An earnout is a contractual mechanism in an M&A transaction under which a portion of the purchase price is contingent on the acquired business achieving specified performance targets after closing. Earnouts are used most commonly when the buyer and seller have different views on the value of the business — typically because the seller believes the business will grow significantly in the near future while the buyer is unwilling to pay for that growth upfront without evidence it will materialize. The earnout allows the deal to close at a price the buyer is comfortable with today, with the seller retaining the opportunity to earn additional consideration if the optimistic projections prove correct.
Earnouts sound like a straightforward bridge between valuation gaps, but in practice they are among the most frequently disputed provisions in any M&A agreement. The fundamental tension is that after closing, the buyer controls the operations of the acquired business and therefore has significant influence over whether earnout targets are achieved. If the buyer makes post-closing decisions that reduce costs, cut the sales team, integrate the acquired business into a larger organization, or redirect the business model, those decisions may prevent the earnout from being achieved even if the underlying business was performing well. The resulting disputes are common, expensive, and difficult to resolve.
Financial Metrics vs. Operational Metrics
The first major design choice in an earnout is whether to use a financial metric or an operational metric as the performance benchmark. Financial metrics are the most common: revenue and EBITDA are the most frequently used, though gross profit, net income, operating income, and other financial measures are also used depending on the nature of the business. Operational metrics — such as the completion of a specified product development milestone, the execution of a minimum number of customer contracts, or the regulatory approval of a product — are used in industries like life sciences and technology where financial performance depends on achieving specific non-financial outcomes.
Revenue-based earnouts are popular because revenue is relatively simple to calculate and is less susceptible to manipulation through accounting choices than EBITDA. However, revenue-based earnouts can be manipulated through pricing decisions, channel mix, and the timing of contract execution. EBITDA-based earnouts are popular because they capture the profitability of the business rather than just its top line, but they are susceptible to manipulation through expense allocation — the buyer can charge corporate overhead, increased management fees, or allocated shared service costs to the acquired business in ways that reduce its EBITDA and make the earnout harder to achieve.
Whatever metric is chosen, it must be defined with precision. The definitions of revenue and EBITDA for earnout purposes should specify exactly how these figures will be calculated, what accounting standards apply, how intercompany transactions will be treated, whether corporate overhead will be allocated, and whether changes in accounting methods are permitted. A vague definition invites disputes.
The Implied Covenant of Good Faith in Earnout Administration
One of the most important legal concepts in earnout disputes is the implied covenant of good faith and fair dealing, which courts have consistently held applies to contracts governed by the law of most U.S. states. The implied covenant requires each party to a contract to act in a manner that does not deprive the other party of the reasonable benefit of its bargain. In the earnout context, this means that a buyer cannot deliberately take actions designed to prevent the earnout from being achieved, even if those actions are not expressly prohibited by the purchase agreement.
Courts have applied the implied covenant to award earnout payments in cases where buyers integrated the acquired business in ways that made it impossible to measure the earnout metric, dramatically reduced the acquired business’s sales force, diverted key customers to other parts of the buyer’s organization, or deliberately avoided booking revenue through the acquired entity. The key question courts ask is whether the buyer acted in a commercially reasonable manner with respect to the acquired business during the earnout period, with reasonable consideration for the seller’s interest in achieving the earnout.
However, the implied covenant is not a guarantee of the earnout payment. Courts generally hold that a buyer is entitled to operate its business in the way it sees fit, including making operational decisions that may reduce the chances of earnout achievement, as long as those decisions are made in good faith for legitimate business reasons and not for the purpose of avoiding earnout payments. The line between permissible business decisions that happen to reduce earnout and impermissible bad-faith actions designed to avoid earnout is not always clear, and much earnout litigation is fought in exactly this gray zone.
Post-Closing Integration and Its Effect on Earnouts
The most common source of earnout disputes is post-closing integration decisions. When a buyer integrates the acquired business into its existing operations — consolidating sales teams, combining back-office functions, migrating customers to the buyer’s platforms, or merging product lines — the revenue and EBITDA that can be attributed to the acquired business may become difficult or impossible to measure. Buyers argue that integration is a legitimate business decision that creates value for the combined enterprise, even if it makes earnout calculation impossible. Sellers argue that integration decisions that destroy the earnout effectively constitute a deprivation of their contractual right to earn additional consideration.
The drafting solution is to include express covenants in the purchase agreement that govern the buyer’s post-closing operational conduct during the earnout period. These covenants may include obligations to operate the acquired business as a standalone entity (or with defined constraints on integration), to maintain existing sales and marketing resources, to not divert revenue or customers away from the acquired business, and to use commercially reasonable efforts to maximize earnout achievement. The strength of these covenants is inversely proportional to the buyer’s flexibility to integrate, so buyers resist robust protective covenants while sellers push for them. The outcome depends on relative bargaining power.
Accelerators, Step-Downs, and Clawbacks
Earnout structures can be designed with incentive features that reward exceptional outperformance or impose consequences for significant underperformance. Accelerators are provisions that pay more than the standard earnout amount if performance significantly exceeds the target — for example, if the earnout metric is 100 percent of target, the seller receives the base earnout, but if performance reaches 120 percent of target, the seller receives 150 percent of the base amount. Accelerators align the seller’s and buyer’s incentives around exceptional performance and make the earnout economically attractive to sellers even at high probability scenarios.
Clawbacks are the reverse: provisions that require the seller to return a portion of previously paid consideration if the earnout metric falls significantly below target in a subsequent period. Clawbacks are most commonly seen when the earnout spans multiple periods and the buyer is concerned about a seller who is able to game the metric in early periods at the expense of later performance. Sellers should resist clawback provisions as a general matter, and if they cannot be avoided entirely, should negotiate for limited clawback amounts with a defined cap and a cap on the seller’s total post-closing financial exposure.
Dispute Resolution Provisions
How earnout disputes are resolved is at least as important as how the earnout is designed. The two primary mechanisms are arbitration and independent accounting expert determination. In an independent accounting expert determination, an accounting firm is appointed to calculate the earnout amount based on the purchase agreement definition and applicable accounting standards. This process is relatively fast and inexpensive but is limited to the accounting calculation — it cannot resolve legal questions such as whether the buyer breached its operational covenants.
Full arbitration (or litigation) is required to resolve legal disputes about the buyer’s conduct during the earnout period. Arbitration is generally preferable to litigation in earnout contexts because it is faster, more confidential, and allows the parties to select arbitrators with relevant business and accounting expertise. However, arbitration can still be expensive and time-consuming, and the outcome is not always predictable. Sellers should also ensure that the purchase agreement clearly establishes the exclusive remedy framework for earnout disputes — specifying whether the seller can pursue damages for breach of operational covenants in addition to or instead of the accounting expert determination.
The lessons from decades of earnout litigation are clear: earnouts work best when the metric is simple and objectively verifiable, when the acquired business is operated as a standalone entity during the earnout period, when operational covenants are specific and enforceable, and when the dispute resolution mechanism is clearly defined. Business owners who accept earnout provisions as a significant component of their deal consideration should insist on these protections and should have experienced M&A counsel review and negotiate the earnout provisions with the same care as the headline price.