Here is how it usually shows up. You are a founder. You spent eight years building a company. A buyer wants to pay you ten million dollars for it. You are shaking hands, the lawyers are drafting, and somewhere around page forty of the purchase agreement the number changes. Seven million at closing. Three million “earnout,” payable over the next two years if the business “hits its numbers.” Your advisors tell you not to worry — everybody does earnouts, and the numbers are conservative.
Two years later, the buyer sends a letter saying the business missed its targets. You read the letter, then the purchase agreement, then the letter again. You call your lawyer. And you begin to realize that the three million dollars you thought was your payday was actually a lawsuit you did not yet know you were going to file.
This is the version of the earnout story that nobody tells founders before they sign. Not because anyone is hiding it — most M&A lawyers will warn you in the abstract — but because the abstract warning does not make it through the adrenaline of a deal that is actually happening. So let me try something different and walk you through what an earnout actually is, how it goes sideways, and what you should be looking at before you sign.
What the word actually means
An earnout is a contract mechanism that makes part of the purchase price contingent on the performance of the business after closing. You and the buyer agree on some metric — revenue, EBITDA, product milestones, regulatory approvals, customer retention — and on how much of the purchase price will ride on whether those metrics get hit during a stated measurement period, usually one to three years.
The theory behind earnouts is sound. It is a way to bridge disagreement about what the company is worth. You think your business is about to inflect; the buyer thinks maybe, maybe not. Instead of killing the deal over the gap, you agree to a base price plus an earnout, so that if you were right, you capture the upside, and if the buyer was right, the buyer does not overpay. In the right transaction, an earnout is elegant.
In the wrong transaction — or the wrong transaction structure — it is a trap. And the wrong structures are more common than the right ones, because an earnout creates a two-year period in which the buyer controls the levers of the business and you are measuring the buyer’s performance against a target that the buyer has every operational incentive to miss.
The three questions that decide whether your earnout is a payday or a lawsuit
Before you sign anything, there are three questions to get clean answers to. They are in order of how much money they move.
First: what is the metric, and who computes it? If the metric is revenue, define revenue. What counts as a sale? What counts as a recognized sale? What happens if the buyer changes the accounting policy? What if the buyer bundles your product with theirs and allocates the revenue to the other product? What if the buyer moves a customer to a different contract structure after closing that delays recognition? The purchase agreement should include a one-page exhibit showing how the metric will be calculated, with worked examples. If the buyer’s draft does not have that exhibit, you are signing a target you cannot see.
Second: what does the buyer have to do to support the business during the earnout period? This is the single most litigated clause in earnout disputes. Most purchase agreements include a covenant like “Buyer will use commercially reasonable efforts to operate the business in a manner consistent with past practice.” That language is nearly meaningless. “Commercially reasonable efforts” is a four-word phrase that has produced ten-figure litigation awards in Delaware. It is not a shield — for you or for the buyer. What you want, if you can get it, is a specific affirmative covenants list: the buyer will maintain the sales team at not less than N people; will spend not less than $X on marketing; will not discontinue the product line during the earnout period; will not require the seller’s management team to prioritize other products. Specific covenants are enforceable. “Commercially reasonable efforts” is negotiable only at the margins once litigation starts.
Third: what happens if things change? Businesses get acquired by bigger businesses. Leaders leave. The economy shifts. Your earnout agreement needs acceleration triggers — events that collapse the earnout into a defined cash payment rather than forcing you to litigate the counterfactual. A change of control of the buyer is the obvious one: if the buyer gets sold to a third party during your earnout period, what happens to your earnout? Termination of your employment without cause is another. So is discontinuation of the business line. If these are not pinned down in writing, you will be renegotiating them under pressure two years from now.
Why earnouts go to court
Delaware has become the hot laboratory for earnout disputes, in part because Delaware targets are common and in part because the Court of Chancery is fast and sophisticated enough to handle the accounting fights that these cases turn into. A few representative cases will tell you how the judges see the landscape.
In Himawan v. Cephalon, a buyer’s failure to aggressively pursue a milestone was held not to breach the “commercially reasonable efforts” covenant because the agreement did not require the buyer to act against its own interests. In Snow Phipps Group v. KCAKE Acquisition, the opposite: the court read a specific commercial covenant as requiring concrete action and ordered performance. The through-line is that courts enforce what the contract says. Vague covenants produce vague outcomes; specific covenants produce specific outcomes. Whether that produces a payday or a loss depends almost entirely on the drafting.
The recent run of nine- and ten-figure earnout awards is not a sign that founders are winning these fights. It is a sign that the deals at the top of the market have earnouts large enough that a dispute is worth litigating to judgment. For a founder with a three-million-dollar earnout on a ten-million-dollar sale, the math of litigation rarely works out. The defense is in the drafting, not the litigation.
A few practical rules
The following are not bright-line rules — earnouts are situational — but they are the defaults I start from when a founder asks me to review a term sheet.
Keep the earnout short. One year is workable. Two years is manageable. Three years is asking the buyer’s operating team to run the business to your metric for longer than they are likely to want to. If the buyer insists on a three-year structure, you should probably renegotiate the split between base price and earnout rather than extending the runway.
Prefer metrics you can observe. Revenue and gross margin are better than EBITDA, because they depend on fewer adjustments. Product milestones and regulatory events are better than financial metrics, because they are binary. Customer retention clauses are a trap — you do not control the buyer’s customer service.
Build in an audit right. At minimum, you should have the right to audit the buyer’s calculation of the metric once a year and to dispute it through a neutral accountant. Without that right, you are accepting the buyer’s math.
Resist “integration” language. Purchase agreements sometimes provide that the buyer has sole discretion over how to integrate the target into its existing business. When you read that, read it as: the buyer has sole discretion to tank your earnout. Negotiate it out or narrow it to actions that do not materially affect the earnout metric.
Finally — and this is more art than science — price the earnout into your gut. If the business does not work economically without the earnout, the earnout is functionally the purchase price. Negotiate as if that money is going to come or not come based on what the buyer does, not based on what the business does.
Where to go from here
If you are staring at a term sheet with an earnout in it and trying to figure out whether the structure is fair, the thing to do is not to read the internet for an hour. It is to sit down with the document and have someone walk you through the three questions above, one exhibit at a time. We have written more on the sell-side negotiating dynamic in our post on seller-friendly vs. buyer-friendly deal terms, and the broader M&A context lives on our M&A practice page.
If you are closer to the signing deadline than the research-an-article deadline, feel free to reach out to my firm manager, Magda, at Magda@montague.law, or fill out our contact form. Mention you read this post.
— John
