Earnout structures — the shadow P&L.

An earnout is a promise to pay later, conditional on performance — which means the whole arrangement turns on a single question: whose accounting decides whether the performance happened? Left unaddressed, the answer defaults to the buyer's books, and the buyer's books are full of costs and conventions that have nothing to do with the seller's organic results. The shadow P&L exists to answer that question fairly before the deal closes, and it starts with knowing when an earnout is even the right tool.

§ 01 · When an earnout fitsThree situations.

An earnout isn't a default; it's a tool for three specific problems. It bridges a valuation gap when the seller's ask exceeds the buyer's supported price — the delta becomes contingent consideration tied to a performance target, which is the structure a disciplined multiple points to when the asset is worth more than a buyer can finance outright. It retains a key person when the owner carries an outsized share of revenue, structured as a retention payment across the integration window. And it validates unverifiable growth — a seller claiming a large pipeline that hasn't closed gets paid for it only if it materializes. In each case the earnout converts a disagreement about the future into a payment that depends on the future actually arriving. The legal anatomy of the clause is in drafting the earnout.

§ 02 · The shadow P&LWhose accounting decides.

The shadow P&L is the most important protection in any EBITDA-based earnout, because accounting friction — the gap between what the seller earned and what the buyer's system reports — comes from three sources that have nothing to do with performance. Timing: the seller books commission when written, the buyer when the carrier pays 30–90 days later. Allocation: the buyer assigns 10%–15% of revenue in corporate overhead the seller never carried. Definition: what counts as marketing expense, or whether a system migration is capitalized or expensed. The worked case makes the stakes vivid — the same agency, measured two ways, produces opposite payout decisions ($265K on the buyer's books, $470K on the shadow P&L). The shadow P&L is the negotiated agreement that strips the friction out before it can erode a payment the seller fairly earned.

§ 03 · Three line categoriesHow the shadow P&L is built.

A shadow P&L is built from three categories of line item, each doing a defined job. Add-backs restore value the buyer's ownership injected: corporate-overhead allocations, integration costs like a system migration or rebranding, above-market management fees, and transaction-tied retention bonuses all come back, because the seller's organic book didn't incur them. Exclusions block erosion from revenue the seller didn't generate: business cross-sold to the buyer's pre-existing clients, revenue from lines the buyer introduced, and non-organic expense investments like an office expansion are all carved out so the seller is neither credited nor charged for the buyer's moves. Shadow credits attribute revenue the seller sourced that lands elsewhere — typically 50% of the first-year commission on referred business that books on the buyer's other lines, so a seller who feeds the buyer's benefits or commercial desk gets fair partial credit. Built this way, the shadow P&L measures the seller's actual contribution, no more and no less.

§ 04 · Choosing the metric and the controlsRevenue, EBITDA, and the safeguards.

The metric choice follows the deal's shape. Revenue is used in roughly 65% of agency earnouts because it's clean, verifiable against carrier production reports, and hard to manipulate — and it's the right pick for a short earnout (12 months or less) with limited seller authority, where simplicity reduces disputes. EBITDA fits a long earnout (24–36 months) with significant seller autonomy, because over that horizon and with that control the seller's operating decisions deserve a comprehensive measure. In a hard market, supplement revenue with policy-count retention to strip out the 5%–10%-plus rate inflation that would otherwise reward the seller for market conditions rather than performance. Three controls protect both sides: a clear hierarchy of accounting rules (the seller's historical practices first, then GAAP with negotiated adjustments, then generic GAAP), a third-party review of the buyer's computation by the seller's accountant within 30–60 days of the measurement date (with a jointly-appointed firm as arbiter on dispute), and — non-negotiable for any EBITDA-based earnout — a sample calculation exhibit attached to the purchase agreement that demonstrates the exact line-by-line logic on historical data. Designed before signing, the earnout becomes a shared model rather than the most-litigated artifact of the deal. Where this number comes from is covered in risk-adjusted multiples.

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