Earnout provisions can turn a deal impasse into a workable path forward. By tying part of the purchase price to future performance, buyers temper risk while sellers capture value they believe will materialize.
As part of Sequoia Legal’s Earnout Provisions Guide, this article explains how earnouts work, their benefits and risks, and the legal considerations businesses must address. It highlights how earnouts align buyer and seller interests in complex transactions.
The discussion below offers practical, Denver-informed insights that apply broadly across industries, helping dealmakers understand how to structure earnouts effectively and avoid common pitfalls.
How earnout provisions align buyer and seller interests
Bridging valuation gaps without breaking the deal
An earnout makes a portion of the purchase price contingent on the acquired company hitting specific milestones after closing (often 12–36 months). That structure lets a buyer pay less upfront and a seller participate in upside if projected growth actually arrives. In short, earnout provisions convert a valuation debate into a performance bet.
Incentives that point in the same direction
- Sellers remain motivated post-close because additional payments depend on hitting targets.
- Buyers reduce overpayment risk, especially in markets with pricing uncertainty.
- Management continuity becomes more valuable, since the people who drove pre-close results can help realize post-close goals.
A simple illustration: a Denver-based SaaS seller believes its pipeline will push ARR from $8M to $12M within 18 months. The buyer is skeptical. An ARR-based earnout, paid only if ARR hits agreed thresholds, transfers that growth risk to the seller while keeping the deal intact.
Where alignment is strongest
Earnouts are particularly effective in sectors with lumpy or trajectory-driven outcomes (software, life sciences, medtech, energy services). When targets are objective and operations won’t be radically reconfigured, the interests of both sides tend to stay aligned.
Legal risks tied to earnout contract disputes
Common flashpoints
Earnout litigation and expert determinations often stem from:
- Ambiguous metrics (e.g., “EBITDA” without clear addbacks, or “revenue” without returns/discounts rules).
- Accounting changes post-close that depress measured performance.
- Operational control disputes, did the buyer starve the business of resources or change strategy?
- Integration impacts, shared services, transfer pricing, or customer allocations across portfolio companies.
Implied covenant and efforts standards
Even with a clause stating the buyer has no obligation to operate to achieve an earnout, courts may still apply the implied covenant of good faith and fair dealing. The safer path is to specify operational covenants and an “efforts” standard (commercially reasonable, reasonable best efforts) calibrated to the deal. Delaware law features prominently in earnout case law, but Colorado law, frequently chosen for Denver-centric deals, likewise enforces clear drafting and good-faith performance.
Forum, remedy, and procedure
Parties should define whether disputes go to an independent accountant (for true calculation issues), arbitration (for broader contract issues), or court. Each forum changes timelines, discovery, and leverage. Clear notice periods, data access, and an exclusive dispute pathway reduce gamesmanship and the odds of a costly, slow-moving earnout fight.
Benefits of earnouts in mergers and acquisitions
Practical advantages for both sides
- Price protection: Buyers avoid paying fully for projections that may not materialize.
- Upside participation: Sellers capture value if growth targets are met or exceeded.
- Deal momentum: Earnouts bridge gaps that would otherwise stall negotiations.
- Retention and continuity: Founders and key managers have a tangible reason to stay engaged.
- Financing flexibility: Lower cash at close can make a transaction financeable in tighter credit markets.
Strategic fit
Earnouts shine when diligence reveals strong potential alongside uncertainty: new product launches, regulatory approvals, or commercialization ramps. They can also complement rollover equity, option grants, or seller notes, creating a capital stack that aligns incentives across the full post-close plan.
Structuring earnouts for financial stability and fairness
Choose metrics that reflect value creation
The right metric depends on the business model:
- Revenue or ARR for growth-oriented software, with clear rules on churn, downgrades, and credits.
- Gross profit to discourage revenue that erodes margin.
- EBITDA with defined addbacks, or milestone-based triggers (product releases, FDA clearance) in regulated industries.
Mechanics that lower dispute risk
- Timeframe: Commonly 12–36 months: longer horizons increase external risk.
- Caps/floors: Prevent open-ended exposure and avoid de minimis payouts.
- Payment cadence: Annual, quarterly, or milestone-based: specify timing and manner of payment.
- Security: Escrow, standby letters of credit, or parent guarantees can backstop credit risk.
- Offsets: Clarify if indemnity or purchase price adjustments can offset earnout payments.
- Accounting baseline: GAAP consistently applied with agreed deviations, plus a model illustrating calculations.
Operational covenants and access
Define how the business may be operated: budget approval, hiring thresholds, capital expenditures, product sunsetting, and integration guardrails. Balance is key, overly tight controls feel like seller management: too loose invites disputes. Include reporting cadence, KPI dashboards, and seller’s audit rights so information flow isn’t a bargaining chip.
Change-of-control and acceleration
Address what happens if the buyer sells the company mid-earnout, terminates key personnel without cause, or materially pivots the strategy. Acceleration (full or formula-based), a make-whole payment, or a conversion to a fixed amount can protect sellers while preserving buyer flexibility.
Attorney strategies in drafting clear earnout agreements
Draft like a CFO and a litigator, at the same time
Precision up front avoids expensive corrections later. Effective approaches include:
- Definitions with examples: If EBITDA is the yardstick, attach a sample calculation and a schedule of permitted addbacks.
- Measurement exhibit: A short financial model that shows exactly how targets and payouts are computed.
- Accounting hierarchy: GAAP, then consistent past practices, then explicit overrides: do not leave policy choices to implication.
Calibrated covenants and realistic efforts standards
State how the business will be operated, where discretion remains with the buyer, and what cooperation sellers must provide. If the agreement says the buyer owes no duty to maximize the earnout, pair that with a good-faith obligation and practical integration parameters.
Purpose-built dispute pathways
Reserve calculation disputes to an independent accounting firm and broader contract issues to arbitration or court, with tight timelines and exclusive remedies. Add data-access obligations and a survival period that outlasts the earnout window so parties can actually resolve discrepancies.
Keep employment and purchase price separate
Tie personal employment incentives to separate agreements, not the earnout itself, to reduce wage-and-hour or wrongful-termination crossfire and to keep the earnout squarely in purchase-price territory for tax and contract purposes. Well-drafted coordination clauses keep the documents in sync without merging them.
