The term sheet says your startup is being acquired for $20 million. Read closer: $12 million at completion, and up to $8 million more if the business hits revenue targets over the next two years. That second number is an earn-out, and it has a property the first number does not — it is paid out of the future performance of a business you no longer control, measured by a formula the buyer’s finance team applies, inside a company the buyer runs. Whether you ever see it depends far less on how the business performs than on how the deal was drafted.
Earn-outs are everywhere in Australian startup M&A because they solve the negotiation’s central problem: the founder prices the company on its trajectory, the buyer prices it on its trading history, and neither will move. Deferring part of the price and making it contingent lets both sides be right. But an earn-out is not just a payment schedule. It is a two-to-three-year commercial relationship with your acquirer, governed by a few pages of the share sale agreement that get far less negotiating attention than they deserve.
Earn-Out or Deferred Consideration? They Are Not the Same Thing
Founders use the terms interchangeably; lawyers should not. Deferred consideration is a fixed amount payable later — the price is certain, only the timing moves, and the main risks are the buyer’s credit and your security for payment. An earn-out is contingent — the amount depends on post-completion performance, and may be zero. The distinction drives everything downstream: a fixed deferred payment needs a guarantee or escrow; an earn-out needs all of that plus a measurement regime, conduct covenants and a dispute mechanism. If the buyer wants the risk profile of an earn-out, price it accordingly — a dollar of earn-out is worth materially less than a dollar at completion, and the discount should show up in the headline number you accept.
The Formula Is Where Disputes Are Born
Most earn-outs key off revenue or EBITDA. Revenue is harder to manipulate and simpler to measure — usually the better choice for a startup selling into a larger group. EBITDA looks fairer in theory but imports every argument about cost allocation: does the earn-out entity bear a share of group overheads, management charges, the cost of the buyer’s integration project? An EBITDA earn-out without a negotiated set of accounting policies is an invitation to litigate. Product or regulatory milestones (“completion of platform integration”, “licence granted”) appear in tech deals too — they are cleaner to verify but, as covered below, can carry a nasty tax consequence.
Whatever the metric, the drafting disciplines are the same. Fix the accounting policies at signing — ideally the target’s historical policies, consistently applied, with the buyer’s group policies expressly subordinated. Include a worked example as a schedule, calculated on real numbers. Define what happens to the formula if the buyer bolts the business onto an existing unit, migrates customers to its own contracts, or rebrands the product — because in an integration, revenue “of the target” stops being an observable fact and becomes a contested allocation. And give the sellers information and audit rights during the earn-out period: management accounts monthly or quarterly, the earn-out calculation with supporting workings, and access to the records behind it.
The Buyer Runs the Business — So Covenant the Buyer’s Conduct
Here is the structural problem: after completion the buyer controls every lever that determines the earn-out — pricing, hiring, sales focus, which entity books the revenue — and its financial incentive is to keep the payment low. Founders sometimes assume the law fills this gap with an obligation of good faith. In Australia, do not rely on that. A duty of good faith is not implied as a matter of course in commercial contracts — its availability varies between jurisdictions and contract types, and Australian courts have been reluctant to use it to rewrite a bargain between well-advised parties. The protection has to be express.
A well-drafted seller position includes covenants that during the earn-out period the buyer will operate the business as a going concern, in the ordinary course and consistent with an agreed plan or budget; will not divert customers, revenue or opportunities to other group entities; will maintain agreed levels of working capital and sales resourcing; and will not take action with the purpose, or predictable effect, of reducing the earn-out. Buyers will push back with a “no fetter on our discretion to run the group” clause — the negotiation lands somewhere in between, but silence lands you at the buyer’s end. Add an acceleration clause: if the buyer on-sells the business, discontinues the product, or undergoes a change of control during the earn-out period, the maximum earn-out becomes payable immediately. Otherwise the buyer can simply restructure your metric out of existence.
Finally, route disputes to expert determination rather than the courts for calculation disagreements — an independent accountant, acting as expert not arbitrator, with a defined scope and timetable. Conduct-covenant breaches are a different animal and stay justiciable; contemporaneous records (board papers, budgets, emails about resourcing decisions) decide those fights, which is another reason information rights matter.
The Tax Layer: Subdivision 118-I and the Five-Year Rule
Since reforms enacted in February 2016, qualifying earn-outs receive look-through CGT treatment under Subdivision 118-I of the Income Tax Assessment Act 1997 (Cth), applying to earn-out rights created on or after 24 April 2015. Look-through treatment means the earn-out right is ignored as a separate asset: payments you later receive are treated as additional capital proceeds of the original share sale, your prior-year assessment is amended when they arrive, and — critically — the 50% CGT discount and any small business CGT concessions that applied to the share sale can apply to the earn-out proceeds too, provided the relevant conditions continue to be met. (One wrinkle: the additional proceeds can affect eligibility for some concessions, such as the retirement exemption’s lifetime cap, so the concession analysis needs to be run on the whole-of-deal numbers.)
But the conditions are specific, and startup deals fail them more often than founders expect. Broadly, the right must be created on the disposal of shares (or other assets) that were active assets; the future payments must not be reasonably ascertainable at completion; all payments must be capable of being provided within five years after the end of the income year of the sale; the payments must be contingent on, and reasonably related to, the future economic performance of the business; and the parties must deal at arm’s length. A milestone earn-out hinging on product integration or a regulatory approval — rather than on economic performance — is at real risk of falling outside the regime. So is an earn-out with a tail longer than the five-year window, or a fixed deferred payment dressed up as an earn-out (a “reasonably ascertainable” amount does not qualify).
A non-qualifying earn-out is taxed under ordinary CGT principles: the earn-out right is a separate CGT asset whose market value is counted in your capital proceeds at completion — meaning tax on money you have not received and may never receive — with later payments then assessed against the right itself, generally without the concessions that attached to your shares. Model the tax outcome before you agree the structure, not after.
The Employment Trap
Buyers routinely want founders to stay on, and often want earn-out payments conditional on the founder remaining employed. Tread carefully. The more an earn-out looks like a reward for future services — forfeited if you resign, scaled to your continued employment rather than the business’s performance — the greater the risk the ATO characterises payments as ordinary income (remuneration) rather than capital proceeds, taxed at marginal rates with no discount, and potentially dragging PAYG withholding and superannuation consequences for the buyer. Keep the earn-out tied to business performance and payable to all sellers in proportion to their shares; deal with retention through a separate, market-rate employment package. If the buyer insists on employment-linked forfeiture, get tax advice on the structure before signing, not at return time.
The Bottom Line
An earn-out is a perfectly good tool for bridging a genuine valuation gap — and a terrible substitute for a price the buyer simply doesn’t want to pay upfront. Treat the contingent component as at-risk: negotiate the metric and accounting policies as hard as the headline number, covenant the buyer’s conduct expressly rather than trusting implied good faith, secure acceleration on restructures and on-sales, and structure the arrangement to qualify for look-through CGT treatment from the outset. The founders who get burned are rarely the ones whose businesses underperformed — they are the ones whose sale agreements assumed the buyer would run the business the way the seller would have.
This article is general information only, not legal or tax advice — earn-out structuring depends heavily on the deal, the metric and your tax position. Viridian Lawyers advises Australian founders and startups on M&A exits, sale agreement negotiation and earn-out structuring, working alongside your tax advisers on the Subdivision 118-I analysis. If there is an earn-out in your term sheet, get in touch before you sign it.
