The buyer is offering an earnout based on gross profit targets rather than bottom-line EBITDA to bridge a valuation gap, but we are worried they will alter operational decisions. What covenants must we demand in the purchase agreement to protect our payout?

Question

Tyler Smith · Accepted Answer

A gross profit earnout is inherently safer than an EBITDA earnout because it shields you from arbitrary corporate overhead, management fees, and aggressive corporate cost allocations. However, gross profit remains vulnerable if the buyer changes your pricing models, adjusts vendor fulfillment channels, or shifts key sales personnel to other corporate divisions post-close.

If you agree to a gross profit earnout to bridge a valuation gap, the purchase agreement must include explicit operational covenants that restrict the buyer ability to manipulate your margins:

- Operational continuity covenants. Require the buyer to operate the acquired business in the ordinary course consistent with past practice. Mandate that your sales team, compensation plans, and delivery models remain intact throughout the earnout period.
- Pricing and discounting control. Include a clause stating that no customer discounts, rebates, or bundled pricing across the buyer other portfolio assets can be applied to your business without your prior written consent.
- Cost-of-goods-sold safeguards. Ring-fence the direct costs applied to your gross margin calculation. Specify that internal transfer pricing, shared procurement charges, or arbitrary vendor reallocations cannot be charged against your gross profit line.
- Acceleration on operational breach. Demand that if the buyer breaches these operational covenants, terminates your operational leadership without cause, or sells the division before the earnout concludes, the earnout immediately accelerates and becomes payable in full.

Never rely on good faith. Define every metric mathematically in the definitive legal agreement and bind the buyer to strict operational restrictions.