A financial sponsor is offering a high headline price but wants twenty-five percent of it tied to a three-year earnout based on net income. How do we rewrite the earnout metrics in the LOI to prevent their post-acquisition corporate overhead from wiping out our payout?

Question

Tyler Smith · Accepted Answer

Never agree to an earnout based on net income or net profit. Once the buyer takes control, they will load your business with corporate overhead allocations, management fees, and integrated operational costs that will quickly reduce your net income to zero. To protect your post-close payout, you must push to base the earnout on gross revenue or gross margin. These top-line metrics are much harder for a buyer to manipulate through accounting adjustments. If the buyer insists on using EBITDA or operating income, you must negotiate strict covenants in the purchase agreement. These covenants must explicitly exclude any allocated corporate overhead, parent company legal fees, or debt service from the calculation of your target metrics. You should also maintain operational authority over your division during the earnout period. Use your weekly Level 10 Meeting to track these specific earnout metrics on your scorecard. If the buyer plans to integrate your sales or delivery teams, establish a pre-determined transfer pricing agreement for shared services. The goal is to keep your operational metrics isolated and clean. If they cannot promise operational transparency and clean accounting, you should reduce the earnout percentage and demand more cash at close, even if it means accepting a slightly lower headline valuation.