An earnout allows a buyer to pay part of an acquisition price based on the acquired business’s performance after closing. It can bridge a valuation gap, but it also creates a difficult question: who controls the conduct and accounting choices that determine whether the seller gets paid?
Define the metric before negotiating the percentage
Revenue, gross profit, EBITDA, patient encounters, subscriptions, and collections are not interchangeable measures. Each can be affected by timing, accounting classifications, refunds, and the allocation of shared expenses. A contract that says “20 percent of annual profit” without a definition invites conflict. Specify the measurement period, accounting standard, excluded items, treatment of extraordinary transactions, and whether historical accounting methods must be maintained.
Healthcare and regulated-business transactions may involve payer recoupments, changes in reimbursement, licensure restrictions, or transitions in provider enrollment. The parties should identify how those events affect the calculation, rather than assume ordinary retail accounting concepts will suffice. For deeper diligence on those issues, see healthcare business acquisitions and hidden compliance liabilities.
Identify who can influence performance
After closing, the buyer may control staffing, marketing, pricing, referral relationships, vendor selection, and expense allocations. The seller may have no operational authority but still depend on the buyer’s decisions for the earnout. Consider negotiated operating covenants, limits on diversion of revenue, and restrictions on discretionary allocations. These must be realistic: buyers often need flexibility to integrate the business and respond to market conditions.
A covenant requiring the buyer to maximize the earnout may be commercially unacceptable. A narrower obligation not to take specified actions primarily intended to avoid payment may be more workable, but drafting and enforceability require close attention to governing law.
Build the reporting system into the agreement
State when statements are due, which records support them, and how long the seller has to object. Specify access to books, workpapers, source data, and relevant personnel. If an independent accountant will resolve disputes, define the accountant’s jurisdiction: mathematical and accounting disputes may be suitable for expert determination, while allegations of breach or bad faith may require a different forum.
Do not overlook confidentiality. Access rights may involve patient, employee, customer, or proprietary information. Reports should be structured to permit verification without unnecessarily disclosing protected data.
Address extraordinary events
What happens if the buyer sells the acquired company, changes accounting systems, closes a location, or transfers customers to an affiliate? What if the seller leaves employment or breaches a restrictive covenant? An earnout should address acceleration, forfeiture, offset, and survival where commercially appropriate. Those terms can materially change the purchase price.
Separate indemnity from the earnout
Buyers may seek to offset indemnification claims against contingent payments. Sellers may object to withholding based on unproven allegations. Define whether offsets are permitted, what notice and proof are required, and whether disputed amounts must be escrowed. Review the purchase agreement as a whole, including representations, warranties, working-capital adjustments, and dispute-resolution provisions.
Draft for the dispute that could occur
A clear calculation example attached as a schedule can expose ambiguities before signing. Model scenarios involving revenue declines, payer offsets, acquisitions, and management fees. Determine which records will exist two years after closing and who will retain them.
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Legal reference: Contract interpretation and the implied covenant of good faith and fair dealing depend on governing law. For New Jersey, see Sons of Thunder, Inc. v. Borden, Inc., 148 N.J. 396 (1997), and Brunswick Hills Racquet Club, Inc. v. Route 18 Shopping Center Associates, 182 N.J. 210 (2005). Neither decision establishes a universal earnout formula.
Use a numerical example to expose ambiguity
Assume a seller is entitled to 25 percent of annual EBITDA above $400,000, subject to a $300,000 maximum payment. If the business generates $600,000 in EBITDA before a $75,000 management fee imposed by the buyer’s affiliate, is the earnout $50,000 or $31,250? The answer depends on whether the fee is included and whether it was permitted under the agreed accounting methodology. An exhibit with sample calculations can expose this dispute before closing.
The parties should test the formula using a profitable year, a break-even year, an acquisition of a second location, and a material customer loss. Consider whether the measurement uses cash or accrual accounting and whether changes to reserves, deferred revenue, or bad-debt estimates may alter the result.
Design the objection process as a sequence
A useful mechanism might require a calculation statement within a defined period after year-end, supporting schedules, a limited review period, written objections identifying disputed items, a negotiation interval, and referral of unresolved accounting items to an independent expert. The contract should explain who pays the expert and whether the determination is final for mathematical issues. Alleged fraud or breach of operating covenants may require a separate judicial or arbitral process.
A vague right to inspect “reasonable records” can become contentious. Specify access to general ledgers, relevant contracts, reconciliation schedules, and supporting transaction data, subject to confidentiality and appropriate privacy safeguards.
Consider taxes and purchase-price characterization
Earnout payments may interact with allocation of purchase price, employment arrangements, tax reporting, and transaction structure. An amount contingent on the seller remaining employed may raise different questions from consideration paid solely for transferred equity or assets. Tax and accounting advisers should evaluate the structure before the agreement is signed. Legal drafting cannot substitute for transaction-specific tax analysis.
Closing checklist
Before execution, confirm that the earnout definition matches the financial model; operating covenants and exceptions are consistent; reporting obligations survive closing; the records needed to audit performance will exist; offsets are controlled; and a buyer sale or reorganization will not silently defeat the payment mechanism. The purchase agreement, employment agreement, transition-services agreement, and any escrow provisions should tell the same story.
Legal authorities and the limits of implied duties
New Jersey recognizes an implied covenant of good faith and fair dealing in contracts, but that doctrine does not replace an earnout formula the parties could have negotiated. In Sons of Thunder, Inc. v. Borden, Inc., 148 N.J. 396 (1997), the Court considered conduct frustrating contractual expectations. In Brunswick Hills Racquet Club, Inc. v. Route 18 Shopping Center Associates, 182 N.J. 210 (2005), the Court examined a party’s conduct in exercising contractual rights. Neither case supplies a default accounting rule for acquisitions. The practical lesson is to negotiate objective metrics, records access, and post-closing conduct rules expressly.
For acquisition earnouts governed by another state’s law, New Jersey doctrine may not control. Choice-of-law and forum provisions should be assessed before relying on any state-law remedy.
Related BOLO analysis: For the transaction-side context, review business mergers, acquisitions, and transaction counsel.
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