The buyer wants to tie forty percent of our enterprise value to a post-closing earnout based on gross margin targets, but they are taking over daily operations. How do we structure the covenant of good faith and operational guardrails to prevent them from choking our supply chain to miss the payout?

Question

Tyler Smith · Accepted Answer

When a buyer takes operational control, a gross margin earnout is a minefield. If they control the supply chain, they can easily inflate cost of goods sold or shift expenses to choke your payout. To prevent this, your stock purchase agreement must include explicit operational covenants.

First, negotiate a covenant of good faith and fair dealing that legally obligates the buyer to operate the business in a manner consistent with historical practices. This means they cannot arbitrarily change vendors, renegotiate terms, or redirect sales to other entities they own.

Second, tie the earnout to revenue or gross profit targets rather than net income, which is too easy to manipulate with corporate overhead allocations.

Third, establish a joint operating committee that meets monthly, mirroring your historical Level 10 Meeting structure, to review performance metrics. You must retain veto power over key decisions that directly affect the earnout metrics, such as changing primary vendors or altering customer pricing.

Fourth, insert an acceleration clause. If the buyer breaches these covenants, fails to fund the agreed budget, or terminates you without cause, the entire remaining earnout must accelerate and become immediately payable.

Do not rely on verbal promises during negotiations. If it is not in the definitive agreement, it does not exist. Your ability to collect on this earnout depends entirely on the operational guardrails you establish before signing.