The buyer offers a higher enterprise value if we accept a three-year earnout tied to adjusted EBITDA, but our deal team advises against EBITDA-based metrics. Why are EBITDA earnouts dangerous for a departing seller, and how should we negotiate the metric?

Question

Tyler Smith · Accepted Answer

EBITDA earnouts in the lower middle market are notoriously difficult to collect. Once a buyer takes control of your business, they control the income statement below the gross margin line. They can allocate shared corporate overhead, hire redundant management, increase corporate travel budgets, or shift executive salaries into your operating entity, wiping out your target EBITDA while technically keeping the business profitable.

If you agree to an earnout structure to bridge a valuation gap, you must never tie the payout to a bottom-line metric like EBITDA or net income unless you retain absolute operational and financial veto power. Instead, negotiate to anchor the earnout strictly to top-line metrics that the buyer cannot manipulate through cost allocation:

- Gross revenue or contracted annual recurring revenue, verified by cash receipts.
- Unit volume or active recurring customer retention counts.
- Gross profit, calculated using an unalterable, pre-agreed formula for direct cost of goods sold that excludes any allocated corporate overhead.

In addition to setting the metric at or above gross profit, mandate structural guardrails in the purchase agreement. Require the buyer to operate the business consistent with past practice, maintain adequate operating working capital, and prohibit the redirection of customer inquiries or sales leads to other corporate divisions. If the buyer insists on an EBITDA earnout without granting operational veto authority on expenses, treat that earnout value as zero dollars on your personal balance sheet.