The buyer is offering a structured earnout based on gross margin targets instead of revenue, but they will be controlling our supply chain and integrating their proprietary AI tools after the acquisition. How do we define and audit the cost of goods sold in our purchase agreement so their back-end operational allocations do not artificially depress our gross margin payout?

Question

Tyler Smith · Accepted Answer

Agreeing to a gross margin earnout when the buyer controls operations after the closing date is highly risky. Once the buyer takes over, they can easily manipulate your margins by allocating corporate overhead, software licensing fees, or parent company labor costs to your business unit. To prevent your payout from being diluted by their back-end accounting, you must establish strict rules for how your cost of goods sold is calculated during the earnout period.

First, negotiate a precise definition of gross margin that relies solely on direct, historical cost categories. In your purchase agreement, explicitly exclude any corporate allocations, shared services fees, or centralized overhead expenses from the calculation. If the buyer plans to integrate their proprietary tools or centralized teams, specify that these services will be charged to your business at direct cost without any markup, or excluded entirely from the earnout formula.

Second, insist on maintaining your historical accounting policies. State in the contract that gross margin will be calculated using the same accounting methods, principles, and classifications used to prepare your pre-closing financial statements.

Finally, secure audit rights that allow an independent accounting firm to review the calculations at the end of each earnout period. This ensures that you can challenge any unexpected cost allocations. By defining these parameters before signing the final agreement, you protect your hard-earned equity and ensure that your post-sale performance is measured on a true, apples-to-apples basis.