We negotiated an earnout based on gross profit to avoid back-office overhead allocations, but we are terrified the buyer will cut our sales budget or underfund inventory post-close, making the targets mathematically impossible. What specific operational and resource-commitment covenants must be included in the purchase agreement to protect our payout?

Question

Tyler Smith · Accepted Answer

Basing an earnout on gross profit protects you from corporate overhead allocations, but it leaves you vulnerable to resource starvation. If the buyer reduces marketing spend, freezes hiring, delays vendor payments, or fails to maintain inventory, your top-line capacity collapses and your gross profit target becomes unreachable. You must bind the buyer to strict affirmative covenants in the definitive purchase agreement.

First, establish a mandatory minimum operating budget. Specify the exact dollar amounts or percentages of revenue the buyer must allocate toward marketing, direct labor, and inventory replenishment during each measurement year.

Second, include an operational continuity covenant requiring the buyer to operate the business in the ordinary course consistent with past practice. This prevents them from redirecting sales leads to their existing platform companies or deprioritizing your product line.

Third, secure commercial veto power over key personnel. The purchase agreement must state that you retain authority over hiring, firing, and compensation for the revenue-generating roles on your Accountability Chart during the earnout period.

Finally, negotiate an immediate acceleration clause. If the buyer materially breaches their funding commitments, merges your operations into another entity without your consent, or defaults on debt covenants, the full earnout amount must become immediately due and payable.

Never sign an earnout agreement that grants a buyer total operational discretion while holding your balance sheet hostage to financial milestones they control.