How an Earnout Review Works
The review normally begins with the acquisition agreement and related schedules. Reviewers identify the performance period, measurement definitions, thresholds, caps, payment percentages, accounting policies, and adjustment provisions. These requirements are then compared with the company's underlying financial records and operational data.
The reviewer typically traces reported performance back to source transactions and evaluates whether the calculation applies the contractual definitions consistently. Particular attention is given to adjustments that can materially change the earnout amount, such as excluded expenses, acquisitions, foreign exchange movements, unusual transactions, revenue recognition changes, or changes in accounting policies.
- Agreement terms: Identify the precise earnout formula, targets, deadlines, and settlement provisions.
- Financial performance: Reconcile reported revenue, EBITDA, profit, or other metrics to supporting records.
- Adjustments: Test whether permitted exclusions and normalization adjustments comply with the agreement.
- Operational evidence: Validate customer, sales, production, or retention measures when they form part of the earnout.
- Payment calculation: Recalculate the final amount using the agreed methodology and supporting evidence.
Financial Calculation and Reconciliation
Where the earnout is linked to a financial metric, the review should independently reproduce the calculation. For example, suppose an agreement provides $1 million when EBITDA reaches $10 million and $2 million when EBITDA reaches $12 million, with a straight-line earnout between the two thresholds.
If adjusted EBITDA is $11 million, the earnout would be calculated as $1 million + (($11 million - $10 million) ÷ ($12 million - $10 million)) × $1 million, resulting in $1.5 million. The reviewer should then trace the $11 million adjusted EBITDA figure to the general ledger and verify every permitted adjustment against the transaction agreement.
Accounting and Reporting Considerations
Accounting consistency is essential because earnout calculations often depend on financial reporting classifications and period-end adjustments. A properly structured chart of accounts can make it easier to trace relevant revenue, operating expenses, and adjustments to the underlying general ledger.
A P L Review can complement an earnout assessment by examining income statement performance and identifying material movements in revenue, costs, margins, and profitability. A Coding Review can further validate whether transactions have been assigned to the appropriate accounts or cost categories before they affect the earnout calculation.
The review should also consider whether tax treatments influence reported performance. For transactions involving different jurisdictions, sales tax validation may require examination of applicable jurisdiction rules, exemptions, nexus considerations, and the treatment of tax amounts within revenue calculations.
Contract and Operational Evidence
The financial calculation is only one part of an earnout review. The underlying contract determines which operating outcomes qualify for payment. A detailed Contract Review helps establish how ambiguous terms, definitions, exclusions, reporting rights, and dispute provisions should be interpreted.
Operational evidence can include customer contracts, sales reports, invoices, subscription records, retention statistics, production data, or other source documentation. For procurement-related businesses, a purchase order may also provide supporting evidence for transaction timing, commercial terms, and revenue-related activity when those records are relevant to the earnout metric.
Controls and Auditability
Strong documentation allows both parties to understand how the earnout figure was produced. The review should maintain a clear trail from contractual requirements through source data, accounting entries, adjustments, calculations, approvals, and final payment.
In vendor management processes, Audit Trails can provide visibility into actions performed by humans or AI, supporting transparency and review. Similar principles are useful when documenting earnout calculations because each material decision should be traceable to supporting evidence and an applicable contractual provision.
Best Practices for Earnout Reviews
- Start with the agreement: Convert contractual language into a clear calculation framework before reviewing financial data.
- Reconcile independently: Recalculate performance metrics rather than relying solely on management-prepared schedules.
- Document adjustments: Maintain evidence for every normalization, exclusion, or classification change.
- Separate financial and operational measures: Validate each metric using the most appropriate underlying records.
- Preserve audit evidence: Retain source reports, calculations, approvals, and supporting documentation for the review period.
Summary
Earnout Review provides a disciplined method for validating contingent acquisition payments against contractual performance requirements. By combining agreement analysis, financial reconciliation, operational evidence, accounting review, tax considerations, and documented controls, organizations can establish whether an earnout calculation accurately reflects the transaction terms and underlying business performance.