The buyer wants to tie our earnout to gross margin targets rather than top-line revenue or EBITDA, but we are worried about inflation and supply chain fluctuations. How do we negotiate safeguards into a margin-based earnout?

Question

Tyler Smith · Accepted Answer

Tying an earnout to gross margin is incredibly risky because external market forces can crush your margins even if you run operations perfectly. If the buyer insists on a gross margin target, you must negotiate clear operational guardrails. First, define the cost of goods sold with absolute precision in the purchase agreement. Ensure that no post-close corporate overhead allocations or shared service fees can be slipped into your gross margin calculation. Second, build in an inflation-adjustment clause. If your raw material or labor costs increase beyond a certain percentage, the gross margin targets must adjust downward proportionally. Third, ensure you retain operational control over pricing. If the buyer forces you to lower your prices to win market share, it will destroy your margin percentage. Your deal structure should state that if the buyer exercises pricing authority, the earnout triggers automatically. Use your weekly Level 10 Meeting to keep the transition team aligned on these metrics post-close, but do not rely on goodwill. Secure these protections in the legal text. A well-structured earnout protects you from external economic shifts and ensures you get paid for the actual value you deliver, not the market conditions you cannot control.