Earnouts are a common feature of M&A transactions. They are often used to bridge valuation gaps when buyers and sellers cannot agree on the purchase price at closing. In theory, an earnout allows sellers to participate in future upside while giving buyers comfort that they are paying for performance actually achieved. However, in practice earnouts are among the most frequently litigated provisions in purchase agreements.
When disputes arise, they are rarely about whether the business performed well or poorly in a general sense. Instead, they commonly turn on how the earnout was defined, calculated, and administered under the purchase agreement itself. One of the most common sources of earnout disputes is the calculation of Adjusted EBITDA, particularly when buyers rely on pro forma adjustments. Pro Forma Adjustments can be useful tools in valuation analyses or quality-of-earnings reports, but they become far more contentious in the earnout context.
Pro Forma Adjustments often reflect assumptions about future operations, synergies, or cost savings, many of which depend on decisions made by the buyer after closing. Unless the purchase agreement clearly states whether such adjustments are permitted, and under what circumstances, they can be used to materially alter EBITDA and prevent an earnout from being triggered, regardless of the business’s actual performance. These disputes are less about arithmetic and more about definitions. Earnout provisions often hinge on defined terms such as “Adjusted EBITDA” and “Pro Forma Adjustments.”
Drafting lessons are straightforward but often overlooked. Earnout provisions require an unusual level of precision because they operate after closing, when incentives diverge and cooperation breaks down. Agreements should clearly define the applicable performance metrics, specify the exact measurement period and endpoint, and state whether results must be calculated on an actual or pro forma basis.
Where discretion is unavoidable, it should be expressly limited in the purchase agreement. Dispute resolution mechanisms should also be aligned with the types of disputes likely to arise, recognizing that accountants are well-suited to resolve numerical disagreements but not contractual compliance issues. Where a purchase agreement clearly defines how and when an earnout is to be calculated or how disputes are to be resolved, courts are unlikely to excuse noncompliance based on convenience, industry custom, or hindsight.
Ultimately, earnout disputes are largely preventable. Most arise not because one party acted in bad faith, but because the agreement left too much room for interpretation. In earnouts, ambiguity is not a compromise, it is a risk. Clarity at the drafting stage is what determines whether an earnout functions as a bridge between parties or becomes a battleground after closing. If you are negotiating an earn-out or are involved in a dispute concerning one, we encourage you to contact us at Foundry Law Group. We help clients precisely define earn-out provisions and avoid the common pitfalls that give rise to costly and prolonged post-closing disputes.
