Alex is Sprintlaw’s co-founder and principal lawyer. Alex previously worked at a top-tier firm as a lawyer specialising in technology and media contracts, and founded a digital agency which he sold in 2015.
An earn out agreement can help bridge the gap when a buyer and seller disagree on what a business is worth. It is common in Australian business sales where the seller believes the business will keep growing, but the buyer wants protection in case revenue drops after settlement. The trouble is that many deals go wrong because the earn-out terms are vague, the performance targets are too easy to manipulate, or the parties rely on verbal promises about how the business will be run after completion.
This is where founders and business owners often get caught. A seller may assume they will still have enough control to hit the targets. A buyer may assume they can integrate the business straight away without affecting the earn-out. This guide explains what an earn out agreement usually covers, the legal issues to check before you sign, the mistakes that lead to disputes, and how to document the arrangement so the sale price mechanism is much clearer from day one.
Overview
An earn out agreement is a contractual arrangement where part of the purchase price for a business is paid later, depending on whether agreed performance targets are met after completion. In Australia, it is usually documented in the business sale agreement or a separate deed that works alongside the sale documents.
The value of an earn-out is that it can get a deal across the line when the parties have different views on future performance. The main risk is that if the drafting is loose, both sides may have very different expectations about how the targets are measured and what each side can do after settlement.
- How the earn-out amount is calculated, including the formula, timing and any caps or minimum thresholds.
- What financial metric is being used, such as revenue, gross profit, EBITDA, customer numbers or retained clients.
- Who controls the business after completion and what operational decisions could affect the result.
- What accounting methods, reporting standards and adjustments apply to the calculation.
- What access rights the seller has to financial records, management accounts and supporting information.
- Whether there are restrictions on the buyer changing pricing, staffing, suppliers or the structure of the business during the earn-out period.
- How disputes about the calculation are handled, including expert determination or another dispute process.
- How the earn-out interacts with restraints, warranties, indemnities and any ongoing employment or consultancy arrangement.
What Earn Out Agreement Means For Australian Businesses
An earn out agreement means the final sale price is not fixed entirely at completion. Instead, some of the price depends on what happens in the business after the sale.
That sounds simple, but the commercial effect can be significant. For a seller, an earn-out can be a way to secure more value if the business performs as expected. For a buyer, it can reduce the risk of overpaying for goodwill, customer relationships or forecast growth that may not actually eventuate.
Why buyers and sellers use earn-outs
Earn-outs are common where value is tied closely to the seller's relationships, reputation or know-how. You often see them in service businesses, agencies, professional practices, software businesses, ecommerce brands and other SMEs where future performance is harder to price with confidence.
A buyer may be willing to pay more overall if some of that price is conditional. A seller may accept delayed payment if they are confident the business will meet the agreed targets. In that sense, the earn-out works as a risk-sharing tool.
How an earn-out usually works
The sale contract usually provides for an upfront amount at settlement and one or more later payments if performance conditions are met over a defined period. The earn-out period might run for 6 months, 12 months, 24 months or longer, depending on the business and the deal.
The agreed targets might relate to:
- total revenue generated during the earn-out period
- profitability, such as EBITDA or net profit
- number of active customers retained after settlement
- renewal of key contracts
- milestones, such as product release, regulatory approval or rollout targets
Some agreements use a sliding scale rather than an all-or-nothing payment. For example, if the business hits 80 per cent of the target, part of the earn-out is paid. If it hits 100 per cent or more, the full amount is payable, sometimes with a cap.
Why drafting matters so much
The legal issue is not just whether the target is met. The real question is whether the contract clearly explains how to measure the target and what each party can and cannot do during the earn-out period.
For example, suppose the earn-out is based on revenue from existing customers. If the buyer changes pricing, bundles services differently, moves customer accounts into another group entity or stops marketing the acquired product line, the seller may say the buyer has undermined the earn-out. If the contract does not deal with these situations, a dispute becomes much more likely.
Where the earn-out sits in the sale documents
In many Australian business sales, the earn-out terms are built into the main sale agreement. In other deals, there may be a separate earn-out deed, especially where the mechanics are detailed or the seller remains involved after completion.
The earn-out often interacts with several other parts of the transaction documents, including:
- restraint clauses that stop the seller competing with the business
- employment or consultancy agreements if the seller stays on
- warranties and indemnities about the business
- completion accounts or purchase price adjustment clauses
- security arrangements if payment is deferred
That is why an earn-out should not be treated as a short side arrangement. It usually affects the whole deal structure.
Legal Issues To Check Before You Sign
The most important legal issue is clarity. Before you sign a contract, the earn-out formula, control rights and dispute process should be clear enough that both sides can apply them in real life without guessing.
Define the performance metric carefully
Words like revenue, profit and customer can seem straightforward until money is on the line. The contract should say exactly what counts and what does not.
Points that often need detail include:
- whether GST is included or excluded
- whether revenue is recognised on invoice, cash receipt or another basis
- which expenses can be deducted if the metric is profit-based
- how bad debts, refunds, discounts and credits are treated
- whether related-party transactions are included or excluded
- whether sales through a different entity in the buyer's group count toward the target
If the business has seasonal fluctuations, lumpy contracts or long sales cycles, the formula should reflect that. A metric that looks simple on paper can produce a distorted result in practice.
Deal with post-sale control and conduct
Control after completion is often the biggest practical issue. A buyer usually wants freedom to run the business as it sees fit. A seller wants some protection so the buyer does not take steps that make the earn-out impossible to achieve.
The agreement may need to address matters such as:
- whether the buyer must operate the business in the ordinary course during the earn-out period
- whether key staff must be retained, if reasonably possible
- whether the buyer can materially change pricing, branding, supplier arrangements or product lines
- whether the buyer can merge the business into another operation or change accounting systems
- whether the seller has any management role, consultation rights or approval rights
Buyers usually resist broad restrictions, and that is understandable. The solution is often to identify the specific conduct that would unfairly distort the earn-out, rather than trying to lock down every business decision.
Set reporting and information rights
A seller cannot verify an earn-out without reliable access to information. Before you rely on a verbal promise that you will be kept informed, make sure the contract sets out what reports will be provided and when.
This might include:
- monthly or quarterly management accounts
- access to source records relevant to the calculation
- notice of material changes to the business
- the right to ask reasonable questions about the numbers
- a limited audit or inspection right through an accountant
These rights should be practical and proportionate. The buyer will usually want confidentiality protections and sensible limits on disruption.
Choose a dispute mechanism that fits the issue
Earn-out disputes are often technical accounting disputes mixed with contractual interpretation issues. A well-drafted agreement should say how those disputes are resolved.
Common options include:
- good-faith negotiation between the parties within a set timeframe
- referral of accounting issues to an independent expert
- arbitration or court proceedings for broader contractual disputes
The clause should also say whether the expert acts as an expert or an arbitrator, what material can be provided, who pays the costs initially and whether the determination is final except for obvious error.
Check how the earn-out interacts with other obligations
An earn-out rarely stands alone. It often sits beside restraints, handover obligations, employment terms and deferred payment arrangements.
For example, if the seller must stay on as an employee for 12 months, what happens to the earn-out if the buyer terminates that employment early? If the seller breaches a restraint, can the buyer set off that loss against the earn-out payment? If there is a warranty claim, can the buyer withhold earn-out amounts pending resolution?
These interactions should be stated clearly. If not, each side may assume rights that are not actually written into the contract.
Consider security and recoverability
If a meaningful part of the price is deferred, the seller may want comfort that the amount will actually be paid if earned. Depending on the deal, this might involve a guarantee from a holding company or director, a security arrangement, or other negotiated protections.
The right approach depends on the transaction structure and the relative bargaining power of the parties. Sellers should also speak with their accountant or tax adviser about any tax treatment questions linked to deferred consideration.
Common Mistakes With Earn Out Agreement
The most common mistake is assuming goodwill and trust are enough. Earn-outs need precise contract drafting because even sensible business people can remember the same conversation very differently once the numbers matter.
Using vague targets
A target like maintain revenue or grow the client base is too loose on its own. It does not explain the accounting basis, the time period, or what happens if a customer pays late, cancels, downgrades or moves to a different service.
This is where disputes often start. If the formula cannot be applied mechanically, the parties end up arguing over intention.
Ignoring how the buyer will run the business
Sellers often focus on the payment amount and overlook the buyer's ability to change the business after completion. Buyers often focus on flexibility and underestimate how their decisions could undermine the agreed target.
For example, a buyer may centralise functions, change software, replace staff, stop advertising a product line or cross-sell a substitute service through another entity. Those decisions may be commercially sensible, but they can alter the earn-out result dramatically.
Leaving key assumptions outside the contract
Founders sometimes rely on side conversations about budget, staffing, marketing spend or the seller's ongoing role. If those assumptions matter to the earn-out, they should appear in the written terms.
Before you sign, ask yourself whether the deal still works if every verbal promise disappears and only the contract remains. If the answer is no, more detail is needed.
Not aligning the earn-out with the handover plan
Many SMEs depend heavily on the seller's relationships. If the earn-out assumes those relationships will transfer smoothly, the contract should deal with the handover properly.
That may involve:
- introductions to major customers and suppliers
- a transition period where the seller assists the buyer
- defined duties if the seller remains in the business
- clear boundaries on authority and reporting lines
If the handover is vague, both performance and accountability can suffer.
Forgetting dispute costs and timing
A dispute clause that simply says the parties will discuss the matter is not enough. If there is no timetable or expert process, the earn-out can remain unresolved for months while cash flow and goodwill deteriorate.
Small and medium businesses especially need a process that is commercially realistic. The clause should help bring the issue to a decision, not just postpone the fight.
Overcomplicating the structure
Some earn-out clauses become so technical that neither party can easily model the outcome. Complexity is sometimes necessary, but unnecessary layers of adjustments, exceptions and carve-outs can create more uncertainty, not less.
A simpler formula that both sides can test against actual business scenarios is often safer than a highly engineered mechanism that only works in theory.
Not documenting set-off rights properly
Buyers sometimes assume they can deduct warranty claims, indemnity claims or other losses from the earn-out payment. Sellers often assume the earn-out is ring-fenced and must be paid separately.
If set-off is intended, the contract should say so and explain the process. If it is not intended, that should also be clear.
Failing to plan for edge cases
Real businesses do not always perform neatly through a measurement period. A major customer might be lost for reasons outside either party's control. A regulatory change might affect sales. The buyer might sell the business again during the earn-out period.
The contract should consider events such as:
- what happens if the buyer sells or restructures the business
- what happens if the seller dies, becomes incapacitated or leaves an agreed role
- what happens if a key contract is terminated unexpectedly
- whether force majeure style events affect the target calculation
- whether the earn-out accelerates on a later sale of the business
You do not need to predict every scenario, but the obvious ones should be addressed before you accept the purchaser's standard terms or circulate a draft for contract review to the other side.
FAQs
Is an earn out agreement legally enforceable in Australia?
Yes, if it is properly documented with clear terms, consideration and agreement on the essential mechanics. Problems usually arise not because earn-outs are unenforceable in principle, but because the formula or obligations are too uncertain.
Should the earn-out be in the sale agreement or a separate deed?
Either can work. Many transactions include the terms in the main business sale agreement, but a separate deed can make sense where the earn-out mechanics are detailed or there are ongoing obligations after completion.
What is the best metric for an earn-out?
There is no single best metric. Revenue is easier to measure but can ignore costs. Profit-based metrics may reflect value better but are easier to influence through accounting treatment and spending decisions. The best option depends on the business model and the specific risks in the deal.
Can a buyer change the business during the earn-out period?
Usually yes, unless the contract limits that right. The real issue is whether the agreement places boundaries on changes that could unfairly affect the earn-out calculation.
What happens if the parties disagree about the earn-out calculation?
The contract should set out a dispute process, often starting with negotiation and then referring technical accounting issues to an independent expert. If the clause is poorly drafted, the dispute may become slower and more expensive to resolve.
Key Takeaways
- An earn out agreement lets part of the business sale price be paid later if agreed performance targets are met.
- The key legal issues are the calculation formula, accounting treatment, post-sale control, information rights and dispute resolution.
- Most earn-out disputes come from vague drafting, unwritten assumptions and business changes after completion that affect the target.
- The earn-out should be aligned with restraints, warranties, indemnities, handover obligations and any ongoing employment or consultancy arrangement.
- Before you sign, test the clause against real scenarios so both sides understand how the mechanism works in practice.
If you want help with sale agreement drafting, earn-out formula terms, restraint clauses, or dispute resolution provisions, you can reach us on 1800 730 617 or team@sprintlaw.com.au for a free, no-obligations chat.
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Alex SoloCo-Founder
