The buyer wants our three-year earnout to be based on net revenue, but we are worried they will discount our prices to drive volume and destroy our brand value. How do we structure a gross-profit-based earnout to protect our incentives?

Question

Tyler Smith · Accepted Answer

Revenue-based earnouts are attractive because they are difficult for a buyer to manipulate through creative corporate accounting or overhead allocations. However, they create a dangerous misalignment of incentives. If the buyer can drive revenue by slashing your prices, offering unsustainable discounts, or taking on low-margin clients, they can hit their revenue targets while completely destroying the gross margins and long term viability of your business.

To protect your business and your payout, you should negotiate to base the earnout on gross profit dollars rather than gross revenue. This ensures both parties remain aligned on pricing integrity and margin health. When negotiating this structure, define gross profit clearly in the purchase agreement as net sales minus direct labor and direct materials, using the exact same gross margin accounting principles you used historically.

To prevent the buyer from making unilateral pricing decisions that harm your gross profit, build an operational covenant into your purchase agreement. This covenant should state that the buyer cannot discount your standard pricing or alter your customer credit terms by more than a specific percentage, such as five percent, without your written consent during the earnout period. Use your weekly scoreboard and Rocks to track gross profit margins closely. If the buyer attempts to force low-margin volume through your system, you will have the legal and operational framework to veto those moves and protect your earnout.