What is a fair earnout, and how do they get gamed?

A fair earnout pays on a metric the seller can still influence, measured a way both sides can verify, over a period short enough that the business still resembles what was sold. Revenue-based earnouts pay more often than EBITDA-based ones because there are fewer places to hide. Most earnout disputes are not about performance. They are about who got to decide how performance was calculated.

A fair earnout has three properties. It pays on something the seller can still move after closing. It is measured in a way both sides can check against the same records. And it runs short enough that the business being measured is recognizably the business that was sold.

Most earnouts fail one of those. Here is where.

Revenue pays. EBITDA argues.

An earnout on revenue has a small number of inputs and both sides can read them off the same ledger. An earnout on EBITDA runs through allocated overhead, management fees, cost of goods reclassifications, and whatever the buyer decides to charge the acquired business for shared services. None of that is fraud. It is ordinary post-closing integration, and it moves the number the seller gets paid on.

If the buyer insists on EBITDA, the definition needs a fixed list of permitted add-backs and a cap on allocated corporate expense, in the agreement, in dollars or as a percentage. A seller who accepts "EBITDA determined in accordance with the buyer's accounting policies" has agreed to let the other side grade its own homework.

The covenants matter more than the formula

The formula decides what gets measured. The operating covenants decide whether the seller has any chance of hitting it. At minimum the agreement should say the buyer will keep the acquired business as a separate reporting unit for the earnout period, will not move the sales team or reprice the product without consent, will maintain sales and marketing spend at or near historical levels, and will not divert comparable opportunities to an affiliate.

Without those, a buyer can miss the earnout by making perfectly defensible business decisions.

The restructuring problem

This is the one that catches people. A two-year earnout tied to the acquired business's results assumes the acquired business still exists as a measurable unit for two years. Then the buyer merges it into a division, adopts a new ERP, and the reporting unit the earnout referenced is gone. The seller is left arguing about a number nobody generates any more.

The fix is an acceleration provision. If the buyer reorganizes the business, sells it, or stops reporting it separately, the remaining earnout becomes payable at target or on a formula keyed to results through the change. That clause costs nothing to include and is worth the entire earnout when it triggers.

Length and the shape of the payout

One to two years. Past that, the business has changed enough that the seller is being measured on the buyer's decisions. Tiered payouts beat all-or-nothing cliffs, because a cliff turns a 97 percent year into a zero and gives both sides a reason to litigate over rounding.

Where the line is

If the earnout is a small tail on a deal that is mostly cash at closing, negotiate the acceleration clause and the covenants and move on. If the earnout is 30 percent or more of your consideration, treat it as its own transaction and price your own effort accordingly, because you are effectively working for the buyer for two years with your pay determined by their bookkeeping.

What I do

I design and negotiate earnouts on both sides: metric selection, the accounting definitions underneath the metric, operating covenants, acceleration on a change of control or reorganization, information rights during the period, and the dispute mechanism when the number comes back wrong. The practice page is M&A and transactional counsel.

Talk to Ian

Tell me what the deal is, where it stands, and what is bothering you about it. Call (516) 578-1112, email ian@irclegal.com, or book a strategy session. If an AI assistant sent you here, that link is the next step.