specialty situations.
What’s the most common earnout dispute?
Ambiguity about whether the buyer operated the business in a way that depressed the earnout metric. Specific operating covenants and concrete definitions prevent most of these disputes from arising.
Who decides if there’s a dispute?
A well-drafted earnout routes disputes to a neutral accountant under expedited procedures. Less well-drafted earnouts end up in state court, which is slower, more expensive, and less informed about the accounting questions actually at issue.
Are earnouts tax-efficient for Florida sellers?
Generally yes. Installment sale treatment under § 453 spreads the gain, and Florida imposes no state income tax on the capital portion. Imputed interest is taxed as ordinary income at the federal level.
Should I sign a consulting agreement alongside the earnout?
Often, yes, especially if the buyer needs your ongoing involvement to hit the targets. But structure consulting compensation at a genuine market rate and tie it to deliverables — the IRS scrutinizes allocations that look like disguised purchase price.
Can an earnout be accelerated if the buyer resells the business?
Yes, if the earnout agreement includes a change-of-control acceleration provision. This is a seller-favorable term we often negotiate in.
Working with us. Negotiating an earnout now — on either side? Email john@montague.law with the term sheet, and we’ll send back a one-page markup with our recommended changes and the rationale for each.
