Earn-Outs: How They Work and How to Protect Yourself

An earn-out is a term in a share or asset sale agreement that makes part of the purchase price payable only if the business hits agreed financial targets in the months or years after completion. English law gives the seller almost no protection once the deal has completed beyond what the sale agreement actually says, which is why the drafting of an earn-out matters more than almost any other part of the contract.

We act for both buyers and sellers on earn-out deals, and the pattern is consistent: the commercial terms get negotiated hard, the legal protections around them get left to the last fortnight, and the seller discovers two years later that the buyer was entitled to do the very thing that destroyed the target. This article sets out how earn-outs work, how the choice of financial metric changes the risk, the protections each side needs, how disputes get resolved, and the tax point that catches sellers out.

What an earn-out is and why it is used

An earn-out splits the price into an amount paid at completion and one or more further payments calculated by reference to the performance of the business after completion. The further payments are usually expressed as a percentage of, or a multiple of, an agreed financial measure for one or more post-completion periods, subject to a floor, a cap, or both.

The reason earn-outs exist is that buyers and sellers rarely agree on what a business is worth. The seller prices the business on where it is going. The buyer prices it on what it has already proved. An earn-out bridges that valuation gap by letting the seller take the upside if the forecast comes good, while the buyer only pays for growth that actually materialises. In owner-managed businesses, an earn-out also keeps the departing owner engaged through the handover, which matters where customer relationships, technical knowledge or regulatory permissions sit with one or two individuals.

Earn-outs are common where the business depends heavily on the seller personally, where a key contract is up for renewal, where the business is young or fast-growing, or where the buyer cannot get comfortable on a particular risk found in the due diligence process when buying a business. They are also used where the buyer simply cannot fund the whole price at completion, although that is really a funding problem and is usually better solved with deferred consideration, which is a fixed sum payable later rather than a sum contingent on performance.

The practical difference matters. Deferred consideration is a debt: the seller knows the number and is negotiating for security and interest. An earn-out is a contingent right: the seller does not know the number and is negotiating for control over the things that will determine it. Many deals use both, with a fixed deferred instalment sitting alongside a performance-linked earn-out.

How the metric is chosen, and why the choice is the whole deal

The single most important commercial decision in an earn-out is which financial measure the payment is calculated on. The three in common use are revenue, gross profit and EBITDA, which stands for earnings before interest, tax, depreciation and amortisation and is the usual proxy for operating profit. They sit at different points in the profit and loss account, and that position determines how much of the buyer’s post-completion conduct can affect the seller’s money.

Buyers push for EBITDA because it is the measure they are buying. Sellers push for revenue because it is the measure they can least easily be cheated out of. Where the parties land tends to depend on bargaining strength and on how much integration the buyer intends. Gross profit is the usual compromise, because it keeps the seller away from the buyer’s overhead decisions without rewarding the seller for selling at a loss.

The worked illustration below shows why this is not an accounting technicality. It uses a fictional target company and a set of ordinary, entirely legitimate buyer decisions, none of which are made in bad faith.

That spread is the reason a seller should never agree a metric in heads of terms without working it through on the numbers. It is also the reason that, on an EBITDA earn-out, the protections described below stop being optional.

Accounting policies matter as much as the metric

Once the metric is agreed, the next question is how it will be calculated. A sale agreement that says the earn-out is based on EBITDA and stops there is an invitation to a dispute, because EBITDA is not a defined term in UK GAAP or IFRS. Earn-out accounts need their own hierarchy of accounting policies, usually expressed as: first the specific policies set out in a schedule to the agreement, then the policies and practices consistently applied by the target in its last audited accounts, then the applicable financial reporting standard. Specific policies override consistency, and consistency overrides the standard.

This is the same architecture used for completion accounts, and the drafting problems are identical. If you are also negotiating the completion mechanism, our note on completion accounts and the locked box alternative covers the accounting hierarchy in more detail.

The schedule should deal expressly with the items most likely to move the number:

• Group management charges, head office recharges and the cost of shared services, which should normally be excluded unless they replace a cost the target genuinely bore before completion
• Transaction costs and the buyer’s own acquisition and financing costs, which should be excluded
• Exceptional and non-recurring items, with a definition rather than a bare reference to the concept
• Changes in revenue recognition policy, provisioning policy and the treatment of work in progress
• Intra-group trading, which should be stated to be on arm’s length terms
• Integration, restructuring and redundancy costs arising from the acquisition itself
• The treatment of capital expenditure the buyer requires the target to make

The phrase we use with clients is that there must be no cherry-picking of costs. The buyer should not be able to push its costs into the target and pull the target’s revenue out of it. A well-drafted schedule says so in terms, rather than relying on a general good faith obligation to produce the same result.

What a seller needs: conduct of business covenants

English law does not imply a general obligation on a buyer to run the acquired business so as to maximise an earn-out. The courts will imply a term that the buyer will not deliberately and in bad faith do something to defeat the earn-out, but that is a narrow protection and very hard to prove. What actually protects a seller is a set of express conduct of business covenants in the sale agreement.

The leading English authority on how much those covenants are worth is Porton Capital Technology Funds and others v 3M UK Holdings Ltd and another [2011] EWHC 2895 (Comm), decided by Mr Justice Hamblen on 7 November 2011. The sellers of a diagnostics business had an earn-out based on 2009 net sales. The sale agreement required the buyer to seek regulatory approvals diligently and to market the products actively in the major markets, and provided that the target would not cease to carry on the business without the sellers’ written consent, such consent not to be unreasonably withheld. The agreement also contained an acknowledgement that the buyer was under no obligation to conduct its business so as to increase the earn-out.

The buyer decided the product had failed, asked the sellers to consent to closing the business, offered US$1.07m in compensation, and shut the business down when consent was refused. The court found the buyer in material breach of both the diligence obligation and the active marketing obligation, held that the sellers’ refusal of consent was not unreasonable, and awarded the sellers damages of US$1,299,808.

Three points from that judgment are worth carrying into any earn-out negotiation. First, the express covenants did the work. The general acknowledgement that the buyer need not maximise the earn-out was expressly subject to the covenants, so it did not neuter them. Second, the court accepted that in deciding whether to give consent the sellers were entitled to have regard to their own interest in earning as large an earn-out payment as possible, and were not required to balance that against the buyer’s costs. Third, a vague covenant is a weak covenant: the parties spent a long trial arguing about what “actively marketed” meant.

The covenants worth negotiating for are these:

• The target will be carried on as a separate business, with separate accounting records, for the earn-out period
• No transfer of customers, contracts, employees or assets out of the target without the seller’s consent
• No change to the target’s accounting reference date or accounting policies without consent
• No material change to pricing, discounting or the product and service mix without consent
• No group recharges, management charges or intra-group trading other than on arm’s length terms
• A minimum level of working capital, marketing spend or headcount, expressed as a number rather than as a standard of effort
• Specific, measurable obligations where something must actually be done, such as a licence applied for or a facility retained, with a deadline attached
• Consent requirements expressed as consent not to be unreasonably withheld or delayed, which gives the seller a real veto without making the business unmanageable

Access to information, and the right to check the figures

A seller who has left the business has no statutory right to its management accounts. Without an express information right, the first the seller sees of the earn-out calculation is the buyer’s statement, and by then the year is over. The agreement should give the seller monthly or quarterly management accounts during the earn-out period, a right of access to the underlying books and records and to the target’s finance staff and auditors, and a reasonable period, usually 20 to 30 business days, to review the draft earn-out statement before it becomes binding.

The information right should also be drafted so that it survives the seller’s departure from employment. Sellers frequently agree an information right that is expressed to apply while the seller is a director or employee, which the buyer can then switch off by terminating the role.

Resale, change of control and acceleration

The single largest gap in most earn-out drafting is what happens if the buyer sells the target, or itself changes hands, during the earn-out period. If nothing is said, the seller is left with an earn-out measured against a business that has been absorbed into a larger group and can no longer be measured at all.

The usual solution is an acceleration clause. On a defined trigger event the unpaid earn-out either becomes immediately payable at a stated figure, or is deemed to have been earned in full, or is calculated on an agreed formula such as the average of the periods already completed. Triggers normally include a sale of the target or of substantially all its business or assets, a change of control of the buyer, an insolvency event affecting the buyer, and a material breach of the conduct of business covenants that is not remedied.

Acceleration is also the seller’s practical answer to the enforcement problem. Suing a buyer for breach of a conduct covenant means proving what the earn-out would have been in a counterfactual world, which is expensive and uncertain. A clause that converts breach into a liquidated payment avoids that. Where the buyer is a special purpose vehicle or a thinly capitalised company, the seller should additionally look for security: a parent company guarantee, an escrow or retention account, or a charge over the target’s shares.

Good leaver and bad leaver: what happens if the seller stops working there

Where the seller stays on after completion, the earn-out is usually linked in some way to that continued involvement. How that link is drafted is critical, both commercially and for tax, and it is where the two issues collide.

Leaver provisions divide the ways a seller can cease to be employed into good leaver and bad leaver categories. A good leaver typically covers death, permanent incapacity, retirement at an agreed date, redundancy, and termination by the buyer other than for cause, and usually also resignation in response to the buyer’s own repudiatory breach. A bad leaver typically covers summary dismissal for gross misconduct, resignation before an agreed date, and breach of restrictive covenants.

A seller should push for the earn-out to be preserved in full on a good leaver departure, calculated as if the seller had remained in post. A buyer will want some reduction, often pro-rated to time served. The genuinely dangerous drafting is total forfeiture of the earn-out on any cessation of employment, however caused, because it hands the buyer a mechanism to extinguish a large part of the price by terminating an employment contract. If you are structuring the post-completion employment arrangements at the same time, the employment law issues around service agreements and restrictive covenants should be worked through alongside the earn-out, not after it.

Where several shareholders are selling and some are staying on, the leaver mechanics also need to work with any surviving shareholders’ agreement and with the articles of the buyer vehicle, particularly on a management buy-out or buy-in where the sellers are taking shares in the acquiring company.

What a buyer needs from an earn-out

Earn-out drafting is usually written up as a seller protection exercise, which understates the buyer’s exposure. A buyer who signs up to tight conduct of business covenants has bought a business it cannot integrate for two or three years, which may be most of the reason it was buying.

The protections a buyer should be negotiating for are:

• A cap on the total earn-out, so the acquisition cannot become uneconomic if a single large contract lands
• Integration freedom, either generally or in defined areas, with the earn-out calculation adjusted on an agreed basis to strip out the effect of integration decisions
• A right to set off warranty and indemnity claims, and any completion accounts adjustment, against unpaid earn-out instalments
• Thresholds and hurdles, so that the earn-out is only payable above a baseline performance level rather than from the first pound
• Restrictive covenants and, where the seller stays on, a service agreement with notice and garden leave provisions that do not interact perversely with the leaver mechanics
• A clear statement that the earn-out is contingent and not guaranteed, and that no particular level of performance is warranted
• Agreed treatment of the earn-out in the buyer’s own accounts and, where relevant, in its banking covenants

The honest position is that integration freedom and seller protection are in direct conflict, and the negotiation is about where the line sits. On most SME deals the workable answer is a gross profit metric, a tight list of specific prohibitions rather than a general carry-on-as-before covenant, and an acceleration clause that prices the buyer’s freedom rather than preventing it. That way the buyer can integrate, and the seller gets paid for the consequences.

How earn-out disputes are resolved

Almost every earn-out agreement provides for disputes about the calculation to go to an independent accountant acting as an expert rather than as an arbitrator. The expert determines the disputed items, and the determination is final and binding in the absence of manifest error or fraud.

The reason that matters is that an expert determination is extremely difficult to challenge. The leading authority is Jones v Sherwood Computer Services plc [1992] 1 WLR 277, in which Lord Justice Dillon held that the first step is to see what the parties agreed to remit to the expert, and that a determination will only be set aside if the expert departed from those instructions in a material respect, for example by valuing the wrong number of shares or the shares of the wrong company. An expert who does exactly what the contract asked, but reaches an answer the court would not have reached, binds the parties. That analysis was reviewed and applied by the Court of Appeal in Barclays Bank plc v Nylon Capital LLP [2011] EWCA Civ 826.

The practical consequences for drafting are straightforward. The expert determination clause should state precisely what the expert may decide and whether that includes questions of contractual interpretation as well as accounting, how the expert is appointed if the parties cannot agree, the timetable for submissions, who bears the costs, and that the expert must give reasons. A non-speaking determination with no reasons is almost unchallengeable, which is excellent if you win and intolerable if you do not.

Disputes about the buyer’s conduct, as opposed to the arithmetic, usually fall outside the expert’s remit and go to court. That split needs to be deliberate rather than accidental, because a clause that sends everything to an accountant will see the accountant decline jurisdiction over the parts that matter most. Where a dispute has already arisen, it will usually be handled by our contract disputes team rather than the corporate team that drafted the agreement.

The tax trap: when earn-out consideration is taxed as income

Earn-out consideration is normally treated as part of the capital consideration for the shares and taxed as a chargeable gain. There are two circumstances in which that treatment can be lost, and both need flagging to the seller’s accountant before heads of terms are signed, not after completion.

Timing: the Marren v Ingles problem

Where the amount of the future consideration is unascertainable at completion, which is the defining feature of an earn-out, HMRC’s Capital Gains Manual confirms the position established in Marren v Ingles (54 TC 76): the right to receive future unascertainable payments is a chose in action, an incorporeal asset which is itself a chargeable asset for capital gains tax purposes. The practical effect is that the seller is taxed twice over, once on the market value of the earn-out right at completion and again when the right is satisfied, with the base cost of the right set against the second gain.

Where the earn-out is to be satisfied by issuing shares or loan notes rather than cash, section 138A of the Taxation of Chargeable Gains Act 1992 can apply. It treats a qualifying earn-out right as a security of the acquiring company, so that the share reorganisation rules apply and no gain crystallises until the shares or loan notes received in satisfaction of the right are themselves disposed of. For rights conferred on or after 10 April 2003 that treatment is automatic where the conditions are met, unless the seller elects for it not to apply.

Character: earnings rather than consideration

The more serious risk is that part of the earn-out is treated not as sale consideration at all but as employment income, taxable at income tax rates of up to 45 per cent with national insurance on top, rather than at capital gains tax rates. HMRC’s Employment Related Securities Manual states the policy plainly: where an earn-out includes an element that passes value to a prospective employee of the acquiring company as reward for services over a performance period, that remuneration element should be within the charge to income tax and national insurance contributions.

ERSM110940 sets out the key indicators HMRC uses to decide that an earn-out is further sale consideration rather than remuneration. They are worth reading as a drafting checklist:

• The sale agreement demonstrates that the earn-out is part of the valuable consideration given for the securities in the old company
• The value received from the earn-out reflects the value of the securities given up
• Where the seller continues to be employed, the earn-out is not compensation for the seller not being fully remunerated for that continuing employment
• Where the seller continues to be employed, the earn-out is not conditional on future employment, beyond a reasonable requirement to stay to protect the value of the business being sold
• Where the seller continues to be employed, there are no personal performance targets incorporated in the earn-out
• Non-employees or former employees receive the earn-out on the same terms as employees who remain

HMRC also treats evidence that future bonuses were reclassified or commuted into purchase consideration as an indicator that the earn-out is, at least partly, remuneration. Where an earn-out is partly consideration and partly a reward for services, HMRC’s position is that the value must be apportioned on a just and reasonable basis, so the risk is not all or nothing.

Where the earn-out is to be satisfied in securities, there is a separate exposure under Chapter 5 of Part 7 of the Income Tax (Earnings and Pensions) Act 2003. Section 471(3) deems securities options acquired by continuing employees to be acquired by reason of employment, and section 471(4) extends that to employees ceasing employment when the business is sold. HMRC’s guidance is that income tax and national insurance are potentially chargeable on receipt of the earn-out securities, but that where the earn-out can be shown to be further consideration for the disposal of securities rather than value obtained by reason of employment, no income tax liability arises.

Three drafting consequences follow. Keep the earn-out and the seller’s remuneration visibly separate, with a market rate salary under the service agreement so the earn-out cannot be characterised as deferred pay. Avoid personal performance targets in the earn-out formula. Make sure that selling shareholders who are not staying on receive the earn-out on the same terms as those who are.

The practical point for sellers is that losing capital treatment can also cost Business Asset Disposal Relief, which from 6 April 2026 charges qualifying gains at 18 per cent, against capital gains tax main rates of 18 and 24 per cent, and income tax rates rising to 45 per cent plus national insurance. That is a very large difference on a seven-figure earn-out. This article states the legal position and the structuring points only. Confirm your own tax position, the availability of any relief, and whether to seek advance clearance, with your accountant or tax adviser before heads of terms are agreed.

If the capital gains tax position on your exit generally is the live question, our note on incorporation and capital gains tax changes covers the wider planning issues, and our legal guide to selling a business sets the earn-out in the context of the whole transaction.

Earn-out protections checklist

This is the list we work through with sellers before heads of terms are signed. Buyers should read it as the list of concessions they will be asked for, and decide in advance which of them they can live with.

What this means for you

An earn-out is not a soft landing on price. It converts a known sum into a contingent one and then hands most of the levers that determine it to the other side. That can still be the right deal, and often is where the valuation gap is genuine and the buyer is credible, but it is only the right deal if the metric is chosen on the numbers, the accounting policies are written down, the conduct covenants are specific, the information rights survive the seller’s departure, and there is an acceleration clause that makes a resale or a breach a payment event rather than a litigation project.

For buyers, the equivalent point is that an earn-out bought cheaply in heads of terms becomes expensive later if the covenants prevent the integration the acquisition was for. It is better to pay slightly more at completion for a free hand than to spend the next three years asking the seller for consent.

We act on both sides of these transactions, which means we negotiate earn-out terms knowing exactly how the other side will come at them. If you are at heads of terms on a sale or purchase and the price has an earn-out in it, that is the right moment to take advice, not after the sale agreement has been drafted around it.

You can read more about the process on either side on our pages for selling a business and buying a business, or about the wider transaction on our mergers and acquisitions page. Our guide to selling a business and our guide to buying a business cover the steps either side of the earn-out, and if valuation is the live issue, our note on what affects the price of a practice and our guide to preparing a practice for a smooth exit are a useful read.

To talk through an earn-out on a deal you are working on, get in touch with our corporate team, call us on +44 207 566 1188, or email info@gurvelegal.com.