The buyer insists on a three-year earnout tied to gross profit targets instead of revenue, but our gross margins fluctuate based on material costs and subcontractor pricing. How do we negotiate the earnout metric and cost of goods sold definitions so inflation does not kill our payout?

Question

Tyler Smith · Accepted Answer

Earnouts tied strictly to gross profit can be an operational trap if the definition of cost of goods sold is ambiguous. Buyers prefer gross profit over revenue because revenue earnouts can encourage reckless discounting, while sellers avoid net income earnouts because buyers can load corporate overhead onto the P&L. Gross profit is a workable compromise only if you establish strict accounting definitions before signing.

First, negotiate a fixed cost schedule for overhead allocation inside cost of goods sold. Specify exactly which expense categories belong in direct costs. Exclude allocated corporate management fees, parent company software licenses, shared facilities, and executive travel. If the buyer plans to consolidate supply chain purchasing or shift direct labor onto their shared services team, benchmark those costs at a fixed percentage or historical baseline.

Second, include an inflation indexation or input cost buffer. If raw materials or subcontractor rates increase past a defined threshold, the gross profit hurdle must adjust downward automatically, or product pricing adjustments must be mandated by covenant.

Third, demand operational veto rights on pricing and product mix. If the buyer decides to discount your legacy offering to cross-sell their enterprise software, your earnout margin will collapse. Build a covenant requiring buyer adherence to existing pricing matrices unless mutually agreed. In your Accountability Chart, ensure you or an incentivized key leader retains seat authority over operational delivery and vendor contracting throughout the earnout window.