An earnout is a contingent payment structure where part of the purchase price is deferred and paid only if the business achieves specified performance targets after the close. They sound elegant — buyer gets downside protection, seller gets upside if they are right about the business. In practice, earnouts are among the most litigated clauses in private M&A. Use them deliberately, with precise drafting, or not at all.
When Earnouts Appear in ETA Deals
Earnouts are most common in three scenarios: when the buyer and seller disagree on valuation (the earnout bridges the gap by making part of the price contingent on performance), when the business has a volatile or lumpy revenue history that makes trailing EBITDA an unreliable predictor of future performance, or when the seller's continued involvement is important to business performance and the earnout is structured as a retention incentive.
In the ETA context, earnouts appear most often in service businesses with key-person dependency, businesses with one or two large customer relationships that may or may not survive the transition, and situations where the seller's representation and warranty insurance is unavailable or too expensive.
The Litigation Problem
The American Bar Association's 2023 Private Company M&A Deal Points study found that 28% of private company deals with earnout provisions resulted in litigation or formal dispute resolution over the earnout payment. Only 44% of earnouts were paid in full; 19% were partially paid; 9% were fully forfeited. This is not primarily because sellers are deceptive — it is because earnout triggers are inherently ambiguous and the post-close period introduces operational disagreements that infect earnout measurement.
The most common disputes: accounting methodology (seller claims revenue under contract before delivery; buyer claims revenue only on delivery), seller interference clauses (seller argues you managed the business in a way that prevented them from achieving the earnout), and extraordinary items exclusions (whether a new contract, lost customer, or one-time cost counts in the earnout EBITDA).
What a Well-Drafted Earnout Looks Like
A defensible earnout has: a precise, unambiguous metric (revenue is easier to measure than EBITDA; EBITDA is a judgment call); a clear measurement period (12 months, 24 months — shorter is better); a defined accounting methodology (GAAP, or the specific accounting treatment for this business agreed in writing before close); and an operating covenant requiring you to operate the business in a manner consistent with past practice with respect to the earnout metric.
Include an anti-sandbagging provision preventing you from making unusual accounting changes that would suppress the earnout metric. Include a seller access right — the seller should be able to audit the earnout calculation with their own accountant. Include a dispute resolution mechanism: independent accountant arbitration (faster and cheaper than litigation) is standard.
When to Accept vs. Reject a Seller's Earnout Demand
Accept earnouts when: the business has 2–3 years of strong performance and the earnout is a small percentage of total consideration (10–15%), the earnout metric is revenue-based and cleanly measurable, and the seller is transitioning out and will have no operational influence on post-close performance.
Push back hard or reject earnouts when: the earnout represents more than 25% of total consideration, the metric is EBITDA or any income-statement metric you control post-close, the seller is remaining involved in the business in any capacity (creates massive incentive conflicts), or the business has lumpy project-based revenue where timing will inevitably create disputes.
If you must accept an earnout the seller insists on, offer a lower earnout target in exchange for a shorter measurement period and a revenue-based (not EBITDA-based) trigger. Revenue is harder to manipulate on your side post-close and easier to audit on the seller's side. The seller's attorney will push for EBITDA because it is harder to verify — hold the line.
Escrow as an Earnout Alternative
Before agreeing to a complex earnout, explore a simpler alternative: a cash holdback in escrow. Instead of a contingent payment, you hold back 10–15% of the purchase price in a neutral escrow account, released to the seller over 12–24 months subject to satisfactory performance of representations and warranties and normal business performance. This is cleaner, eliminates most performance metric disputes, and gives both parties certainty about the mechanics of release.