Earnout Basics
An earnout is a contingent payment mechanism where part of the purchase price depends on the practice achieving specific performance targets after the sale closes. Instead of receiving your full purchase price at closing, you receive additional payments over time if and when the practice hits agreed upon metrics.
Why Buyers Use Earnouts
From the buyer's perspective, earnouts reduce acquisition risk by tying part of the payment to actual post closing performance, bridge valuation gaps when buyer and seller disagree on practice value, incentivize sellers to support successful transitions, and align seller compensation with results the buyer actually receives.
Typical Earnout Structure
Example: DSO Earnout Structure
Total Deal Value: $2,000,000
Cash at Closing: $1,400,000 (70%)
Equity Rollover: $300,000 (15%)
Earnout: $300,000 (15%) over 3 years
Earnout Terms: Seller receives $100,000 annually if practice maintains 95% of trailing twelve month collections. Payment reduced proportionally if collections fall below 95%. No payment if collections fall below 80%.
The core problem with earnouts is apparent in this example: the seller no longer controls the factors that determine whether they receive their money. The DSO decides marketing spend, staffing levels, fee schedules, and operational policies. These decisions directly affect collections but are entirely outside the seller's control.
Common Earnout Metrics
Earnouts can be based on various performance measures. Each metric has different manipulation vulnerabilities and measurement challenges.
| Metric | How It Works | Manipulation Risk |
|---|---|---|
| Collections | Total cash collected during measurement period | Medium. Can be affected by fee schedule changes, collection policies, patient mix shifts. |
| Production | Total value of dental services provided | Medium. Less susceptible to collection timing but affected by scheduling and treatment acceptance. |
| EBITDA | Earnings before interest, taxes, depreciation, amortization | High. Easily manipulated through expense allocations, overhead charges, accounting decisions. |
| Patient Retention | Percentage of active patients remaining after transition | Medium. Affected by marketing, scheduling, staff retention, and how "active" is defined. |
| New Patients | Number of new patients acquired during period | High. Directly controlled by marketing spend and referral source management. |
EBITDA earnouts are most dangerous for sellers. EBITDA can be reduced through management fees, overhead allocations, shared service charges, and accounting adjustments that have nothing to do with actual practice performance. Collections based earnouts are generally safer because cash received is harder to manipulate than accounting calculations.
How Buyers Manipulate Earnouts
Buyers rarely set out to intentionally cheat sellers on earnouts. More often, legitimate business decisions made for operational reasons happen to reduce earnout metrics. But the result is the same: you receive less than you expected.
Marketing Reduction
Cutting marketing spend reduces new patient flow and eventually collections. The buyer saves money while your earnout suffers.
Fee Schedule Changes
Accepting more insurance plans or reducing fees to increase volume can temporarily boost patient counts while reducing per patient revenue and collections.
Staff Reassignment
Moving your best hygienist to another location or replacing experienced staff with lower cost employees affects production and patient retention.
Scheduling Changes
Reducing hours, changing appointment availability, or overbooking can affect patient satisfaction and willingness to return.
Overhead Allocation
For EBITDA earnouts, allocating corporate overhead, management fees, or shared service costs to your location reduces calculated earnings.
Patient Diversion
Routing new patients to other locations or encouraging referrals to other practices in the network reduces your location's metrics.
Accounting Adjustments
Timing revenue recognition, expense classification, and other accounting decisions can shift earnings between periods to minimize earnout payments.
Capital Decisions
Delaying equipment repairs or replacements can affect patient experience and production capability during the earnout period.
The Fundamental Problem
You cannot control earnout outcomes after you sell. Even with strong contractual protections, buyers have thousands of small decisions that affect practice performance. Earnouts essentially require you to trust that the buyer will operate the practice in ways that maximize your payment rather than their own interests. This is why experienced sellers prefer cash at closing over earnout promises.
Seller Protection Strategies
While you cannot eliminate earnout risk, strong contract provisions can reduce manipulation opportunities and provide remedies if problems occur.
Objective Metrics
Use collections rather than EBITDA. Define exactly what counts as "collections" and how they are measured. Eliminate subjective adjustments.
Audit Rights
Right to review books, records, and calculations supporting earnout determinations. Include access to practice management system and bank statements.
Operational Covenants
Require buyer to maintain minimum marketing spend, staffing levels, operating hours, and fee schedules during earnout period.
Acceleration Clauses
If buyer sells the practice or DSO during earnout period, remaining earnout accelerates and becomes immediately payable at maximum amount.
Floor Payments
Minimum earnout payment regardless of metrics. Even if targets are missed, you receive a guaranteed floor amount.
Dispute Resolution
Defined process for resolving earnout calculation disagreements, including independent accountant determination and binding arbitration.
Sample Protective Language
The following concepts illustrate the types of protections experienced counsel negotiates. Actual language should be drafted by your attorney for your specific situation.
- Marketing covenant: Buyer shall maintain marketing expenditures at no less than 80% of trailing twelve month average during earnout period.
- Staffing covenant: Buyer shall not reduce clinical staff FTEs below current levels without seller consent during earnout period.
- Fee schedule covenant: Buyer shall not reduce UCR fees more than 5% or add PPO participation without seller consent during earnout period.
- Acceleration trigger: Upon sale of buyer or substantially all buyer assets, maximum earnout becomes immediately due and payable.
- Floor payment: Notwithstanding earnout calculations, seller shall receive minimum annual payment of $75,000 for each earnout year.
Reviewing An Earnout Offer?
Get experienced analysis of earnout terms, manipulation risks, and negotiation strategies before you commit.
Schedule ConsultationNegotiating Earnout Terms
If you decide to accept an earnout, negotiation focus should be on limiting downside risk rather than maximizing upside potential.
Negotiation Priorities
Reduce the earnout percentage. The less of your deal tied to earnout, the less risk you carry. Push for more cash at closing even if it means lower total deal value. A certain $1.5 million beats an uncertain $1.8 million.
Shorten the earnout period. Longer periods mean more opportunities for things to go wrong. Push for one year earnouts rather than three. If multi year earnouts are required, negotiate for annual measurement and payment rather than cumulative targets.
Use conservative baselines. Targets based on historical performance are safer than projections. If your practice collected $1.2 million last year, a 95% retention target ($1.14 million) is more achievable than a 5% growth target ($1.26 million).
Avoid cliff structures. Earnouts that pay nothing below a threshold (cliffs) are worse than proportional earnouts that scale with performance. Push for pro rata payment based on actual achievement rather than all or nothing thresholds.
Negotiate meaningful protections. Every protection discussed above should be on the table. Buyers will resist operational covenants, but strong sellers can often negotiate reasonable protections.
What To Walk Away From
Earnout Red Flags
- EBITDA earnouts with buyer controlled expense allocations
- Targets based on aggressive growth projections rather than historical performance
- Cliff structures that pay nothing if targets are narrowly missed
- No audit rights or transparency into calculations
- No operational covenants protecting against manipulation
- Earnout exceeding 25% to 30% of total deal value
- Earnout periods longer than 2 to 3 years
Should You Accept An Earnout?
The decision to accept an earnout depends on your alternatives, risk tolerance, and confidence in the specific structure offered.
Accept An Earnout If:
- The earnout premium over cash alternatives is substantial (20%+ higher total value)
- Targets are based on conservative historical performance, not projections
- You retain meaningful operational influence during the earnout period
- Contract protections limit buyer's ability to manipulate metrics
- You can afford to receive less than maximum earnout without financial hardship
- You trust the specific buyer based on their track record with other sellers
Reject An Earnout If:
- The earnout premium is modest (less than 15% over cash alternatives)
- Targets require growth or performance improvements beyond historical levels
- You will have no operational control or influence post closing
- Buyer resists reasonable protective covenants and audit rights
- You need the full purchase price for retirement or other financial obligations
- The buyer has a reputation for earnout disputes with other sellers
The best earnout is no earnout. If you can achieve acceptable value with all cash at closing, take it. Earnouts should be accepted only when the premium is substantial and protections are strong. Compare DSO versus private buyer offers carefully, understanding that DSO headline prices often include earnout components that reduce certain value.
