How does a lender treat an earnout in an acquisition?

An earnout solves a disagreement about the future. The buyer thinks the business will do one thing, the seller thinks it will do better, and the gap gets bridged by a payment contingent on what actually happens. That is a sensible instrument. It becomes a problem when the contingent payment lands in a year where the business is also servicing acquisition debt.

What the lender does with it

The arithmetic that decides it

• Coverage without the earnout: 1.71. Comfortable.
• A fixed earnout of 125,000 falling due in year two: coverage becomes 210,000 divided by 248,129 — 0.85.

The business cannot pay both. So it pays the bank and asks the seller to wait, which is exactly what the subordination agreement contemplates, and the deal that felt collaborative at signing becomes a dispute at the first measurement date.

The structure that works

Define the earnout as a share of the increment it measures, payable from cash actually collected, in arrears.

Same deal, restructured: the earnout is 35 per cent of gross profit above a 1,000,000 baseline, capped at 250,000 in total, payable annually in arrears within 90 days of audited or reviewed figures.

If incremental gross profit in year two is 360,000, the earnout payment is 126,000 — almost identical to the fixed version. But the cash flow is different, because the increment that triggered the payment also generated cash. If 55 per cent of that incremental gross profit flows through to cash after the costs of producing it, available cash flow rises to 408,000. After paying the 126,000 earnout, coverage against the senior debt is 2.29, with a cushion of about 159,000.

The earnout is now self-funding. The seller gets paid more when the business does better, the lender is not squeezed, and the buyer is not writing a cheque out of a year that did not produce the money.

Getting the metric right

The metric determines whether the structure works. Rank them:

• Cash collected — best for the buyer's cash flow, because payment follows money in the door. Sellers dislike it because collection is in the buyer's hands.
• Gross profit — good middle ground. Harder to manipulate than net profit, directly related to cash generation, and both parties can verify it.
• Revenue — simple and verifiable, but a revenue earnout can be earned on unprofitable sales. If you use it, pair it with a minimum margin condition.
• Net profit or EBITDA — worst for disputes. Every allocation, owner salary, management fee and capital decision becomes an argument, because the buyer now controls the accounting.

Define the measurement in the agreement, line by line: which accounts, which accounting basis, who prepares the statements, what happens to costs the buyer introduces, how a dispute is resolved and by whom.

Clauses that prevent the predictable fights

• A cap, stated in dollars, and a floor below which nothing is payable.
• Payment conditioned on senior debt coverage at a stated level after the payment, with deferral rather than forfeiture if the test fails, and interest on deferred amounts.
• Acceleration on sale. If the buyer sells the business during the earnout period, what happens? Silence here produces litigation.
• Protection against the buyer starving the metric — no relocating revenue to an affiliate, no unusual charges to the measured unit, a commitment to operate in the ordinary course.
• Protection for the buyer from the seller's departure — if the earnout depends on the seller's relationships, the seller's continued involvement should be an obligation, not a hope.
• Set-off against the earnout for breaches of representations and warranties. The earnout is the most useful security a buyer has and most agreements fail to make it available.

One practical note on timing: measurement periods that end on the acquisition anniversary rather than the fiscal year end create extra accounting work and extra room for argument. Align the earnout period with your accounting year wherever the seller will accept it, so the figures come out of the same close process that produces everything else.

What to do before you agree an earnout

1. Ask your lender, in writing, whether they will permit an earnout at all and on what terms. Do this before the letter of intent is signed.
2. Model coverage in every year of the earnout period, including the payment. If any year falls below the lender's requirement, the structure is wrong.
3. Convert a fixed earnout into a share-of-increment earnout, and show the seller the arithmetic — they usually end up with more.
4. Get the subordination agreement drafted early, and have the seller's counsel review it before closing week.
5. Write the measurement definition with your accountant, not your lawyer alone.
6. Agree the dispute mechanism and the accounting standard in the same clause as the metric.