Evaluating an earnout proposal

An earnout makes part of a practice sale price contingent on results after closing. For an OB-GYN practice, that can bridge a gap between what owners believe the practice is worth and what a buyer will pay. It can also transfer risks to sellers while leaving them with little control over staffing, payer strategy, scheduling capacity, billing, or operating decisions that determine the measurement. Treat an earnout as a separate conditional payment. Price its economics, operating controls, and collection risk on their own. Compare its value with cash at closing, understand what must happen to earn it, and negotiate the information and decision rights needed to know whether the buyer calculated it correctly.

Start with the reason for the earnout

Ask what uncertainty the earnout is meant to resolve. A buyer may be uncertain that recent growth will continue, that a new physician will stay, that a service line will reach its forecast, or that normalized earnings accurately reflect the practice's operating capacity. A seller may believe a buyer has not credited its established referral base, favorable payer contracts, a growing employed-provider panel, or the earnings impact of recent investments. Those are different disagreements. A single revenue target cannot fairly address all of them.

Request the buyer's valuation bridge in writing. It should show the purchase price supported by historical financial results, the adjustments made to reported earnings, the buyer's forecast, and the specific assumption that creates the contingent payment. A proposal may pay an additional amount if the practice reaches a revenue target. Ask why revenue fits when the valuation discussion has focused on earnings. Collections can lag while revenue rises, and new provider compensation or operating costs may absorb the increase. When the buyer says the earnout rewards retention, identify whose continued service creates value and how the agreement measures it.

Then test whether the uncertainty can be measured and influenced. A seller who remains employed and controls a defined operating unit may have meaningful influence over production and retention. A selling partner who retires at closing usually does not. If the buyer will control the billing platform, staffing, payer contracting, and expense allocations, a seller may bear outcome risk without having the levers to affect outcomes. In that case, negotiate a more objective measure, a shorter measurement period, stronger operating protections, or more cash at closing instead of accepting a headline contingent amount.

Translate the headline into actual consideration

Separate stated enterprise value from what each owner may receive. A proposal might advertise a total value that combines closing cash, debt repayment, working-capital adjustments, rollover equity, a seller note, and an earnout. These are not interchangeable. Closing cash is available at settlement subject to closing adjustments. A note depends on repayment terms and the buyer's credit. Rollover equity depends on future enterprise value, governance, dilution, and a later liquidity event. An earnout depends on post-closing performance and the contract's calculation rules. Present each component separately in a sources-and-uses or owner proceeds schedule.

Calculate the amount attributable to each seller using the actual ownership and allocation provisions. In a multi-owner OB-GYN group, ownership percentages may differ from compensation shares, ancillary distributions, or the way partners expect sale proceeds to be divided. Confirm whether the earnout is paid to the selling entity or directly to individuals, whether it follows ownership percentages, and whether it is conditioned on continued employment. A service condition can turn some or all of the payment into compensation as compensation in economic substance, not sale consideration, with different tax and payroll treatment, plus forfeiture consequences. The agreement's tax allocation and purchase-price allocation should be reviewed alongside the employment documents.

Build a a downside case, a central case, and an upside case view and do not count its full face value as proceeds. Estimate the probability of each outcome, the time until payment, any holdback or offset rights, and the effect of taxes and transaction costs. A contingent $2 million payable in two years is not economically equivalent to $2 million in cash at closing. Even if the formula appears attainable, the payment may be delayed by a dispute, financial restatement, buyer insolvency, or a contractual restriction. Ask whether the buyer will place funds in escrow, provide a guarantee, or pay from a creditworthy parent. A promise from a thin acquisition subsidiary deserves a different risk assessment from cash held by a solvent obligor.

Define the metric and the accounting rules

The metric must be precise enough that two accountants using the same records would produce the same answer. For a collections measure, specify cash received from payers or patients, refunds, recoupments, credit balances, unapplied cash, and receipts tied to pre-closing services. A net revenue definition needs rules for contractual allowances and bad debt. State separately how denials and late remittances are handled. For EBITDA, identify the accounting policies and each permitted adjustment. State the rules for owner compensation and central support charges. Set out rent and bonus treatment, then address acquisition costs. Avoid terms such as "adjusted EBITDA" without an attached schedule of allowed adjustments.

OB-GYN practices have timing patterns that make cutoff provisions important. Claims for services rendered before closing may be submitted, appealed, or paid after closing. Newborn-related billing arrangements, global obstetric billing cycles, bundled services, and payer recoupments can create differences between service dates and cash dates. The contract should state whether these amounts belong to the seller's pre-closing economics, the earnout period, or neither. Define who performs follow-up work, who bears the expense, which entity recognizes the receipt, and how the measurement avoids counting the same economics twice.

Specify the measurement period start and end dates, reporting basis, and any annualization method. A partial first quarter should not be compared directly with a full quarter without a stated adjustment. A seasonal pattern, changes in provider schedules, or a deliberate closure of office sessions can distort a short window. If the earnout spans several periods, state whether shortfalls can be carried forward, whether one strong period can offset a weak period, and whether the test is cumulative or annual. Define the source records; define currency and rounding conventions, and the accounting hierarchy if the purchase agreement conflicts with the buyer's ordinary policies.

Match the measure to OB-GYN practice economics

Revenue targets are simple to describe but can reward activity that does not produce durable earnings. Clarify whether the target measures charges, net revenue, cash collections, or revenue after refunds and contractual adjustments. Charges may be affected by fee schedules and coding practices without a corresponding change in cash receipts. Collections may reflect prior-period work or changes in follow-up effort. Net revenue can change when payer mix shifts, contract rates are renegotiated, or a new location is added. The measure should fit the buyer's stated investment thesis and should not depend on a bookkeeping choice controlled only by the buyer.

An earnings target can reflect cost discipline, but the buyer can influence it through management fees, shared-service allocations, central billing charges, recruiting costs, technology expenses, and compensation decisions. If the buyer charges the practice for a regional office or allocates corporate overhead after closing, the earnout may fall even when the acquired operations perform well. Define which costs may be charged, whether allocation methods must be consistent, and whether costs must be commercially reasonable and applied consistently to comparable practices. Set a fixed cost base or attach a schedule of allowable charges for the earnout calculation.

For an OB-GYN group, provider capacity and continuity may matter as much as demand. A target can be affected by physician departures, associate start dates, call coverage arrangements, clinic session availability, midlevel staffing, referral patterns, office locations, or payer enrollment delays. The contract need not guarantee that every provider stays or every forecast is reached. It should distinguish ordinary business risk from buyer-directed decisions that materially change the operating platform. For example, if the buyer consolidates locations, redirects referrals, changes billing vendors, or transfers a provider's business to an affiliate, the formula should explain how those decisions are reflected in the acquired practice's results.

Preserve practical operating and information rights

A seller should not assume that the buyer will operate the practice to maximize an earnout. After closing, the buyer may be integrating systems, changing leadership, reallocating staff, or pursuing strategy at the platform level. State the buyer's operating discretion and the boundaries that protect the measurement. Potential protections include consistent accounting methods, no diversion of the acquired practice's revenue, no extraordinary expense allocation, maintenance of records, and no deliberate action whose primary purpose is to avoid payment. Vague promises to use "commercially reasonable efforts" can be hard to enforce, so pair any standard with observable duties and specific examples.

Information rights make the formula usable. Require regular statements that show the metric calculation, source data and adjustments, then compare the result with the threshold with the threshold. A monthly dashboard can flag problems early, while a formal quarterly statement can support reconciliation. Sellers should have access to relevant ledgers, collections reports, provider-level production data where appropriate, payer remittance information, and allocation schedules, subject to privacy and confidentiality controls. Define a reasonable process for asking questions and receiving supporting records. If access is limited to a year-end report, errors may be difficult to reconstruct after systems or personnel change.

Create a dispute process with deadlines and a neutral accounting expert. Typically, the buyer delivers a calculation with supporting schedules, the seller has a defined review period, and the parties exchange objections that identify specific disputed items. Unresolved accounting questions go to an independent accountant acting as an expert, not an arbitrator, with authority limited to the disputed calculations and a written decision. Allocate fees according to the outcome or another agreed rule. Set a finality date, but preserve exceptions for fraud, intentional misstatement, or failure to provide required records. The contract should also say whether undisputed amounts are paid while a dispute proceeds.

Model the trade with an illustrative example

All numbers in this example are illustrative and do not describe a market benchmark or a particular practice. Assume a three-physician OB-GYN group receives an offer with $8.0 million of cash consideration at closing and an earnout of up to $2.0 million. The earnout pays $1.0 million if the acquired operations generate at least $12.0 million of defined net collections in the first measurement year, plus another $1.0 million if collections reach $12.6 million. The owners' normalized historical net collections were $11.5 million, and the buyer's integration plan assumes that one physician hire, a new office session schedule, and improved claims follow-up will produce the increase.

The threshold is not automatically fair because it is close to a forecast. Owners should reconstruct the bridge from the $11.5 million baseline. How much growth comes from signed payer rate changes, added capacity, reduced denials, or simply an assumption about patient volume? Are collections measured by service date or deposit date? Does the measure include receipts from pre-closing services? Are refunds and payer recoupments deducted? What happens if a physician's payer enrollment is delayed or the buyer chooses not to open the planned sessions? If a $200,000 shortfall eliminates the entire first tranche, a cliff threshold may create a disproportionate loss relative to actual performance.

Suppose the sellers estimate, for illustration, a 60 percent chance of earning the first $1.0 million and a 25 percent chance of earning the second tranche, with overlap because the second requires the first threshold. A rough probability-weighted gross value is $850,000 before delay, taxes, costs, or collection risk, assuming the probabilities already reflect the nested thresholds. If payment is expected after one year and the sellers apply an illustrative 10 percent annual discount for time and risk, the first tranche's probability-weighted value is about $545,000 and the incremental second tranche's value is about $114,000, for roughly $659,000. This is a negotiation model, not an appraisal. Different assumptions about probability, discount rate, or payment security will change the result.

Compare that modeled value with a request for $700,000 more in guaranteed closing cash or a smaller earnout with a lower first threshold and quarterly measurement. The sellers might prefer a $1.2 million earnout with no cliff, paying proportionately between $11.5 million and $12.3 million of collections, if it aligns payment more closely with actual performance. The buyer might prefer an earnings measure or retain a higher upside ceiling. Each counterproposal should reveal who controls the key inputs and what evidence supports them. The negotiated structure is useful only if its rules can be applied from records both sides can inspect.

Review employment and ownership, including how each affects payment

Many physician transactions combine a sale agreement with employment, consulting, restrictive covenant, rollover documents, and transition terms. Read them together. If a seller must remain employed to receive the earnout, determine whether resignation, termination without cause, disability, death, or a buyer-directed role change forfeits the payment. A seller can be economically penalized for leaving an unsuitable role even when the business met its target. Decide whether earned amounts vest as achieved, whether termination without cause accelerates or preserves payment, and whether the buyer can offset alleged employment claims against it.

Check the interaction with working capital, indebtedness, indemnity claims, and other purchase price adjustments. A buyer should not be able to recover the same amount twice by reducing closing proceeds, asserting an indemnity claim, and withholding an earnout for the same issue. Set-off rights should be limited to defined, finally determined obligations or held in a separate escrow. Determine whether earnout payments are subject to caps, subordination, lender consent, or restrictions in financing documents. A payment that is contractually due but blocked by a lender covenant may be much less valuable than its face amount suggests.

Avoid common mistakes

One common mistake is treating the maximum earnout as part of the sale price in partner discussions. It is a ceiling, not a promise. Show guaranteed and contingent proceeds separately in each owner's schedule. A partner nearing retirement may value certainty differently from a partner continuing with the buyer, and an earnout tied to continued work may allocate value unevenly even when the purchase agreement distributes it pro rata. Address that disagreement before signing exclusivity terms or making informal promises among owners.

Another mistake is accepting a vague metric because the buyer says it is standard. Standard language does not establish that the measure fits a specific practice or that the buyer's accounting system will produce an auditable result. Ask for a sample calculation using historical periods and apply the proposed definition to actual practice data. If the seller cannot reproduce the output, the formula is not ready for signature. Avoid relying on a verbal assurance that the buyer will be fair when the contract gives it discretion over costs and records.

Owners also underestimate operational interference and dispute friction. A technically precise formula can still be difficult to collect if the buyer controls all information, the earnout is payable by an undercapitalized subsidiary, or a dispute freezes all payments. Some sellers focus narrowly on the target and ignore payment timing, security, offsets, tax treatment, and survival after termination. Others accept a short measurement period that rewards a temporary collection push or penalizes a hiring delay. Work through a calendar of operations and reporting dates, then ask how a realistic disruption changes the outcome.

Finally, do not confuse diligence with negotiation. Historical financial statements, claims aging, provider rosters, payer contracts, and compensation data help establish a credible baseline. The seller still needs to negotiate the definitions, operating covenants, information access, and remedies. Have transaction counsel and a financial adviser model the mechanics together, including tax characterization and any accounting policy choices. A lawyer can improve enforceability while an accountant tests whether the formula tracks actual practice economics; neither review substitutes for the owners understanding the trade they are making.

Action checklist

Separate cash, notes, rollover equity and escrows, plus the earnout amounts in the proceeds schedule.
Identify the buyer's uncertainty and connect each contingent payment to that specific assumption.
Define the metric, accounting policies, cutoff rules, measurement period and thresholds; specify any carryforward mechanics.
Test the formula against historical practice data and build a downside case, a central case, and an upside case cases.
Protect against buyer-controlled reallocations, revenue diversion, and inconsistent accounting.
Negotiate regular statements, supporting records, audit access, a neutral dispute process, and payment security.
Read employment and termination terms alongside tax treatment and offset rights. Check the indemnity terms and financing limits, then confirm ownership allocation before agreeing to the earnout.
Compare the earnout's risk-adjusted value with guaranteed cash and document each owner's understanding before signing.

If the practice operates several locations or affiliated entities, identify the exact business perimeter. A buyer may combine acquired operations with another group, move clinicians or contracts between entities, or centralize billing. Without a defined perimeter, the seller may not know which revenue and costs, along with the providers included enter the calculation. If the earnout is based on a larger platform, require a consistent allocation methodology and access to the records needed to apply it.

Questions about your own practice? Contact richard@doctorsinvestorclub.com.