Earnouts: The Deal Isn’t Done at Closing
An earnout is supposed to bridge a valuation gap between buyer and seller. When it works, the seller gets paid for value the business has not yet delivered, and the buyer pays only if the value materializes. In theory, that is an elegant solution to a hard problem.
In practice, earnouts are among the most heavily litigated provisions in private M&A. The reason is straightforward. An earnout does not actually resolve the valuation disagreement. It defers it.
The parties close the deal believing they have agreed on the economics. They have not. They have agreed on a methodology for calculating part of the purchase price later, during a period when their incentives will no longer be aligned. The seller wants the earnout to be earned. The buyer, now operating the business, may have reasons to make decisions that reduce the likelihood of earning it. Whether those decisions are legitimate business judgment or a breach of the implied obligation to operate in good faith is exactly what the parties end up fighting about.
Earnouts are not boilerplate. They are price terms, and the drafting determines whether the price actually gets paid.
The Metric: What Are You Actually Measuring?
The first question in any earnout is what metric triggers payment. Revenue, EBITDA, gross profit, customer retention, regulatory approval, contract renewal, and product launch milestones are all common. Each has different implications for how the business will be run during the earnout period and where disputes are most likely to arise.
Revenue-based earnouts are often easier to measure, but they can still be manipulated by either party. Sellers can pull revenue forward at the expense of margin. Buyers can defer or restructure revenue recognition. EBITDA-based earnouts introduce significant disputes over how operating expenses are calculated, what corporate allocations are included, and how integration costs are treated. Milestone-based earnouts avoid the accounting fight but introduce binary outcomes: the milestone is hit or it is not, and the parties disagree about whether the buyer’s conduct caused the result.
Whatever metric is chosen, the definition has to do more work than the parties usually give it credit for. A definition that says “EBITDA calculated in accordance with GAAP, consistently applied” is not a definition. It is the start of a dispute. The agreement needs to specify what is included, what is excluded, how unusual or non-recurring items are treated, and how the metric is adjusted for events the parties did not anticipate.
How to think about it: Before agreeing to a metric, both parties should be able to walk through a calculation using the prior year’s financials and arrive at the same number. If they cannot, the definition is not finished. An illustrative calculation attached to the agreement, using the same line items and treatments that will govern the earnout, is the single most useful drafting tool for preventing later disputes.
Operating Covenants: What the Buyer Agrees to Do
Once the deal closes, the buyer controls the business. Every decision the buyer makes during the earnout period affects whether the earnout is earned. Operating covenants are the contractual mechanism that constrains the buyer’s post-closing discretion.
The seller’s strongest position is a covenant requiring the buyer to operate the business consistent with past practices and to refrain from actions designed to frustrate the earnout, often coupled with a commercially reasonable efforts standard tied to specific business drivers. The buyer’s strongest position is no covenant at all, with the buyer free to operate the acquired business in whatever manner serves the broader corporate interest. The middle ground, where most deals land, involves specific commitments around staffing, capital expenditure, integration timing, pricing, and protection of customer relationships, often with carve-outs for decisions taken in good faith based on legitimate business considerations.
The absence of express operating covenants does not mean the buyer is free to act with no constraint. Courts in many jurisdictions imply an obligation of good faith and fair dealing that prevents the buyer from taking actions specifically designed to defeat the earnout. But relying on implied covenants is a poor substitute for express ones. Implied covenants are litigated after the fact, expensive to enforce, and uncertain in outcome.
How to think about it: Sellers should identify the specific business practices that drive performance and negotiate covenants that protect them. Buyers should identify the operational flexibility they will need and negotiate carve-outs that preserve it. A covenant package that does neither, that simply requires the buyer to operate “consistent with past practices,” sounds protective but is too general to enforce predictably.
Disruption Events: What Happens If the Business Is Sold, Integrated, or the Seller Is Terminated
Earnouts assume that the business and the seller remain in roughly the same configuration during the earnout period. Often they do not. The buyer may sell the acquired business to a third party. The seller, if continuing as an employee, may be terminated. The business may be merged into a larger operating unit and lose its independent identity.
Each of these events raises a question the parties should answer at signing. If the buyer sells the business mid-earnout, does the earnout accelerate, terminate, or continue with the new owner? If the seller is terminated without cause, does that operate as a constructive acceleration of the earnout, or is the seller’s right to participate forfeited? If the business is integrated and the metric can no longer be calculated cleanly, how is the earnout measured?
Sellers generally want acceleration on a change of control or termination without cause. Buyers generally want flexibility to make those decisions without triggering an automatic payment obligation. The right answer depends on the deal, but the question needs to be answered in the agreement. Silence on these issues is not neutrality. It is a future fight waiting to happen.
How to think about it: Map the foreseeable events that could affect the earnout: sale of the acquired business, termination of the seller, restructuring of the business unit, change in accounting methodology, departure of key employees. For each, the agreement should specify whether the earnout accelerates, continues, terminates, or is recalculated. Anticipating these scenarios in the drafting is much easier than negotiating them after they happen.
Dispute Resolution: How Disagreements Get Decided
Earnout disputes typically fall into two categories: disagreements about how the metric was calculated, and disagreements about whether the buyer breached an operating covenant or implied duty. The agreement should treat them differently.
Calculation disputes are accounting questions. They are best resolved by an independent accountant whose determination is final and binding, similar to the dispute resolution mechanic used in working capital adjustments. The accountant’s role should be limited to specific calculation issues, with the rest of the contract’s dispute resolution provisions reserved for everything else.
Covenant and good faith disputes are different. They are legal questions, often involving the buyer’s business judgment, the reasonableness of operational decisions, and the application of implied duties. These do not belong in front of an accountant. They belong in front of a court or arbitrator, depending on the agreement’s broader dispute resolution framework.
Agreements that send all earnout disputes to a single accountant create problems. An accountant is not equipped to decide whether a buyer breached an operating covenant. An agreement that sends all earnout disputes to court or arbitration creates the opposite problem: routine calculation disagreements become expensive and slow to resolve.
How to think about it: The dispute resolution mechanic should distinguish between calculation disputes and substantive disputes. Calculation disputes go to an accountant for a fast, binding decision on specific line items. Covenant and good faith disputes go to the agreement’s general forum. Drafting this distinction clearly at signing avoids procedural fights about jurisdiction when the substantive fight starts.
The Takeaway
An earnout is a contractual answer to a problem the parties could not resolve at the table. They could not agree on what the business is worth, so they agreed on a method for paying part of the price later, based on what actually happens. That structure is useful, but it carries the disagreement forward rather than resolving it.
The deals where earnouts work are the ones where the parties drafted carefully: a defined metric supported by an illustrative calculation, operating covenants that reflect the actual drivers of the business, clear answers to the foreseeable events that could disrupt the measurement, and a dispute resolution mechanic matched to the type of dispute. The deals where earnouts produce litigation are the ones where those decisions were left for later.
Later, in this context, usually means after the relationship between the parties is already strained. That is the wrong time to discover that the deal documents do not answer the questions that now matter most.
This post is general information only and does not constitute legal advice. For questions about your specific situation, contact Cruxterra Law Group.
