Earn-Outs in M&A Deals: Structuring Tips and Common Pitfalls

Earn-outs are a useful bridge between buyer and seller when valuation expectations diverge. The seller believes the business will grow; the buyer wants to pay only for performance that actually materialises. An earn-out aligns both views by paying part of the price contingent on future performance. Used well, they unlock deals that would otherwise stall. Used poorly, they generate disputes that consume management attention long after completion.

What is an earn-out?

An earn-out is a contingent component of the purchase price, payable if specified performance milestones are met after completion. The milestones can be financial (revenue, EBITDA, profit) or operational (customer retention, product delivery, regulatory approvals).

Typically, the earn-out is paid in instalments over a defined period (commonly 12–36 months) following completion, in addition to the upfront consideration paid at signing or completion.

Why use one?

Earn-outs are most useful when:

• The buyer and seller disagree on valuation
• The business has near-term growth that is not yet reflected in historical earnings
• Founder retention is critical, and the earn-out provides incentive
• The business is in a sector where future performance is meaningfully uncertain
• The buyer wants to manage post-completion integration risk

Common structures

Revenue-based earn-out. Payment depends on hitting revenue targets. Simple to measure, but can incentivise sellers to drive volume at the expense of margin or customer quality.

EBITDA-based earn-out. Payment depends on EBITDA performance. Better aligned with profitability, but requires careful definition of EBITDA and detailed accounting machinery.

Milestone-based earn-out. Payment depends on specific events (e.g. regulatory approval, retention of a key customer, signing a new contract). Cleaner to measure but creates binary outcomes that can produce disputes.

Hybrid. Combines elements (e.g. payment increases linearly with revenue between $X and $Y, then bonuses on specific milestones).

Structuring considerations

Performance metrics. Define them with surgical precision. "EBITDA" as commonly understood is not the same as EBITDA as defined for the purposes of an earn-out. Spell out exactly what is included and excluded.

Period. Long enough to be meaningful, short enough to avoid uncertainty. 12–24 months is typical; 36 months is the upper end.

Operating constraints. Sellers often request constraints on the buyer's post-completion conduct (e.g. preserving the brand, keeping the business as a separate division, not making material acquisitions). Buyers want maximum flexibility. The negotiation here is critical.

Cap and floor. Earn-outs are usually capped (a maximum payable amount) and may have a floor (a minimum amount payable regardless of performance). The cap protects the buyer; the floor protects the seller.

Acceleration. What happens if the buyer sells the business mid-earn-out? If a key seller-employee dies, becomes incapacitated, is dismissed without cause, or resigns? Acceleration triggers should be explicit.

Dispute resolution. Build in a clear process for resolving accounting disputes (typically an expert determination), separate from broader contract disputes.

Common pitfalls

Pitfall 1: Vague metrics. "EBITDA" defined by reference to general accounting principles invites disputes. Define every line item.

Pitfall 2: Missing accounting machinery. Without clear rules on how performance is measured and reported, earn-outs become a battleground. Build in mid-year reviews, end-of-period reports, and dispute mechanisms.

Pitfall 3: Buyer behaviour. Sellers fear that the buyer will sandbag the business to avoid paying the earn-out (e.g. by reallocating revenue, increasing intercompany charges, or cutting marketing). Operating restrictions help, but go too far and the buyer is hamstrung.

Pitfall 4: Insufficient documentation. The earn-out clause is one of the most heavily disputed provisions in M&A contracts. Skimping on drafting is false economy.

Pitfall 5: Tax treatment. The tax treatment of earn-out payments differs from upfront consideration. The wrong characterisation can produce surprising tax outcomes for both buyer and seller.

Pitfall 6: Information asymmetry post-completion. The seller has limited visibility into the business after completion. Build in reporting obligations so the seller can monitor progress.

A simple checklist

• Clear definition of every metric and adjustment
• Defined accounting principles, ideally with a worked example
• Reporting obligations (monthly or quarterly statements)
• Dispute resolution path (expert determination)
• Operating restrictions on the buyer (and any carve-outs)
• Acceleration triggers
• Tax treatment understood and documented
• Cap and floor (where appropriate)

How Luma Legal can help

We have negotiated and drafted earn-out structures across multiple deals and sectors. We help buyers and sellers craft a structure that achieves the commercial deal, with the precision necessary to avoid disputes down the track.