Earnouts are a mechanism used in M&A transactions to bridge the gap between a buyer's and seller's view of a target company's value. The buyer pays an initial consideration at completion, and then pays additional amounts in the future if the business achieves defined performance targets. They are particularly common in transactions involving businesses where future performance is uncertain, or where the seller believes the business has significant upside that the buyer is not prepared to pay for upfront.
In Indian M&A, earnouts are less common than in the US, but they are used in certain types of transactions, particularly in the technology and professional services sectors. When they are used, they need to be structured very carefully.
How Earnouts Are Structured
An earnout consists of three key elements: the performance metric, the measurement period, and the payment formula. The performance metric is what the business must achieve to trigger the earnout payment. Common metrics include EBITDA, revenue, gross profit, or in some cases non-financial metrics such as number of customers or users, or regulatory milestones. The measurement period is the duration over which performance is assessed, typically one to three years post-completion. The payment formula determines how the earnout amount is calculated once the metric is established.
Each of these elements creates scope for dispute if not defined precisely. What counts as revenue? Does it include intercompany transactions? How are one-off items treated in the EBITDA calculation? What happens if the buyer makes an acquisition that changes the business during the earnout period?
The Fundamental Tension in Earnout Transactions
After completion, the buyer controls the business. The seller is typically out of operational management. The buyer's decisions about investment, cost structure, pricing, and strategic direction will all affect the earnout metric. A buyer who wants to avoid paying the earnout has significant ability to manage the business in ways that depress the metric, at least on paper.
This creates a fundamental tension. The seller has an incentive to maximise near-term financial performance. The buyer may have an incentive to invest for the long term in ways that depress near-term earnings. Or, in the worst case, a buyer may manage the business in ways specifically intended to avoid the earnout trigger.
The most litigated earnout disputes globally, and increasingly in India, arise not from fraud but from the buyer exercising genuine business judgment in ways that happen to prevent the earnout from being achieved. The question of whether the buyer had an implied obligation to manage the business in a way that gave the seller a fair opportunity to achieve the earnout is one that Indian courts have not definitively resolved.
Protective Provisions for Sellers
Sellers should negotiate specific protective provisions to reduce the buyer's ability to manipulate the earnout outcome. These include an obligation on the buyer to operate the business in the ordinary course during the earnout period, restrictions on the buyer's ability to merge the target business with other businesses in a way that makes the earnout metric unmeasurable, an obligation to maintain the same accounting policies that applied pre-completion, information rights allowing the seller to monitor performance during the earnout period, and an obligation to pay the earnout promptly on achievement without seeking to dispute or set off other claims.
Dispute Resolution
Earnout disputes typically arise over the calculation of the metric. The acquisition agreement should specify clearly how disputes about the earnout calculation are to be resolved. A tiered process is common: the parties first attempt to agree the calculation through discussion, then submit unresolved disputes to an independent accountant or expert for determination, with the expert's decision being final and binding. Submitting earnout disputes to general commercial arbitration is slower and more expensive and is usually not the preferred mechanism for what is essentially a financial calculation dispute.
Indian Law Considerations
Earnout obligations are contractual payment obligations and are enforceable under Indian law as such. The Specific Relief Act, 1963 allows specific performance of contracts for the payment of money, and a buyer who refuses to make a properly due earnout payment can be compelled to do so by court order. The limitation period for enforcement of the earnout obligation runs from the date on which payment was due and not made.
Disclaimer: This article is for informational purposes only and does not constitute legal advice. It does not create a lawyer-client relationship. For advice specific to your situation, please consult a qualified legal professional. LawCite Advocates is a law firm registered in India.