Start with the economic trade
An earnout is deferred, conditional consideration, not guaranteed purchase price. Its expected value is lower than its face amount because the target may not be met, payment may be delayed, and the buyer's credit or the agreement's enforcement provisions may matter. A proposal advertising a $10 million price may actually mean $8 million at closing and up to $2 million later under conditions that the seller cannot control. Owners should compare the certain portion and contingent portion separately, instead of allowing the maximum to anchor their view of value.
Begin by asking what specific valuation disagreement the earnout is intended to solve. A buyer may believe a facility contract is likely to renew but not yet have signed documentation. A seller may expect a new site to ramp faster than the buyer's forecast. The parties may disagree about whether a recent earnings increase reflects durable economics or a temporary staffing pattern. A well-designed earnout ties only the disputed slice of value to evidence that can emerge later. If the proposal instead makes a large share of consideration contingent on broad business performance, it may transfer ordinary ownership risk to sellers after they have surrendered control.
Request a side-by-side comparison of the offer with and without the earnout. Show cash at closing, escrow, seller notes, contingent payments, assumed liabilities, transaction expenses, taxes as advised by the owners' tax professionals, and any rollover equity. A seller note is a debt obligation with its own maturity and credit exposure; rollover equity participates in future enterprise value; an earnout depends on a specified trigger. These instruments are not interchangeable. The comparison should state the amount each owner receives at closing and the range of later proceeds under downside and expected cases, plus the upside case.
Identify the metric that fits the disputed value
The metric should measure the proposition that justified the contingent payment. Common measures include net collections, revenue, earnings before interest and taxes, with depreciation and amortization addressed in the definition, contract retention, or a discrete milestone such as opening a site. Each answers a different question. Collections may be relatively traceable to remittances but shift with billing lag and payer mix. Revenue can be affected by accounting conventions. Earnings may capture the economic outcome, yet it depends on allocations for staffing, management, corporate overhead, and other expenses. Contract retention can be clear in concept while ambiguous about amendments, successor agreements, and partial coverage.
For an anesthesia group, a collections metric requires precise treatment of professional fees, facility payments, denials, refunds, recoupments, credit balances, and accounts receivable existing at closing. If the buyer migrates claims to a new billing platform, the data should still permit reconciliation from service date through remittance. Define whether the metric is based on cash received during the measurement period or on services performed during that period. A cash basis can understate a strong final quarter when payers remit late; a service basis requires a consistent method for estimating uncollected amounts and later adjustments.
An earnings metric demands an equally detailed schedule of permitted and excluded expenses. Consider physician compensation, benefits, locum tenens costs, recruitment, billing fees, corporate overhead, management charges. List rent and insurance separately. Set out the technology charge on its own line. Address one-time integration costs separately. Define whether expenses are charged at actual cost, allocated using a fixed formula, or capped. Clarify whether owner compensation is normalized and whether the buyer can increase management fees after closing. Otherwise, the buyer may control the metric by changing the cost allocations instead of by changing underlying practice performance.
Build a measurement period and baseline
The period should match the time needed for the relevant event to become observable. A contract renewal may require a period extending beyond its notice and negotiation windows. A new location may need a ramp period before comparing results. A broad annual earnings test may be distorted by seasonality, planned downtime, or the timing of payer settlements. A longer period creates more opportunity for results to emerge, but it also prolongs uncertainty and leaves former owners tied to decisions they no longer make.
Set a baseline using records both sides can reproduce. For historical performance, identify the exact fiscal or trailing period, accounting policies, and any normalization adjustments. For a new site, specify the date operations begin and whether the ramp target adjusts for delayed credentialing, construction, or facility readiness. Avoid vague promises to use 'consistent accounting principles.' Attach a sample calculation or schedule showing how the terms work with actual categories. Consistency is difficult to enforce when the agreement never says which policies govern.
Specify how partial achievement is treated. A cliff payment pays nothing below a threshold and the full amount once the threshold is crossed. A graduated formula pays proportionately over a stated range. The graduated approach often reflects the economics more faithfully: missing an earnings target by a small amount need not erase all contingent value. If a cap applies, show the formula at the floor and target, then the cap. State whether excess performance in one period can offset a shortfall in another, whether negative results carry forward, and whether a later period can cure an earlier miss.
Protect the calculation from buyer-controlled decisions
After closing, the buyer usually controls staffing, scheduling, contracts, billing, expense allocation, and integration. The earnout should acknowledge that control. A seller cannot fairly be held to a forecast if the buyer can redirect cases, defer hiring, close a location, reassign a contract, or charge newly created expenses to the acquired operation without accounting rules. A covenant to operate in the ordinary course may help, but its scope must fit the buyer's planned integration and the metric being used.
Some agreements require the buyer to use commercially reasonable efforts to achieve the earnout. That phrase can be hard to apply unless it is anchored in observable duties. The parties could specify that the buyer will maintain the acquired locations open, continue billing covered services through an identifiable entity, preserve access to necessary records, and not divert a defined category of business solely to reduce the payment. If the buyer needs flexibility to consolidate systems or combine operations, provide a consistent allocation method and prohibit selective charges designed to depress the measured result.
The agreement should state whether the buyer may sell, merge, reorganize, or transfer the acquired business before the earnout ends. If a successor takes over, it should assume the payment and reporting obligations. A change of control can also trigger acceleration or a requirement to fund the maximum or a negotiated amount, especially if the transaction makes measurement impractical. The parties should address what happens if the buyer closes a location or terminates the relevant contract for reasons unrelated to performance. Silence leaves the sellers arguing later about whether the buyer's action prevented the condition from occurring.
Make records and review procedures, including how a dispute is resolved usable
A meaningful earnout requires access to information. State how often the buyer will deliver reports, what each report contains, and how quickly it must provide supporting records. A quarterly statement might show cases or services, billings, collections, adjustments, expenses by defined category, contract status, and the formula applied. Sellers should receive records sufficient to test the number, subject to appropriate confidentiality protections. A bare total with no supporting detail makes a right to object theoretical.
Provide a defined review window after each statement, followed by a clear objection process. The seller group may need a representative to receive records and coordinate questions, especially where numerous physician partners sold interests. Permit access for the sellers' accounting or financial advisers under confidentiality obligations. If records are held in systems the buyer controls, specify a retention period long enough to cover the earnout and any dispute. Preserve relevant source data when systems are migrated or vendors change.
Clarify payment mechanics. State when an earned amount is due, whether it is paid in cash, whether permitted setoffs exist, and how any undisputed portion is handled while a disputed portion is reviewed. Broad setoff rights can let the buyer withhold an earnout for unrelated indemnity claims. If the buyer insists on setoff, limit it to finally determined or agreed amounts, or require disputed claims to be held in escrow. Consider whether the payment obligation is guaranteed by a creditworthy parent or secured in another way, particularly when the acquiring entity is thinly capitalized.
Work through an illustrative example
The following numbers are illustrative only. Assume a group sells for $18 million of total stated consideration: $15 million in cash at closing and up to $3 million in contingent consideration over two years. The earnout is tied to adjusted operating earnings from the acquired locations. The proposal pays nothing below $4 million of cumulative two-year earnings, pays proportionately from $4 million to $5 million, and caps at $3 million when earnings reach $5 million. The buyer's forecast is $4.6 million, while the sellers' forecast is $5.2 million.
Under that formula, the expected payment at the buyer's forecast is $1.8 million: the forecast is $600,000 above the $4 million floor, or 60 percent of the $1 million performance band, producing 60 percent of the $3 million cap. The sellers' forecast reaches the cap, so the earnout would pay $3 million. The gap between the forecasts is therefore $1.2 million of contingent proceeds, not merely a difference in how the headline price is described. The owners should model how much of that amount each partner receives after transaction costs and applicable tax treatment.
Now test the formula's sensitivity. Suppose buyer allocations add $300,000 of corporate costs that the sellers did not include in their forecast. Measured earnings fall from $4.6 million to $4.3 million, and the formula pays $900,000. A cost allocation choice has reduced proceeds by $900,000 because each $100,000 change across the band changes the earnout by $300,000. If earnings land at $3.9 million, the cliff eliminates the full payment. A graduated floor or a lower floor may reduce that sharp discontinuity, but it changes the economics and should be negotiated explicitly.
Next examine timing and attribution. If the buyer migrates billing systems mid-period and $250,000 in remittances for services performed at an acquired site cannot be linked to that site, the sellers need a method to attribute the receipts. If a facility agreement moves into a buyer affiliate, the earnings schedule needs to capture the related revenue and costs. If the buyer shuts one acquired location and shifts its cases elsewhere, the agreement must say whether the earnout follows those cases, measures only the original location, or adjusts for the closure. These provisions can matter more than a small change in the stated cap.
Finally, compare certainty. If the buyer instead offers another $1 million in cash at closing but reduces the earnout cap by $1 million, the owners can weigh an immediate amount against a larger contingent amount. The comparison is not complete without considering any change to the purchase price allocation, funding, escrow, or other legal terms. The example illustrates why the group should negotiate the formula and operating protections together. A high cap with a buyer-controlled metric can be worth less than a smaller, well-defined payment with reliable reporting and a clear review mechanism.
Recognize common mistakes
One common mistake is treating the maximum earnout as part of the guaranteed sale price in partner communications. That can create unrealistic expectations and conflict among partners if the contingency is missed. Present the cash at closing separately from each contingent scenario, and explain who bears post-closing collection risk and operating risk, along with contract exposure under the proposed terms. Partner approval should reflect the actual distribution waterfall and each owner's share of contingent proceeds.
Another mistake is negotiating the percentage before understanding the denominator. 'Twenty percent of incremental earnings' sounds simple until the agreement leaves baseline earnings and expenses, while defining the entity boundary undefined. Secure the definitions and formula. Attach example calculations before focusing on the percentage. A small percentage of a manipulated base can produce less than a larger percentage of a cleanly measured one.
Owners also sometimes accept broad buyer discretion in exchange for a larger headline cap. This trade can be reasonable when the sellers understand the risk and the amount at stake is limited. It is dangerous when a material part of expected value depends on preserving a contract or facility relationship and the buyer can reassign or restructure it without attribution rules. Ask the buyer to explain how it expects to operate the acquired business during the measurement period, then reflect that plan in the agreement.
Finally, avoid letting the earnout agreement drift away from other transaction documents. Definitions of the acquired business, excluded assets, working capital, indemnity claims, seller notes, restrictive covenants, and partner distributions can affect the contingent calculation or cash received. Coordinate the purchase agreement, disclosure schedules, transition arrangements, and partner documents so the same terms do not contradict each other. Owners should use their transaction counsel and financial advisers to evaluate the actual documents and consequences; a general framework cannot replace review of the negotiated agreement.
Decide whether the proposal fits the owners
An earnout can be useful when a buyer and seller share a clear view of what evidence will resolve a narrow uncertainty. It is less attractive when the trigger is broad, the buyer controls all relevant inputs, or the owners need predictable proceeds to retire debt or divide partnership interests. The sellers' tolerance for delay and uncertainty may differ, especially if some partners remain with the buyer while others exit. The group should identify those differences before signing so that the payment structure does not quietly assign the risk to a subset of owners.
Evaluate the contingent amount against the value of alternatives. The buyer may increase cash, use a seller note, hold a defined escrow, provide rollover equity, or make a smaller earnout with more objective terms. Each alternative creates different credit exposure and liquidity needs, with control rights and possible upside assessed separately. The appropriate choice depends on the owners' priorities, the buyer's financial strength, tax consequences, and the quality of the underlying forecast. A proposal should be assessed as a complete package instead of by maximizing one number.
Action checklist
- Separate cash at closing, escrow, seller debt, rollover equity, and earnout proceeds in every comparison.
- Identify the precise uncertainty the earnout is meant to resolve and select a metric that measures it.
- Define the baseline, period, accounting policies, included items and exclusions. Set the floor and cap; show the formula between them and define adjustments.
- Map buyer decisions that could affect the metric and negotiate tailored operating protections and attribution terms. Address successor obligations.
- Require regular statements, usable supporting records, a practical objection window, and a defined independent review process.
- Clarify payment timing, setoff limits, security or parent support, change of control, and closure consequences.
- Model downside and expected outcomes, then model the upside at both the practice and individual partner level.
- Have transaction counsel, accounting advisers, and each owner's tax professional review the final integrated documents.
Questions about your own practice? Contact richard@doctorsinvestorclub.com.
