A disagreement over valuation is one of the most common reasons company acquisitions fail. Sellers may be confident that future growth will justify a higher valuation, while buyers are often reluctant to pay today for performance that has not yet materialised.

An earn-out can provide a practical solution. By linking part of the purchase price to the future performance of the target business, it allows buyers and sellers to share risk while enabling transactions that might otherwise stall.

However, whilst earn-outs can be highly effective, they are also a frequent source of post-completion disputes. The difference between a successful earn-out and a costly disagreement often lies in the quality of the drafting.

Key Takeaways

• Earn-outs are commonly used to bridge valuation gaps in company acquisitions.
• Part of the purchase price is deferred and paid only if agreed targets are met.
• Buyers benefit from protection against overpayment.
• Sellers may achieve a higher overall sale price.
• Most disputes arise from accounting issues and business management decisions after completion.
• Careful drafting is essential to minimise risk.

What Is an Earn-Out?

An earn-out is a contractual arrangement under which part of the purchase price is paid on completion, with additional consideration becoming payable if the business achieves specified performance targets after the acquisition.

The targets may be based on:

• Revenue
• EBITDA
• Profit
• Customer retention
• Contract wins
• Other agreed commercial objectives

Earn-out periods typically last between one and three years.

Example

A software company is being sold.

The seller believes a forthcoming product launch justifies a valuation of £10 million, while the buyer believes the business is currently worth £8 million.

To bridge the gap, the parties agree:

• £8 million payable on completion; and
• Up to £2 million payable if agreed targets are achieved over the next two years.

If the business performs as expected, the seller receives the higher valuation. If not, the buyer avoids overpaying.

Why Are Earn-Outs Used?

Earn-outs are primarily used where there is uncertainty about future performance.

Rather than forcing one party to compromise entirely on valuation, the parties agree that future results will determine part of the final purchase price. This allows transactions to proceed were differing assumptions about growth, profitability or future opportunities might otherwise prevent a deal from completing.

Advantages and Disadvantages for Buyers

Advantages

Protection Against Overpayment

Earn-outs allow buyers to link consideration to actual performance rather than forecasts. This is particularly useful when acquiring high-growth businesses, start-ups or companies dependent on future contracts.

Cash Flow Benefits

Deferring part of the purchase price can reduce the amount of funding required at completion and provide greater financial flexibility following the acquisition.

Management Incentives

Where founders or key shareholders remain with the business, an earn-out can align interests by incentivising them to maximise performance during the earn-out period.

Disadvantages

Reduced Operational Flexibility

Sellers often seek protections restricting the buyer's ability to restructure the business, reduce investment or change operating practices. These restrictions can sometimes conflict with the buyer's commercial objectives.

Uncertain Acquisition Cost

Because the final payment depends on future performance, buyers may not know the true cost of the acquisition until the earn-out period has ended.

Advantages and Disadvantages for Sellers

Advantages

Potential for a Higher Valuation

An earn-out can enable sellers to achieve a premium price where they believe future growth has not yet been reflected in historic financial performance.

Facilitating a Transaction

Earn-outs frequently save deals that might otherwise fail because of valuation disagreements. They provide a commercial compromise without requiring either side to abandon its position completely.

Disadvantages

Loss of Control

Once ownership transfers, the seller's entitlement to future payments often depends on decisions made by the buyer. Changes to strategy, staffing or investment can affect whether earn-out targets are achieved.

Credit Risk

Unlike completion consideration, earn-out payments remain future liabilities. If the buyer encounters financial difficulties, the seller may recover only part of the deferred consideration or, in some cases, nothing at all.

To address this risk, sellers sometimes seek escrow arrangements, guarantees or other forms of security.

Common Earn-Out Disputes

Most earn-out disputes do not arise because the parties disagree about the formula itself. The dispute is typically about how that formula should be applied.

Accounting Disputes

One of the most common areas of conflict concerns EBITDA calculations and accounting adjustments.

Issues frequently arise in relation to:

• Management charges
• Exceptional costs
• Acquisition expenses
• Bad debt provisions
• Changes in accounting policies
• Revenue recognition

Example

An earn-out provides for a £1 million payment if EBITDA exceeds £2 million.

Reported EBITDA is £2.1 million.

The buyer later allocates £150,000 of central management costs to the target business, reducing EBITDA to £1.95 million.

The seller receives no earn-out payment.

The dispute is unlikely to concern arithmetic. Instead, it will focus on whether those costs should have been allocated in the first place.

Business Conduct Disputes

Parties also frequently argue about the way the business has been managed during the earn-out period.

Common allegations include:

• Diverting customers to group companies
• Reducing marketing expenditure
• Transferring employees to other divisions
• Delaying contracts
• Changing business strategy
• Altering accounting practices

These disputes can become highly contentious because they often involve commercial, legal and accounting issues simultaneously.

Revenue vs EBITDA Earn-Outs

One of the most important drafting decisions is selecting the performance metric.

The most appropriate metric will depend on the nature of the business and the commercial objectives of the parties.

Key Drafting Considerations

Many earn-out disputes can be avoided through careful drafting.

The acquisition agreement should clearly address:

• The performance metric and calculation methodology.
• Applicable accounting standards and policies.
• Whether historic accounting practices must continue.
• The extent of the buyer's freedom to manage the business.
• Information rights for the seller.
• Procedures for resolving disputes, including expert determination provisions.

In my experience, the clarity of these provisions is often more important than the earn-out formula itself.

Frequently Asked Questions

How long does an earn-out usually last?

Most earn-out periods last between one and three years, although longer periods are sometimes used.

Are earn-out provisions legally enforceable?

Yes. Earn-out provisions are generally enforceable under English law provided they are drafted with sufficient certainty.

What is the most common cause of earn-out disputes?

Accounting issues and disagreements over the buyer's management of the business are among the most common sources of dispute.

Should an earn-out be based on revenue or EBITDA?

Revenue-based earn-outs are usually simpler, whereas EBITDA-based earn-outs often provide a better measure of business performance. The appropriate choice depends on the transaction.

Conclusion

Earn-outs can be an effective way of bridging valuation gaps and facilitating company acquisitions. They allow buyers to reduce the risk of overpaying while giving sellers the opportunity to achieve a higher overall valuation if future performance meets expectations.

However, earn-outs also create an ongoing commercial relationship between buyer and seller after completion. As a result, disputes concerning accounting treatment, business conduct and performance calculations are common.

From an English law M&A perspective, the success of an earn-out depends not only on the formula itself, but on the contractual framework that supports it. Clear drafting, carefully defined accounting principles and robust dispute resolution provisions can significantly reduce the risk of conflict and help ensure that the earn-out operates as intended.

How We Can Help

Earn-out provisions are often among the most heavily negotiated and frequently disputed aspects of a business acquisition. Our Corporate and Commercial team advises buyers, sellers and investors on the structuring, negotiation and drafting of earn-out arrangements, helping clients minimise risk and protect their commercial objectives throughout the transaction process.

To learn more about our corporate law services, please contact our team at Eaton Smith Solicitors or call us on 01484 821400.