Nobody argues about the percentage. They argue about the denominator. Whether a job counts when it is signed, when it is invoiced, or when it is paid. Whether the corporate overhead you charged to the acquired division belongs in the calculation. Whether a customer you both served counts as theirs or yours.
If the earn-out agreement does not answer those questions in specific language, you will answer them later, under pressure, with a seller who is no longer feeling generous. The cure is a short rulebook agreed at the table. Settle it in the same sitting as the pre-close checklist and seller transition plan.
Revenue and when it counts
Pick one recognition rule and name it. For a service business this might be completed work, invoiced work, or collected cash. They produce different numbers in the same quarter. A seller who has a pipeline of signed jobs wants signed. A buyer worried about credit risk wants collected. The compromise is whatever you wrote down.
Write what happens to credits, returns, warranty work, and disputed invoices. If a customer cancels a job after it was counted, does the number come back out? Whoever is on the receiving end of that answer will care a great deal.
Overhead and shared costs
This is the largest source of disputes I have seen. The acquired company now shares a payroll service, insurance, a fleet program, and a leadership team with you. Some of those costs are real and some are allocations you invented. If an earn-out is based on profit, the allocation decides the payout.
Fix the allocation method in the agreement, for example a fixed monthly charge, a list of included services, or an actual cost pass through with an audit right. Say what is excluded, such as acquisition costs, integration spend, and one time restructuring. Without that list, every integration expense is a potential argument.
New versus existing business
Once the businesses are combined, you will win work together that neither would have won alone. Does that count toward the earn-out? If the acquired company's technicians start servicing your customers, whose revenue is it? If your sales team sells their service, is that theirs?
Decide the boundary by customer, by territory, or by product line, and keep a list. A customer list as of closing, updated by a defined process, ends most arguments about attribution. Revenue from your side that you route to them can be counted deliberately, but only if you want it counted.
Who decides, and how fast
Name the person who prepares the calculation, the person who reviews it, and the deadline. Give the seller access to the underlying records, within reason. Agree on a dispute process with a defined timeline and an independent accountant as the tiebreaker, so a disagreement does not turn into a lawsuit by default.
Keep one calculation file, built from the same accounting system you use to report to your own lenders or owners. If the seller sees a different set of books than your board does, you have built an argument into the structure. For the broader effect of the earn-out on your operations, see why an earn-out hurts integration. I would not sign an earn-out until last year's numbers had been run through the definitions and both sides agreed on the answer.
Sequenced list: the earn-out rulebook
Agree these in order, before closing. Each item has an owner.
- Choose the metric and write its definition, including the recognition rule. Owner: the deal lead, with finance.
- List the exclusions: acquisition costs, integration spend, one time restructuring, changes in accounting policy. Owner: finance, with counsel.
- Fix the shared cost allocation method and its audit right. Owner: finance.
- Define the customer base as of closing, and the rule for new customers and cross-sold work. Owner: the sales leader.
- Set the calculation calendar: who prepares it, who reviews it, and the date it is delivered. Owner: finance.
- Agree the dispute process, the tiebreaker, and the time limit on each step. Owner: counsel.
- Run a mock calculation on the last twelve months with the final definitions before you sign. Owner: finance, with the seller's adviser.
Connect it to the rest of the deal
An earn-out and seller financing often arrive together, and they interact in ways that surprise people. If a payment is set off against a claim, the order of payments and the right to offset matter. For the financing side, turn to seller financing and the integration.
Keep the finished rulebook next to the post-merger integration playbook, so the people running the integration can find it. Take the time now. The short conversation at the table costs far less than the long one after closing, and it keeps the seller on your side while you run the business you bought.
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Questions
How do you avoid earn-out disputes after closing?
Put the rules in the agreement before closing: one revenue recognition rule, a fixed method for shared overhead, a customer list that separates new from existing business, and a named person and dispute process for the calculation. Most disputes come from unclear definitions, not from the formula, so a mock calculation on past results before you sign is worth the effort.
Should the earn-out be based on revenue or profit?
Revenue is harder to manipulate through cost allocation but can reward low margin work. Profit tracks value better but invites arguments over overhead. Many buyers use gross profit as a middle path. Pick the one that matches what you actually want the seller to protect.
Can I change the accounting system during the earn-out?
You can, but write down how the earn-out will be measured through the change. A system cutover that shifts timing can move the number for reasons that have nothing to do with performance.
Who should review the earn-out calculation?
Your finance lead prepares it, and an independent accountant should be named in the agreement as the tiebreaker. Both sides should have access to the underlying records. This page is not accounting or legal advice.