Earn-Out Clauses in M&A: Getting Paid on Future Performance (India)

An earn-out clause splits the purchase price in an acquisition into two parts: money paid at closing, and money paid later, only if the acquired business hits agreed targets (usually revenue, EBITDA, or a named milestone) within a set period after closing. It bridges a valuation gap: the seller believes the business is worth more than the buyer will pay upfront, so the buyer says "prove it" and agrees to pay the difference if the numbers show up. The one thing most sellers get wrong: once the deal closes, the buyer runs the business, not the seller, so the buyer controls the very metric the earn-out is paid on. A seller who signs a vague earn-out clause is often signing away control over their own payout. (This guide is published by Adira, which makes contract review and CLM software used on deals like these, so we have a commercial stake in you understanding earn-outs well. It is written to stand on its own regardless of what you buy afterward.)

Plain meaning

Say a buyer offers ₹40 crore for a company but the seller thinks it is worth ₹60 crore once a new product line matures. An earn-out splits the difference into risk: ₹40 crore at closing, and up to ₹20 crore over the next two years if the business hits agreed EBITDA milestones. If the targets are hit, the seller gets the extra money. If not, the seller does not, regardless of why they were missed. That "regardless of why" is the entire fight: the metric is measured inside a business the seller no longer controls, so the clause has to do two jobs at once, define the target precisely, and constrain what the buyer can do with the business while the clock runs.

Who it protects and what triggers it

An earn-out protects the seller, at least in theory, by giving them a claim to future value instead of nothing. It also protects the buyer, by letting them defer a chunk of the price until the business proves it can perform, rather than paying full price for a projection. The trigger is the measurement event: the end of each earn-out period (often annual or quarterly), when the agreed metric, EBITDA, revenue, gross margin, or a milestone, is calculated and compared against the target. Hitting the target (or the pro-rata point on a sliding scale) triggers payment. Missing it, on the buyer's numbers, means no payment, and the seller usually has no automatic remedy unless the clause says otherwise.

What to look for

Five mechanics decide whether an earn-out is a real payout or a paper promise, and none of them are visible if you only read the headline number:

1. How the metric is defined. "EBITDA" is not one number; it depends on accounting choices (how overheads are allocated, whether the buyer's group costs are charged down, how one-off items are treated) that the buyer's finance team controls after closing.
2. Who calculates it, and who can challenge it. Is the buyer's finance team the sole source of the number, or is there an independent accountant and a dispute-resolution mechanic if the seller disagrees?
3. What the buyer promises about how it runs the business. Does the clause require the buyer to run the target in the ordinary course, without shifting costs, revenue, or customers in or out of the earn-out entity? This is the single most exploited gap: without it, a buyer can, deliberately or through ordinary integration, depress the metric by reallocating shared costs, redirecting customers elsewhere in the group, or changing accounting policy mid-stream, none of which needs to be bad faith to hurt the seller.
4. What happens on an early sale or change of control. Does the earn-out accelerate (become payable, calculated on a reasonable estimate) if the buyer exits early, or does the seller simply lose the unpaid balance?
5. How disputes get resolved. Expert determination by an independent accountant is faster for a numbers dispute; arbitration or litigation suits disputes about whether the buyer breached its operating covenants.

The Indian position: FEMA caps deferred and earn-out consideration for cross-border deals

For a purely domestic deal (resident buyer, resident seller), there is no statutory cap on how an earn-out is structured; it runs on ordinary contract law and the SPA's own drafting. But the moment one side is a non-resident, the earn-out runs straight into India's foreign exchange control regime, and this is where most cross-border earn-outs go wrong.

Rule 9(6) of the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (the current rules under which the RBI regulates transfer of Indian equity instruments to and from non-residents) says:

"In case of transfer of equity instruments between a person resident in India and a person resident outside India, an amount not exceeding twenty five per cent of the total consideration: (i) may be paid by the buyer on a deferred basis within a period not exceeding eighteen months from the date of the transfer agreement; or (ii) may be settled through an escrow arrangement between the buyer and the seller for a period not exceeding eighteen months from the date of the transfer agreement; or (iii) may be indemnified by the seller for a period not exceeding eighteen months from the date of the payment of the full consideration, if the total consideration has been paid by the buyer to the seller."

This is often called the "18/25 rule," and it does three things. First, the 25% cap: no more than a quarter of total consideration can be deferred, escrowed, or indemnified. An earn-out worth 40% of deal value, documented as share consideration, is not FEMA-compliant; deal teams sometimes route the contingent element through a separate arrangement (an employment or consultancy payment, a licence fee) instead, but that has its own tax consequences (see the case below). Second, the 18-month outer limit applies whichever of the three mechanisms is used, so a three-year earn-out structured as deferred share consideration does not fit as drafted. Third, "the total consideration finally paid for the shares shall be compliant with the applicable pricing guidelines," so the earn-out cannot dodge FEMA's pricing rules for resident-to-non-resident transfers.

This traces back to RBI Notification No. FEMA.368/2016-RB dated 20 May 2016, later consolidated into the Non-Debt Instruments Rules. If your deal involves a foreign buyer or seller and an earn-out longer than 18 months or larger than 25% of price, get FEMA advice before you sign, not after.

A named Indian case: Anurag Jain v Authority for Advance Rulings

Cross-border earn-outs also collide with a second problem: how the contingent payment gets taxed. In Anurag Jain v Authority for Advance Rulings (Madras High Court, W.P. No. 33856 of 2005, decided 30 September 2008, reported at (2009) 308 ITR 302), Anurag Jain and other shareholders sold their company, Vision Healthsource India Private Limited, to Perot Systems entities under a share purchase agreement, for an upfront payment plus contingent payments of up to USD 7 million over three years against EBITDA targets. Alongside the SPA, Jain signed an employment agreement containing forfeiture clauses tying the contingent payments to his continued employment.

The Authority for Advance Rulings held, and the Madras High Court upheld on writ petition, that the upfront payment was taxable as capital gains, but the contingent, performance-linked payments, being forfeitable if Jain left, were "salary or profit in lieu of salary" under Section 17(3)(ii) of the Income Tax Act, 1961, not sale consideration. The court read the SPA and employment agreement as interdependent: real deferred sale consideration does not usually get forfeited if the seller changes jobs, so the forfeiture clause was the giveaway.

Why this matters: if your earn-out links payment to the founder staying employed and can be forfeited on exit, expect the tax authority to argue it is salary, not capital gains, usually a higher effective rate with different withholding obligations. Keep genuine earn-outs tied to the business's numbers, not the individual's employment, and keep any retention payment in a clearly separate clause.

Red flags

Normal	Red flag	Why it matters
Metric precisely defined, a named accounting standard, line items listed, a worked example	Just "EBITDA" or "revenue," no definition or worked example	Ambiguous metrics get resolved by whoever controls the books, usually the buyer
Express covenant to run the business in the ordinary course, not act to reduce the earn-out	No operating covenant at all	Buyer can legally depress the metric through normal-looking integration
Independent accountant or expert determination on disagreement	Buyer's finance team is sole and final arbiter	Seller has no recourse if the buyer's number looks wrong
Earn-out accelerates on a reasonable estimate if buyer sells or changes control early	Earn-out lapses, or seller has no claim, on an early exit	Buyer can sell right before a milestone would pay out, seller loses everything
Audit right to review the underlying books	No audit right; buyer's calculation is final	Seller cannot verify the number even if it looks wrong
Cross-border earn-out kept within 25% of consideration and 18 months, per Rule 9(6) NDI Rules	Larger or longer than the FEMA limit, no compliance plan	Deal risks being FEMA non-compliant, which can block repatriation
Contingent payments tied to business performance, kept separate from employment terms	Payment forfeited if the founder resigns or is terminated	Tax authorities may recharacterise it as salary, as in Anurag Jain
Expert determination for numbers, arbitration for covenant breaches	No dispute mechanism, or only a slow generic arbitration clause	Numbers disputes need a fast, accountant-led process

Bad clause to better clause

Bad: "If the Company achieves its targets for the two years following Closing, Buyer shall pay Seller an additional amount as determined by Buyer, up to a maximum of INR 20,00,00,000."

What is wrong: no defined metric, no measurement process, Buyer is the sole judge of both the target and the number, no operating covenant, no dispute process, no acceleration on early sale.

Better: "For each of the two 12-month periods following Closing ('Earn-Out Periods'), Buyer shall pay Seller [X]% of the amount by which Adjusted EBITDA (as defined in Schedule [X], per Indian Accounting Standards applied consistently with past practice, excluding Buyer's group overhead not directly attributable to the Company) exceeds INR [target], up to INR 20,00,00,000 aggregate. Buyer shall operate the Company in the ordinary course consistent with past practice, and shall not act with the primary purpose or effect of reducing the Earn-Out, including reallocating Company revenue or customers to another Buyer group entity, or materially changing accounting policy without Seller's consent. Buyer shall deliver the Adjusted EBITDA calculation within 45 days of each Earn-Out Period's end, with supporting work papers; Seller may dispute it within 30 days, in which case an independent accountant, mutually agreed or appointed by [nominating body], shall determine the correct figure, binding absent manifest error. If Buyer transfers control of the Company before an Earn-Out Period ends, the unpaid Earn-Out becomes immediately payable, on a reasonable good-faith estimate as of the transfer date."

What changed: the metric is defined and tied to a named accounting standard, the buyer carries an express operating covenant, there is a calculation deadline and dispute process through an independent accountant, and the earn-out accelerates on a change of control instead of quietly disappearing.

How it interacts with related clauses

An earn-out clause is never the whole payment mechanic; two sibling clauses decide how it actually plays out:

• Conditions precedent. The earn-out sits after closing, but disputes about whether the deal should have closed at all often trace back to how conditions precedent were satisfied or waived before closing. See our guide on conditions precedent in India.
• Indemnity cap and basket. Earn-out disputes and indemnity claims are structurally similar, both involve a seller trying to recover money post-closing from a buyer who now controls the information, but they run on separate clocks and dispute processes. Check whether an indemnity claim can be set off against an unpaid earn-out; this needs to be addressed explicitly, not assumed. See our guide on indemnity caps, baskets, and survival periods in Indian M&A.

You can map out the earn-out mechanics, the operating covenants, and the dispute triggers in a draft SPA, for free, by marking up the document in Weave before you send it back for negotiation.

US and global contrast

Earn-outs are used heavily in the US and UK too, with similar core mechanics: a metric, a measurement period, a dispute process. The real difference is regulatory, not contractual. A US or UK earn-out has no equivalent to India's FEMA 18/25 rule; parties can structure a five-year earn-out worth 60% of deal value if they choose. US case law, Delaware courts especially, has developed substantial precedent on implied covenants of good faith in earn-out disputes, reading in an obligation not to sabotage the metric even when the contract is silent. Indian courts have far less earn-out-specific case law to draw on, which makes writing the operating covenant explicitly into the contract more important here. For any cross-border earn-out touching India, the FEMA limits apply regardless of which country's law governs the contract, because they attach to the underlying share transfer, not the governing-law clause.

FAQ

What is an earn-out clause in simple terms? Part of the purchase price in an acquisition that the buyer only pays if the business hits agreed future targets, usually revenue or EBITDA, within a set period after closing. It bridges a gap between what the seller thinks the business is worth and what the buyer will pay for certain today.

Can a cross-border earn-out run for three years? Not if structured as deferred consideration for the shares themselves. Rule 9(6) of the Non-Debt Instruments Rules, 2019 caps deferred, escrowed, or seller-indemnified consideration between a resident and non-resident at 25% of total consideration and 18 months from the transfer agreement. A longer arrangement needs a different structure, and FEMA advice before signing.

Why would an earn-out payment get taxed as salary instead of capital gains? If it is conditional on the seller staying employed and forfeitable on resignation or termination, as in Anurag Jain v Authority for Advance Rulings (Madras HC, 2008), tax authorities can treat it as salary under Section 17(3)(ii) of the Income Tax Act rather than sale consideration, usually meaning a higher effective tax rate.

What should a seller ask for if the buyer might sell the business before the earn-out period ends? An acceleration clause: unpaid earn-out becomes payable immediately, on a reasonable estimate, if the buyer transfers control early. Without this, a buyer can sell right before a milestone would have paid out and the seller gets nothing.

Who should decide if there is a dispute about the earn-out number? An independent accountant through expert determination for a pure numbers dispute. Reserve arbitration or litigation for disputes about whether the buyer breached its covenant to run the business fairly.

Is an earn-out the same as deferred consideration? They overlap but are not identical. Deferred consideration is payment delayed to a later date, sometimes with no conditions. An earn-out is deferred and contingent, paid only if a performance target is met. FEMA treats both together under the same 25%/18-month cap for cross-border transfers.

This guide gets you to understanding what an earn-out clause does and what Indian foreign exchange law requires for cross-border deals. It does not tell you whether a specific earn-out structure is FEMA-compliant, tax-efficient, or properly drafted for your transaction, that depends on the deal's exact structure and current RBI and tax guidance, and is not legal advice. Talk to a lawyer and, for cross-border deals, an authorised dealer bank or FEMA specialist, before you sign.