The buyer is proposing a four-year earnout based on net income, but we are terrified that their corporate overhead allocations will artificially depress our profitability and wipe out our payout. How do we structure the financial metrics in our purchase agreement to protect our earnout from their accounting adjustments?

Question

Tyler Smith · Accepted Answer

Never agree to an earnout based on net income. Buyers have too many accounting tricks to manipulate that bottom line. They can load your business unit with parent company administrative costs, management fees, shared IT expenses, and marketing overhead. Instead, insist that the earnout be calculated using gross profit or contribution margin. If the buyer insists on using EBITDA, you must negotiate strict accounting covenants in the purchase agreement. Define a customized metric called Adjusted EBITDA specifically for the earnout. This definition must explicitly exclude any allocated corporate overhead, parent company debt service, or shared service fees. It should only include direct expenses incurred by your specific operating unit. To keep operations clean, use your existing EOS Accountability Chart as the baseline for your post-transaction operations. Secure a covenant in the purchase agreement that keeps your leadership team in control of your unit's operating expenses and hiring decisions. This ensures you maintain the authority to execute your growth strategy. Finally, establish a dispute resolution mechanism in the contract. If there is a disagreement over the earnout calculation, the agreement should mandate that both parties submit their books to an independent accounting firm. The fees for this review should be paid by the party whose calculations were furthest from the final independent determination. This keeps both sides honest and prevents the buyer from using administrative delay to starve you of your payout.