Earnouts Without the Drama
Metrics, covenants to operate, and dispute mechanisms
Earnouts can be an effective way to bridge a valuation gap, particularly when a business has genuine growth potential that is not yet fully proven. But they also create fertile ground for disputes when the contract leaves too much open to interpretation. The best way to reduce that risk is simple: draft with clarity.
Choose a Metric That Fits the Business
The right earnout metric depends on the company, its stage of growth, and the risks the parties are trying to allocate. Attorneys at Dougherty Molenda assist clients with finding a metric that works for their deal.
Revenue. Revenue is straightforward and often works well for early-stage businesses. But it can reward growth at any cost and may encourage the pursuit of low-quality or unprofitable business.
Gross profit or margin. These measures better account for both volume and cost, but they require disciplined and consistent accounting treatment.
EBITDA. EBITDA is common in deals involving more mature businesses, but it often becomes the source of post-closing conflict. If EBITDA is the metric, add-backs and exclusions should be defined with precision.
Unit-based metrics. In SaaS, consumer, or subscription-based businesses, metrics such as ARR, net revenue retention, or unit sales may make more sense. When using these measures, it often helps to build in quality controls or other gating requirements.
Define the Playing Field
Many earnout disputes are really fights over post-closing control. The buyer runs the business, but the seller remains economically tied to how that business is operated. That tension should be addressed directly in the agreement.
Consider whether the buyer must operate the business consistent with past practice, pursuant to an agreed budget, or subject to specific operating covenants.
The agreement should also address structural changes. A merger, divestiture, or integration decision can significantly affect earnout performance. If those actions remain permitted, the contract should say how the earnout will be protected or recalculated.
Access rights matter too. Sellers should usually have the right to receive regular financial statements, KPI reports, and other information reasonably necessary to evaluate the earnout.
Spell Out the Calculation Mechanics
The more detailed the mechanics, the less room there is for later disagreement.
Include worked examples in an exhibit. Use them to show exactly how the earnout is calculated under realistic scenarios.
Specify whether calculations must be prepared in accordance with GAAP, consistent past practice, an agreed chart of accounts, or some combination of those standards. General references are rarely enough.
The agreement should also require a written calculation statement, along with a defined review and objection period so disputes surface quickly.
Build in Efficient Dispute Resolution
If an earnout dispute arises, speed matters. A lengthy fight can erase the value the earnout was supposed to create.
Many agreements require disputes to go to an independent accountant or to expedited arbitration as the exclusive remedy for calculation disputes.
Deadlines should be short and clear. A structure such as a 30/30/30 framework, deliver the statement, object within 30 days, resolve within 30 days, keeps the process moving.
Fee-shifting (of attorneys’ fees) can discourage weak positions, and an escrow or holdback can provide a practical source of funds for any adjustment.
The Bottom Line
Earnouts work best when both sides can read the agreement and predict the result without guesswork. The more the contract depends on unwritten assumptions, the more likely it is to end in a dispute.
We help clients draft, negotiate, and, when necessary, litigate earnout provisions. A well-written earnout agreement can preserve deal value and avoid a lawsuit later.
