Earnouts and Seller Financing: Where Disputes Arise

By Michael P. Barry, LMB Partners

A purchase price payable after closing leaves the seller exposed to decisions and financial conditions the seller may no longer control. For Colorado business owners, the important question is how the documents turn that future payment into a measurable, enforceable obligation.

Earnouts and seller notes serve different purposes. An earnout makes part of the price contingent on specified results, such as revenue or earnings. A seller note generally documents debt payable on agreed terms, without requiring the business to hit a performance target. A transaction can include both. Each needs its own payment rules and protections.

Define the earnout calculation

Agree on the metric, measurement period, thresholds, caps, and payment dates. Specify whether results are measured annually or cumulatively and whether a strong year can offset a weak one. Attach sample calculations covering performance above, below, and exactly at the thresholds.

Accounting language deserves particular attention. Generally accepted accounting principles (GAAP) alone may leave room for disagreements about permitted accounting choices. Establish a hierarchy among transaction-specific rules, historical practices, and applicable accounting standards. Address revenue recognition, customer credits, bad debt, reserves, shared overhead, acquisition costs, and related-party charges. Define which customers, products, and business lines count, including revenue generated through the buyer’s other entities.

An earnout based on earnings before interest, taxes, depreciation, and amortization (EBITDA) is especially sensitive to expense allocations. The parties should understand how integration costs and changes in staffing, compensation, or systems affect the calculation.

Address who controls performance

After closing, the buyer may control pricing, staffing, investment, customer relationships, and the timing of sales. A seller’s forecast may assume operating decisions the buyer has no contractual obligation to make.

Negotiate any needed operating commitments expressly. These might address resource levels, diversion of business, discontinuing products, or moving revenue and expenses between affiliates. Buyers should identify the flexibility they need to integrate and operate the business.

Do not assume an implied duty of good faith requires the buyer to maximize the earnout. The contract and governing law matter. Delaware decisions, for example, have enforced negotiated limits on buyer conduct rather than adding protections the seller failed to obtain. Have counsel evaluate the actual language and chosen law.

Make reporting and disputes workable

Require periodic reports, supporting calculations, and access to relevant records, subject to appropriate confidentiality protections. Set deadlines for the buyer’s calculation, the seller’s objections, responses, and payment of undisputed amounts. Allow enough review time after the necessary information is delivered.

Specify who decides each kind of dispute. An independent accountant may resolve defined calculation issues, while claims about diverted business or breached operating covenants may require a court or arbitrator. Address the decision-maker’s authority, document access, costs, and the interaction between proceedings.

Also decide what happens if the seller’s employment ends, the business is resold, operations are discontinued, or the buyer reorganizes. Continuing measurement, successor obligations, or an agreed buyout formula should be negotiated before those events occur.

Evaluate the seller note as a credit decision

Review the obligor’s finances and repayment capacity. Identify interest, amortization, maturity, any balloon payment, prepayment rights, financial reporting, default triggers, cure periods, and remedies. A payment schedule should reflect a credible source of repayment.

If collateral is promised, identify the assets and their owner, obtain the appropriate security documents, and determine how the security interest must be perfected. Filing a UCC financing statement is common, but the required method and jurisdiction depend on the collateral and applicable law. A promissory note alone does not establish a perfected lien.

Investigate existing liens and priority. Collateral value, competing claims, and enforcement costs can limit recovery. Evaluate any guarantor’s resources as well as the guarantee’s terms; neither collateral nor a guarantee assures payment.

Read the senior lender’s restrictions

An acquisition lender may require subordination or an intercreditor agreement. Review payment priority separately from lien priority. The documents may block scheduled payments, require turnover of money received, or impose a standstill that delays enforcement after default.

Negotiate permitted payments, notice and cure rights, standstill duration, and treatment of refinancing or increased senior debt. Reconcile these restrictions with the seller note before signing. A contractual maturity date has limited practical value if another agreement prevents collection when payment comes due.

Control setoff and review taxes

Address whether the buyer may withhold earnout or note payments for indemnity claims. Define notice requirements, disputed versus finally determined claims, limits on withholding, and release of amounts once a dispute ends. Otherwise, a separate purchase-agreement claim can interrupt the expected payment stream.

Bring tax advisors into the structure early. Installment reporting may be available for eligible gain, but it does not defer every tax item. Contingent payments, inventory, depreciation recapture, and interest require separate analysis.

Before accepting deferred consideration, test the payment provisions against underperformance, a dispute, and buyer financial distress. Learn more about LMB Partners’ mergers and acquisitions practice or schedule a consultation to discuss a proposed transaction.

This article provides general information, not legal or tax advice for a particular transaction.