The buyer is insisting on a revenue-based earnout to avoid disputes over expense allocation, but our gross margins vary wildly across different service lines. How do we structure the earnout rules so we do not end up chasing low-margin revenue just to hit the target, while still avoiding post-close overhead disputes?

Question

Tyler Smith · Accepted Answer

While a revenue-based earnout avoids the complex accounting games buyers play with post-close EBITDA, it creates a dangerous incentive to chase unprofitable work just to hit a top-line target. This can lead to operational chaos, employee burnout, and a business unit that is structurally broken by the time the earnout period ends. To resolve this issue, you should propose a gross profit-based earnout with a margin floor. This protects the buyer from paying out on unprofitable volume while protecting you from corporate overhead allocations. First, clearly define gross profit in the purchase agreement. It must be calculated as revenue minus direct material and direct labor costs, with no corporate overhead, shared service allocations, or executive management fees included. Second, establish a margin floor covenant. Specify that only revenue with a gross margin of, for example, forty percent or higher will count toward the earnout targets. This keeps your team focused on high-value work and prevents the buyer from forcing you to take on low-margin strategic accounts that drain your capacity. Finally, align this structure with your weekly Scorecard. Track gross profit dollars per headcount as a leading indicator of performance. By focusing on gross profit rather than revenue or net income, you align the operational incentives of your leadership team with the financial expectations of the buyer, ensuring a clean and fair payout.