Prompt Pack Earnout Provisions Drafting

Earnout Provisions Drafting

When to use this

Use this skill when drafting the earnout section of an M&A agreement (SPA, APA, or merger agreement). Earnouts allow part of the purchase price to be contingent on the target's post-closing performance, bridging the valuation gap when buyer and seller disagree on what the business is worth. They are common in:

• Technology acquisitions (key metric: ARR, MRR, or active users)
• Healthcare and pharma (key metric: regulatory approval milestones, revenue)
• Professional services (key metric: revenue retention from key clients)
• Startups and growth companies with forward-looking valuations

Earnouts are also among the most litigated provisions in M&A — the drafting must be precise.

Required inputs

Optional inputs

• Earnout structure: cumulative vs. independent annual periods
• Catch-up provisions (shortfall in Year 1 can be made up in Year 2)
• Accelerated earnout triggers (change of control post-closing; seller's termination)
• Anti-embarrassment provisions (if buyer sells target within earnout period at a higher multiple, seller shares in excess value)
• Equity vs. cash payment of earnout
• Treatment of earnout on death or incapacity of the seller key person

Document structure

1. Definitions

Define every term used in the earnout provisions with precision:

• Earnout Consideration: the contingent payment, expressed as a formula (e.g., 2x the amount by which EBITDA exceeds USD X)
• Earnout Period: specific start and end dates; fiscal year or calendar year
• Earnout Metrics: define the specific financial or operational metrics
  • If revenue: gross or net? exclude which items (returns, taxes, intercompany)?
  • If EBITDA: define adjustments (management fees, extraordinary items, buyer's shared services allocation?)
  • If ARR: which contracts qualify? minimum contract value? annual contracts only or monthly normalized?
• Accounting Principles: IFRS or US GAAP; consistently applied by whom; define what "consistently applied" means
• Earnout Statement: the document the buyer prepares at end of each period

2. Earnout Calculation

Specify the formula:

"The Earnout Consideration for each Earnout Year shall be an amount equal to [formula], provided that the total Earnout Consideration payable in respect of all Earnout Years shall not exceed [maximum amount]."

• Tiered earnouts: "25% payable if EBITDA exceeds X; 50% if EBITDA exceeds Y; 100% if EBITDA exceeds Z"
• Binary milestone earnouts: "USD X payable on achievement of [regulatory approval / customer contract signature / product launch]"
• Hybrid: financial threshold + strategic milestone

3. Earnout Statement Process

1. Buyer prepares and delivers the Earnout Statement within [30–60] days after end of each Earnout Period
2. Statement must include the calculation in sufficient detail for the Seller to verify
3. Seller has [20–30] days to review; may deliver a Notice of Disagreement specifying items disputed
4. Parties negotiate resolution for [15–20] days after Notice of Disagreement
5. Unresolved disputes referred to an Independent Accountant (not buyer's or seller's auditors); decision is final and binding
6. Costs of Independent Accountant: borne by the party whose position is further from the final determination (or split equally)

4. Payment

• Payment due within [10–20] business days after Earnout Statement becomes final
• Set-off: buyer may set off against earnout only against finally determined (not disputed) indemnity claims
• Interest on late payment: [rate] from due date

5. Operating Covenants (Critical)

The most heavily negotiated section — the buyer's obligations to avoid "sandbagging" the earnout:

Buyer must:

• Operate the target in the ordinary course of business consistent with pre-closing practice
• Fund the business with adequate working capital
• Not divert revenue-generating opportunities away from the target
• Maintain the target's separate legal existence (if applicable)
• Not impose management fees, royalties, or charges on the target that reduce the earnout metric

Buyer must not:

• Merge the target into another group entity in a way that makes the earnout metric unmeasurable
• Materially change the accounting policies applied to the target without consent
• Change the target's fiscal year end
• Reduce pricing of target's products/services in a way that depresses the earnout metric

Seller may request:

• Periodic reporting rights (quarterly management accounts)
• Observer rights on the target's board during the earnout period
• Dispute rights if buyer takes actions that materially affect the earnout

6. Acceleration Events

Define circumstances in which the full earnout accelerates and becomes payable immediately:

• Buyer undergoes a change of control post-closing
• Buyer terminates the seller's employment or services agreement (if seller is also an employee) without cause
• Buyer materially breaches the operating covenant obligations
• Target is sold, wound up, or merged during the earnout period

7. Dispute Resolution

• Accountant expert determination is preferred for financial metric disputes (fast, binding, cost-efficient)
• Milestone disputes (was the milestone achieved?) may go to arbitration
• Specify the expert appointment mechanism: agreed list, or nominated by [ICAEW President / AICPA] if parties cannot agree within [10] days

Jurisdictional notes

Civil-law jurisdictions (UAE onshore, KSA, Lebanon, Egypt)

Civil-law courts may characterize earnout obligations as conditional obligations or contingent debts. Key considerations:

• The condition must be possible, legal, and clearly defined — vague metrics will not be enforced
• Court-appointed experts in civil-law systems may not apply the same accounting precision as Big-4 independent accountants in common-law systems; contract for independent accountant determination
• Penalty clause rules: in most MENA civil-law jurisdictions, courts can reduce penalties and damages to equitable levels; earnout provisions are not penalties but are sometimes treated analogously; use precise formula rather than penalty language

DIFC / ADGM / UK (common law)

• Earnout obligations are enforceable as contractual debt obligations
• Operating covenants will be interpreted strictly; buyer must not take "unreasonable steps" to prevent earnout achievement (implied duty of good faith in DIFC law)
• Expert determination clauses are final and binding unless manifestly wrong (high bar to challenge)

US

• Delaware courts apply strict construction to earnout provisions; ambiguity in metrics has historically been resolved against the party that drafted the contract
• Operating covenant disputes are a major source of post-closing M&A litigation
• Consider using financial metrics defined by reference to GAAP rather than IFRS for US deals

Common mistakes

• Vague metric definitions: "Revenue" without defining inclusions/exclusions leads to the most earnout disputes. Every dollar in or out of the metric must be explicitly addressed.
• No accounting principles specification: If the buyer changes from IFRS to US GAAP post-closing, the earnout metric changes; pin down the exact accounting framework.
• Insufficient operating covenants: Buyers who divert business opportunities or charge management fees without covenants face no contractual liability; sellers need robust protections.
• Set-off risk: Allowing set-off against earnout for any disputed indemnity claim gives buyer an incentive to manufacture or over-claim indemnity claims to avoid paying the earnout.
• No acceleration on buyer's change of control: If the buyer is acquired post-closing, the earnout obligation may be assignable and the new owner may have no interest in achieving it.

Related skills

• [[prompt-pack-disclosure-letter]]
• [[prompt-pack-escrow-agreement]]
• [[prompt-pack-due-diligence-report]]
• [[prompt-pack-investment-agreement-venture-capital]]