The mechanics of structuring an earn-out in a UK acquisition

Why structure matters more than the concept

Most founders understand the basic idea of an earn-out: part of the sale price is deferred and paid later, contingent on the business hitting agreed targets after completion. What causes disputes, and what lawyers spend most of their time on, is the structuring detail. The percentage of price that is deferred and the general rationale get agreed early. The mechanics of how that deferred sum is measured, controlled and paid get argued over for weeks, because they determine whether the earn-out is ever actually collected in full.

Choosing the metric

The first structural decision is what the earn-out is measured against. Common choices are revenue, gross profit, EBITDA, or a specific operational metric such as number of active customers or contracts renewed. Each has trade-offs.

Revenue-based earn-outs are simpler to measure and harder for a buyer to manipulate through cost allocation, but they ignore profitability, so a founder can hit target and still watch margins collapse under new ownership. EBITDA-based earn-outs reward genuine profit performance but are far easier for a buyer to distort, because central overhead recharges, transfer pricing between group companies, and changes to accounting policy can all move the number without changing the underlying business. Where EBITDA is used, the sale and purchase agreement needs a detailed schedule setting out exactly how it will be calculated, including which costs are excluded and which accounting standards apply, agreed before completion rather than left to interpretation afterwards.

The measurement period and payment schedule

Earn-outs typically run for one to three years post-completion. Longer periods increase the total sum at stake but also increase the risk that market conditions, buyer integration decisions or management changes distort the outcome. Structures often stagger payment across multiple measurement periods, for example an amount payable after year one and a further amount after year two, rather than a single cliff-edge payment at the end. Staggering reduces risk for the seller because it crystallises some value early, and gives the buyer more chances to recalibrate targets if the first period reveals the original assumptions were wrong.

Control clauses: the most contested part

Because the founder no longer controls the business after completion but is still financially exposed to its performance, the agreement needs clauses restricting what the buyer can and cannot do during the earn-out period. These typically cover:

• A requirement to run the business substantially in the ordinary course, without material changes to strategy, pricing or headcount that would depress the earn-out metric
• Restrictions on diverting customers, contracts or revenue to other parts of the buyer’s group
• Commitments on continued investment in sales, marketing or product where relevant to the metric
• Rules on how shared or group costs are allocated to the acquired business

Buyers resist tight control clauses because they want freedom to integrate the acquisition into wider operations. Sellers push for them because a vaguely worded earn-out with no operating restrictions is close to worthless. This tension is usually the longest-negotiated part of the whole agreement.

Escrow, holdback and set-off

Separate from the earn-out itself, part of the upfront consideration is often held back in an escrow account to cover warranty claims or working capital adjustments. It is important not to confuse this with the earn-out; escrow is a security mechanism tied to warranties given at completion, while the earn-out is additional consideration tied to future performance. Agreements also commonly give the buyer a right of set-off, allowing it to deduct any warranty claim from the earn-out payment rather than pursuing it separately. Sellers should look closely at set-off rights, since a broadly drafted clause can let a buyer withhold the whole earn-out on a disputed and unresolved claim.

What happens if the founder leaves or is dismissed

Most earn-outs assume the founder or key managers stay on and continue running the business, since their departure is often exactly what would depress performance. Agreements therefore address what happens to the earn-out if the individual resigns, is made redundant, or is dismissed with or without cause during the period. Outcomes range from full acceleration of the earn-out, to pro-rata payment, to forfeiture, and this is negotiated separately from employment terms.

Dispute resolution

Because earn-out calculations depend on figures the buyer controls, the agreement should specify a clear process for the seller to review accounts, raise objections within a set window, and refer unresolved disagreements to an independent accountant for binding determination. Without this mechanism, a seller’s only recourse is litigation, which is slow and expensive relative to the sums often in dispute.

Tax treatment

How an earn-out is taxed depends on its structure, particularly whether it is paid in cash or shares, and whether it is treated as further consideration for the sale (potentially subject to capital gains treatment) or as employment income. This is a specialist area and the tax outcome can materially change the value of a deferred payment, so it needs to be modelled with an adviser before terms are agreed, not after.

Where to check current rules

Earn-out drafting sits within general contract and company law rather than a regulator-specific scheme, but founders should verify tax treatment with HMRC guidance and take advice from a solicitor experienced in M&A before signing anything.