Earnout Provisions Checklist: What the APA Must Spell Out Before You Sign

An earnout is a deferred purchase price mechanism that bridges the valuation gap between what a seller believes the business is worth and what a buyer is willing to pay at closing. The buyer pays a base amount at close and an additional amount post-closing if the business hits agreed performance targets. The structure is common in small business acquisitions where the seller's forward projections are optimistic and the buyer cannot verify them with a short due diligence period.

In theory, earnouts align incentives and make deals possible that could not otherwise close. In practice, they generate significant post-closing disputes when the APA does not specify every element of the earnout with precision. Nearly every earnout dispute is traceable to a provision that was vague or missing at signing. This checklist covers what the APA must spell out before the deal closes. For what happens when disputes arise despite good drafting, see our guide on earnout dispute resolution.

Metric Definition: How Specific Is Specific Enough

The earnout metric definition needs to be as precise as the revenue recognition policy in an audited financial statement. For revenue-based earnouts, the definition should specify: (1) when revenue is recognized (at delivery, at invoice, at cash receipt); (2) how customer credits, returns, and allowances are treated; (3) whether intercompany revenue is included or excluded; and (4) the treatment of deferred revenue from contracts signed before or during the earn period.

For EBITDA-based earnouts, the definition must address: add-backs and exclusions by category (not just "one-time items," which is itself ambiguous); allocation of shared costs between the acquired business and the buyer's other operations; treatment of capex versus operating expenditure; and whether management fees, intercompany charges, or consulting fees paid to the buyer or its affiliates are included in the expense base.

Accounting Standard: The Two-Sentence Fix That Prevents the Most Common Dispute

A business acquired from a founder who maintained cash-basis books will be measured differently when the buyer applies accrual GAAP. Revenue recognition timing changes. Expense accruals appear. The period-end snapshots look different even if the underlying cash flows are identical.

The APA must specify whether the earnout metric is calculated on the seller's historical accounting basis, on GAAP, or on a defined hybrid methodology. It must also require that the same standard be applied consistently throughout the earn period, regardless of changes the buyer makes to the acquired business's accounting practices post-closing. Two sentences in the APA resolve what is otherwise a guaranteed dispute the first time the buyer runs a year-end close under a different accounting system.

Post-Close Operational Covenants: Protecting the Earnout During the Earn Period

The earnout covenants are the seller's primary protection against buyer decisions that reduce the earnout metric during the earn period. These are affirmative and negative obligations that restrict the buyer's operational discretion. Sellers should negotiate for, at minimum, the following covenants in every earnout deal:

• Sufficient funding obligation: The buyer must provide the acquired business with adequate resources, including working capital, personnel, and marketing budget, to operate at historical levels during the earn period.
• No diversion of opportunities: The buyer cannot redirect customers, contracts, or business opportunities from the acquired entity to a related entity if doing so reduces the earnout metric.
• Preservation of business identity: The buyer cannot dissolve, merge, or substantially restructure the acquired entity without seller consent during the earn period.
• Key management continuity: If the seller is remaining post-close in an operating role, the buyer cannot terminate the seller's involvement in a way that damages the business's performance and the resulting earnout metric.
• Intercompany pricing at arm's length: Any transactions between the acquired business and the buyer's other entities must be priced at fair market value and cannot be used to shift revenue or costs in a way that affects the earnout calculation.

Buyers often resist specific covenants as constraining legitimate business judgment. The negotiation trades buyer flexibility against seller payment certainty. When the earnout represents more than 20 percent of total deal value, sellers have stronger grounds to insist on detailed operational covenants.

Sample Earnout Calculation: What a Complete APA Definition Covers

Acceleration: What the APA Must Include for a Business Sale During the Earn Period

Without an acceleration clause, a buyer who acquires a business with an earnout and then sells that business to a third party within the earnout window has no obligation to make earnout payments that were not yet earned. The seller's earnout claim against the original buyer may be meaningless if the original buyer no longer controls the business, and the new buyer has no obligation to the original seller absent an assumption of the earnout.

An acceleration clause solves this by treating a change of control of the buyer or a sale of the acquired business as a triggering event that makes the full remaining earnout immediately payable. Sellers should negotiate acceleration on two triggers: a sale of the acquired business to a third party, and a change of control of the buyer itself (in case the buyer is acquired and the new owner has different operational plans).

Buyers resist broad acceleration clauses because they can create material contingent liabilities in the buyer's own future transactions. The negotiated middle ground is often a partial acceleration, where a portion of the remaining earnout is paid immediately upon a qualifying event, with the remainder continuing on the original schedule under the new owner's control.

Dispute Resolution: What the APA Must Specify Before Signing

The earnout dispute resolution mechanism is almost as important as the metric definition. The APA should specify a two-step process: a good faith negotiation period (typically 30 to 60 days) followed by binding resolution by an independent accountant or accounting firm for measurement disputes. Non-measurement disputes, typically those involving alleged covenant breaches, should go to arbitration or litigation under a separately specified forum.

The APA must specify: who pays for the independent accountant (commonly allocated based on the outcome or split equally); the selection process if the parties cannot agree on a firm; the standard of review (the accountant resolves accounting disputes, not legal disputes about the scope of the earnout definition); the timeline from dispute notice to final determination; and whether the accountant's determination is final and binding or subject to limited appeal.

For the full picture of what happens when earnout disputes reach the resolution stage, including how courts and arbitrators approach buyer conduct claims, see our guide on earnout disputes and resolution. For APA drafting that covers earnout provisions, see the asset purchase agreement review attorney page.

Frequently Asked Questions