How do you structure an earnout clause that is fair and flexible for both parties?

1 Define the earnout period

The earnout period is the time frame in which the seller can earn the additional payments based on the business performance. It can range from a few months to several years, depending on the nature and growth potential of the business. The earnout period should be long enough to allow the seller to demonstrate the value of the business, but not too long to create uncertainty and risk for the buyer. A typical earnout period is between one and three years.

2 Choose the earnout metrics

The earnout metrics are the indicators that determine how much the seller will receive as additional payments. They should be aligned with the strategic goals and expectations of both parties, and reflect the key drivers of the business value. The earnout metrics should also be clear, measurable, and verifiable, and avoid any ambiguity or manipulation. Some common earnout metrics are revenue, EBITDA, gross margin, customer retention, or market share.

3 Set the earnout formula

The earnout formula is the calculation that defines how much the seller will receive based on the earnout metrics. It can be a fixed amount, a percentage, a multiple, or a combination of these. The earnout formula should be simple, transparent, and consistent, and avoid any complex or variable factors that can create confusion or disputes. The earnout formula should also be realistic, achievable, and fair, and balance the interests and incentives of both parties.

4 Include the earnout terms

The earnout terms are the conditions and provisions that govern the implementation and enforcement of the earnout clause. These should include details on payment frequency and method (e.g., cash, stock, or escrow), reporting and auditing requirements (e.g., financial statements or third-party verification), adjustment and dispute resolution mechanisms (e.g., formulas or thresholds), and protection and obligation clauses (e.g., non-compete or non-solicitation). To avoid misunderstandings or litigation, the earnout terms should be comprehensive and leave no loopholes or gaps.

5 Negotiate the earnout clause

The earnout clause is a result of negotiation between the buyer and the seller, and it should reflect the mutual agreement and trust of both parties. The negotiation process should be collaborative, respectful, and flexible, and aim to create a win-win situation. The negotiation process should also be based on facts, data, and projections, and avoid any unrealistic or emotional assumptions or demands. The negotiation process should also involve legal and financial advisors, who can help draft and review the earnout clause and ensure its validity and enforceability.

6 Monitor the earnout clause

The earnout clause is not a one-time deal, but an ongoing relationship between the buyer and the seller. It requires constant monitoring, communication, and evaluation to ensure its smooth execution and fulfillment. The monitoring process should involve regular reporting, feedback, and verification of the earnout metrics and payments. The communication process should involve open, honest, and constructive dialogue between the parties, and address any issues or concerns promptly and professionally. The evaluation process should involve periodic review and assessment of the earnout clause and its impact on the business performance and value.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?