Navigating Earn Out Agreements

Note: Want to skip the guide and go straight to the free templates? No problem - scroll to the bottom.
Also note: This is not legal advice.

Introduction

Navigating Earn Out Agreements is becoming an essential step in the buying and selling of businesses. An earn out agreement is a type of contract that allows buyers to pay sellers a certain amount upfront, with the potential for additional payments when agreed conditions are met. This gap-bridging arrangement helps both parties benefit from the transaction–the buyer may not have the resources to pay for the whole price immediately, and the seller can be compensated for future performance of their business.

It’s no wonder why earn out agreements are so widely used; they protect both buyer and seller from potential future liabilities, provide a way to bridge differences in opinion on the purchase price and make sure both parties are incentivized to conduct business in alignment with one another.

The Genie AI team wants to help make navigating earn out agreements easier through its open source legal template library–the world’s largest collection of these kinds of documents. Millions of data points teach Genie’s AI what market-standard agreements should look like, allowing anyone to draft high quality contracts without paying a lawyer. Plus, all templates can be customized as needed!

When looking to buy or sell your business, considering an earn out agreement can be extremely beneficial; it offers more protection than single payment transactions while still providing room for growth into the future. For further guidance on navigating this process, check out our free step-by-step guide below and access our community library today!

Definitions (feel free to skip)

Applicable Local Laws and Regulations: Rules and laws made by local governments that must be followed in a specific area.
Performance Targets: Goals that must be met for an earn out to be paid out, such as revenue targets, profit targets, or other agreed-upon metrics.
Payment Terms: Conditions related to when and how payments will be made.
Milestones: Steps that need to be achieved in order for payments to be made.
Contingencies: Unexpected events or changes that could affect the agreement.
Variable Earn Out Structure: An earn out structure where the total amount of the earn out is based on the performance of the company and can vary depending on the performance.
Tax Implications: The effects of taxes on an earn out agreement.
Tax Liabilities: The amount of taxes that must be paid by each party involved in the agreement.
Tax Withholdings: The portion of payments that will be withheld for taxes.
Dispute Resolution Process: A method of resolving disagreements between parties, such as mediation or arbitration.
Enforcement Mechanisms: Legal remedies to ensure that payments are made when due, such as court proceedings.
Reporting: Creating reports to track the performance of the company or the progress of the agreement.
Third-Party Providers/Advisors: Professionals, such as accountants or lawyers, that may need to be consulted during the process.
Indemnification: Determining which party is responsible in the event of a dispute or other unforeseen circumstances.
Confidentiality: Determining which information can be shared between the parties and which information should remain confidential.
Conflicts of Interest: Determining if any of the parties involved have a direct or indirect interest in the outcome of the agreement.
Assignment and Transfer of Rights and Obligations: Determining who has the right to assign and transfer rights and obligations under the agreement.

Contents

• Understanding the Basics of Earn Out Agreements
• Research applicable local laws and regulations
• Understand the objectives of all parties involved
• Acknowledge potential risks and contingencies
• Drafting an Earn Out Agreement
• Decide between a fixed or variable earn out
• Decide on the definition of performance targets
• Outline payment terms and milestones
• Include provisions for handling contingencies
• Negotiating the Terms of an Earn Out Agreement
• Identify the parties to the agreement
• Negotiate the terms of performance targets
• Negotiate payment terms and milestones
• Negotiate provisions for handling contingencies
• Tracking Performance and Calculating Payments Under an Earn Out Agreement
• Establish methods of tracking performance
• Establish payment calculation methods
• Establish methods of documenting progress
• Resolving Disputes and Collecting Payments
• Establish a dispute resolution process
• Establish enforcement mechanisms
• Establish methods of collecting payments
• Tax Implications of Earn Out Agreements
• Research applicable taxation laws
• Determine the tax liabilities of the parties involved
• Include provisions for tax withholdings
• Other Considerations for Earn Out Agreements
• Establish methods of reporting
• Identify any third-party providers or advisors
• Include provisions for indemnification
• Include provisions for confidentiality
• Identify and address any potential conflicts of interest
• Include provisions for assignment and transfer of rights and obligations

Get started

Understanding the Basics of Earn Out Agreements

• Understand the definition of earn out agreements, which are arrangements for a seller to receive additional payment in the future based on the performance of the company or assets being sold
• Learn and understand the key components of earn out agreements, such as the earn out period, earn out targets and earn out payment terms
• Understand the potential risks and rewards associated with earn out agreements for both the buyer and the seller
• Identify the important questions to ask when entering into an earn out agreement
• When you can answer these questions and understand the fundamentals of earn out agreements, you will be prepared to move on to the next step.

Research applicable local laws and regulations

• Research the local laws and regulations that apply to earn out agreements in your area.
• Check with your state’s department of commerce or corporation commission to ensure you are following all applicable laws and regulations.
• Consult with a lawyer or financial advisor who specializes in earn out agreements to ensure you are compliant with the local laws and regulations.
• When you are confident you have done your research and you understand the local laws and regulations for earn out agreements, you can move on to the next step.

Understand the objectives of all parties involved

• Identify all the parties involved in the earn out agreement (e.g. seller, buyer, lender, etc.)
• Understand the goals and objectives of each party
• Identify any potential conflict of interests and areas where parties may not agree
• Ask questions to parties and legal counsel to ensure all objectives are fully understood

Once all parties’ objectives are understood, you can move on to the next step.

Acknowledge potential risks and contingencies

• Educate yourself on the potential risks that may arise during the term of the earn out agreement
• Research the common contingencies that may be included in an earn out agreement
• Consult with a lawyer or financial advisor to ensure that all parties understand the potential risks and contingencies
• Make sure all parties are aware of any limitations that could affect the earn out agreement
• Check off this step when you are confident that all parties have a solid understanding of the potential risks and contingencies outlined in the earn out agreement.

Drafting an Earn Out Agreement

• Consult a qualified legal representative to ensure that the agreement adheres to all applicable laws
• Draft an agreement that outlines the details of the earn out, such as the conditions for earning out, the timeline, and any fees associated with the agreement
• Agree on the terms of the earn out, including the amount and type of payment, the conditions under which payment will be made, and any other relevant details
• Have both parties sign the agreement
• When both parties have signed the agreement, you have successfully drafted an earn out agreement and can proceed to the next step.

Decide between a fixed or variable earn out

• Understand the pros and cons of each type of earn out:
• Fixed earn out: typically simpler to structure, but can be more difficult to track performance
• Variable earn out: more complex to structure, but easier to track performance
• Consider the types of business goals you are trying to achieve with the earn out
• Decide which type of earn out best suits your goals
• Check off this step when you have made your decision between a fixed or variable earn out

Decide on the definition of performance targets

• Agree on the definition of performance targets before deciding between a fixed or variable earn out
• Examples of performance targets include sales, profits, and market share
• Determine the specific goals for each performance target
• Consider the metrics that will be used to measure success
• When all performance targets and specific goals have been agreed upon, you can check this off your list and move on to outlining payment terms and milestones.

Outline payment terms and milestones

• Determine the total amount of the earnout and the period of time in which the earnout may be earned
• Identify any conditions that must be met before payments are triggered
• Specify the payment milestones and the dollar amounts associated with each milestone
• Outline the timeline for payments and specify any payment deadlines
• Include provisions for handling contingencies (e.g. what happens if performance targets are not met)
• Agree on a method of calculating the earnout if conditions are met

Check off this step when you have identified all the payment terms and milestones and agreed on a method of calculating the earnout.

Include provisions for handling contingencies

• Research and review any potential contingencies that may impact the earn out agreement
• Discuss and outline how the contingencies will be handled
• Ensure that the agreement explicitly states the responsibilities of each party when it comes to handling contingencies
• Include a clear timeline for addressing contingencies
• Include provisions for how to proceed if the contingencies are not met
• When all contingencies have been accounted for and the agreement is complete, you can move on to negotiating the terms of the earn out agreement.

Negotiating the Terms of an Earn Out Agreement

• Discuss and agree on the terms of the earn out agreement, including the purchase price and the timeline for earning out
• Consider the value of the company, the risks associated with the earn out, and whether the proposed terms are fair and reasonable
• Determine how the earn out payment will be structured and how it will be tied to the performance of the company
• Outline the criteria that must be met before the earn out payment can be triggered
• Specify the terms of the payment, such as the amount, payment schedule, and payment method
• Agree on who will be responsible for collecting, tracking, and reporting the data used to calculate the earn out payment
• Make sure both parties agree on the terms and conditions of the earn out agreement and that it is properly documented

You’ll know you can check this off your list and move on to the next step when you have finalized the earn out agreement and both parties have agreed to the terms and conditions of the agreement.

Identify the parties to the agreement

• Identify all parties to the agreement, including the seller, the buyer, and any third-party advisors.
• Make sure all involved parties are in agreement on the terms of the agreement.
• Document the agreement in writing and have all parties sign it.
• When all parties have signed the agreement, you can check this off your list and move on to the next step.

Negotiate the terms of performance targets

• Outline the targets that need to be met for the earn-out payment
• Decide if the targets will be monitored on a yearly or quarterly basis
• Negotiate the precise performance targets and the timeframe for achieving them
• Agree on the method of calculating the performance targets
• Determine what type of evidence will be provided to demonstrate the achievement of the performance targets
• Negotiate the penalty or reward that will be triggered if the performance targets are met or not
• Once all the terms have been agreed upon, have them documented in the earn-out agreement

How you’ll know when you can check this off your list and move on to the next step:
You will know when you can check this off your list and move onto the next step once both parties have agreed on and documented all the terms related to the performance targets in the earn-out agreement.

Negotiate payment terms and milestones

• Establish the payment terms for the earn-out agreement including the amount, timing, and any conditions that must be met
• Determine the milestones that will be used to measure the target performance and the associated payments
• Agree on the payment method and who is responsible for any associated fees
• Once the payment terms and milestones are agreed upon and finalized, move on to the next step of negotiating the provisions for handling contingencies.

Negotiate provisions for handling contingencies

• Determine what provisions need to be included to address contingencies, such as the seller leaving the business, the buyer failing to meet performance targets, the business being sold to a third party, etc.
• Negotiate terms that would apply in each of these scenarios and decide how to handle them.
• Make sure the contingencies are clearly outlined in the agreement and that all parties are in agreement as to how each contingency should be addressed.
• When the contingencies and their corresponding terms have been negotiated and agreed upon, you can check this off your list and move on to the next step: Tracking Performance and Calculating Payments Under an Earn Out Agreement.

Tracking Performance and Calculating Payments Under an Earn Out Agreement

• Draft and negotiate language covering the specifics of how performance will be monitored and measured
• Determine what metrics or objectives will be used to measure the performance of the company or the individual employee
• Set up a process to track the performance of the company or individual employee on a regular basis
• Establish a timeline for periodic reviews of the performance metrics
• Negotiate payment schedules and amounts to be paid based on the performance metrics
• Set up a system to ensure that payments are made in a timely manner
• Once all of the above steps have been completed, you will be ready to start tracking performance and calculating payments under an Earn Out Agreement.

Establish methods of tracking performance

• Decide what metrics will be used to track performance
• Decide if they will be tracked on a quarterly or annual basis
• Agree to the metrics in writing
• Decide who will be responsible for tracking performance
• Designate a system or software to track performance
• Agree who will have access to the system or software
• Ensure the system will generate accurate tracking reports
• When all the outlined criteria have been agreed upon and the system is in place, this step can be considered complete and you can move on to Establish payment calculation methods.

Establish payment calculation methods

• Determine the total amount of the earn out and agree on how it will be paid out (e.g. lump sum, installment payments)
• Agree on the timeline for payment (e.g. annually, quarterly, etc.)
• Calculate the amount of the earn out that is dependent on performance targets
• Agree on how the payment will be calculated (e.g. fixed, percentage of revenue, etc.)
• Establish the metrics that will be used to measure performance
• Determine the conditions that need to be met for payment
• Establish a payment schedule
• Decide who will be responsible for tracking performance
• Create a process for determining if earn out payments are due

You will know you can check this off your list and move on to the next step when you have all of the above items agreed upon, established, and documented.

Establish methods of documenting progress

• Decide on a method to track the target’s performance, such as financial statements, annual reports, milestones, etc.
• Develop a plan to monitor progress in order to assess whether the earn out is likely to be achieved.
• Agree on a method of reporting the performance that will be used throughout the agreement and make sure it is included in the contract.
• Use a consistent and reliable method of tracking progress and updating information.
• Once all of these steps have been completed, the parties can move on to establishing payment calculation methods.

Resolving Disputes and Collecting Payments

• Set up a system to track payments and make sure all payments are received on time.
• Develop a process to quickly resolve disputes.
• Set up a process to collect payments, such as setting a payment schedule or using an escrow account.
• Make sure all parties agree to the payment or dispute resolution process.
• You can check this step off your list when you have a system for tracking payments, a dispute resolution process in place, and all parties have agreed to the payment or dispute resolution process.

Establish a dispute resolution process

• Agree on a dispute resolution process that is fair to both parties, such as arbitration or mediation
• Establish a timeline for when the dispute resolution process should be completed
• Document the dispute resolution process in the earn out agreement
• Upon completion of the dispute resolution process, both parties should agree to abide by the results
• You will know you have completed this step once both parties have agreed to the dispute resolution process and it has been documented in the earn out agreement.

Establish enforcement mechanisms

• Determine what type of enforcement mechanisms will be used for an earn out agreement, such as court-enforceable agreements, arbitration agreements, or other enforcement methods
• Outline the enforcement mechanisms in writing and be sure to include how and when the earn out agreement can be enforced
• Specify what type of financial penalties will be imposed if the terms of the agreement are not met
• In some cases, a non-financial penalty, such as an injunction, may be imposed
• Once the enforcement mechanisms are established, you can check this off your list and move on to the next step of establishing methods of collecting payments.

Establish methods of collecting payments

• Determine who will be responsible for collecting payments from the buyer
• Establish a system for tracking payments to ensure the buyer follows their payment schedule
• Determine what type of payment will be accepted (cash, check, credit, etc.)
• Set up a way to receive payments (online payments, mail delivery, etc.)
• Clarify if payment will be made in installments or as a lump sum

Once these elements are established, you can move on to the next step in the process of navigating earn out agreements: tax implications.

Tax Implications of Earn Out Agreements

• Research applicable taxation laws in your jurisdiction.
• Look into federal, state, and local taxes that may apply to the earn out agreement, such as income and capital gains taxes.
• Consult a tax professional or attorney to ensure that you are in compliance with all applicable taxation laws.
• When you are confident that you have a good understanding of the applicable taxation laws, you can move on to the next step.

Research applicable taxation laws

• Identify the states and countries with relevant taxation laws that apply to the earn out agreement.
• Research the differences between the taxation laws in each jurisdiction.
• Familiarize yourself with the taxation laws that are applicable to the agreement.
• Understand how the taxation laws will affect the agreement and the parties involved.
• When you have a clear understanding of the taxation laws, you can check this step off your list and move on to the next step.

Determine the tax liabilities of the parties involved

• Identify the taxes that may be due to each party in the agreement
• Consult a tax specialist to determine the specific tax liabilities of each party
• Research applicable taxation laws to ensure all tax liabilities are addressed in the agreement
• Incorporate a clause in the agreement that outlines the tax liabilities of each party
• When all tax liabilities are addressed in the agreement, check this off your list and move on to the next step.

Include provisions for tax withholdings

• Analyze the tax liabilities of the parties involved and consider the applicable tax rate when setting the terms of the agreement.
• Consult a tax attorney or accountant to make sure the appropriate provisions for tax withholdings are included in the agreement.
• Identify and document the effective date of the agreement and the date when taxes will be due.
• Include a clause that stipulates how the tax withholdings will be calculated.
• When you have included provisions for tax withholdings in the agreement, you can check this off your list and move on to the next step.

Other Considerations for Earn Out Agreements

• Clarify who is responsible for any additional taxes that may be due as a result of the transaction (seller, buyer, or both).
• Make sure to include provisions for withholding taxes, and provide details on the amount that should be withheld, and when it should be paid.
• Consider the impact of any existing loan terms, or other financial agreements that may be affected by the earn out agreement.
• Research the applicable state and federal laws and regulations that could impact the agreement.

Once all of the above considerations have been addressed and included in the agreement, you can check this off your list and move on to the next step.

Establish methods of reporting

• Establish methods of reporting that will be used to monitor the achievement of goals and conditions set forth in the earn out agreement
• Analyze the type of data that should be collected, the frequency of reporting, and the format of reports
• Consider who will be responsible for collecting, analyzing, and reporting data
• Determine if a third-party provider or advisor should be used to ensure accuracy and impartiality of data
• Establish a timeline and milestones for reporting to ensure proper tracking of progress
• When reporting methods and processes have been established, this step can be checked off your list and you can move on to the next step.

Identify any third-party providers or advisors

• Research the type and scope of services required for the earn out agreement
• Identify any third-party providers and advisors needed to facilitate the agreement
• Determine the scope of services and fees for each provider
• Draft contracts for each provider and advisor
• Ensure all contracts are legally binding and compliant with relevant regulations
• When all providers and advisors are identified and contracts are in place, you can check this task off your list and move on to the next step.

Include provisions for indemnification

• Identify what type of indemnification is necessary for both parties
• Determine the scope of the indemnification and any related limitations
• Include a limitation of damages clause
• Specify which party is responsible for legal fees
• Draft the language for the indemnification clause and ensure both parties are in agreement
• Once all parties are in agreement, include the language in the agreement and have it signed
• Once all parties have signed, you can check this off your list and move on to the next step of including provisions for confidentiality.

Include provisions for confidentiality

• Draft a confidentiality agreement outlining the proprietary information that is to be kept confidential
• Include clauses to protect any confidential information, such as trade secrets, intellectual property, and financial information
• Ensure that the agreement is signed by all parties before the agreement is finalized
• When all parties have signed the confidentiality agreement and the agreement is in place, you can move on to the next step.

Identify and address any potential conflicts of interest

• Consult with legal counsel to identify any potential conflicts of interest that may arise from the earn out agreement
• Make sure that any potential conflict is addressed in the agreement and that the parties are aware of the risks associated with any potential conflict
• Ensure the agreement is clear in stating the roles and responsibilities of each party
• Clarify that the parties will not take any action that would be detrimental to the other party
• Once all potential conflicts have been identified and addressed, you can move on to the next step.

Include provisions for assignment and transfer of rights and obligations

• Review Earn Out Agreement to determine if any provisions for assignment and transfer of rights and obligations are included
• If no provisions for assignment and transfer of rights and obligations are included, draft and include such provisions in the Earn Out Agreement
• Ensure that any provisions for assignment and transfer of rights and obligations are in line with applicable law
• Check to see if all parties involved have signed off on the provisions for assignment and transfer of rights and obligations
• Once all parties have signed the provisions for assignment and transfer of rights and obligations, you can move on to the next step.

FAQ:

Q: What legal requirements should I consider when negotiating an earn-out agreement in the UK?

Asked by Judy on 12th June 2022.
A: When negotiating an earn-out agreement in the UK, it is important to consider the legal requirements for both parties. First, you need to ensure that all formal documentation is drafted and signed in accordance with UK law. This includes ensuring that any warranties and indemnities which are included in the agreement are adequately drafted and sufficiently clear to be enforceable. It is also important to consider tax implications and any provisions which may allow for changes to the agreement if circumstances change. Finally, be aware of any restrictions or regulations which may impact on the agreement’s enforceability or validity, such as those imposed by the Financial Conduct Authority or Companies Act 2006.

Q: What are the differences between earn-out agreements in the USA and EU jurisdictions?

Asked by Laura on 15th August 2022.
A: Earn-out agreements can vary significantly across different jurisdictions, so it’s important to consider the differences between them. In general, earn-out agreements in the USA tend to have more specifics attached to them, allowing for more precise measurements of performance and outcomes. EU jurisdictions tend to be more flexible, allowing for greater discretion when negotiating terms. Additionally, US earn-out agreements may include provisions for specific remedies in case of breach of contract, such as liquidated damages, whereas EU jurisdictions may only provide for general damages or specific performance.

Q: Are there any particular considerations I should make when negotiating an earn-out agreement for a SaaS business?

Asked by John on 7th December 2022.
A: When negotiating an earn-out agreement for a SaaS business, there are several factors which should be considered. Firstly, you should make sure that any warranties or representations made about the performance of the software are clear and accurate. Additionally, you should consider how payment is structured and what metrics will be used to measure performance. It is also important to ensure that service level agreements (SLAs) are clearly defined and that key performance indicators (KPIs) are established to measure success. Finally, you may want to include provisions which allow for changes in circumstances or conditions which could affect the success of the agreement.

Q: How can I protect myself when entering into an earn-out agreement?

Asked by Jason on 4th April 2022.
A: Protecting yourself when entering into an earn-out agreement is essential to ensure that your interests are safeguarded throughout the process. Firstly, it is important to make sure that all warranties and representations made about the performance of the company are accurate and legally binding. Additionally, it is important to make sure that any payment terms are clear and agreed upon by both parties before signing the agreement. You should also consider including provisions for remedies in case of breach of contract, such as liquidated damages or specific performance clauses. This can give you some protection in case things don’t go as planned during the term of the agreement. Finally, it is essential to have a good understanding of all aspects of the agreement before signing it, so that you can negotiate any terms which may not be favourable to you before committing yourself legally.

Example dispute

Lawsuits Referencing an Earn Out Agreement

• Plaintiff may bring a lawsuit if they believe they have not been adequately compensated for their share of the earn out agreement.
• The plaintiff must provide proof of the validity of the agreement and the amount they believe they are owed.
• The court will review the agreement and any evidence presented to determine if the plaintiff is entitled to the compensation claimed.
• If the court finds that the plaintiff is due compensation, they may award damages to the plaintiff.
• Damages may be calculated based on the amount of the earn out agreement, the profits earned from it, or a combination of both.
• Settlement may also be negotiated between the parties before going to court.

Templates available (free to use)

Earn Out Agreement

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