The buyer is offering a headline valuation that meets our target, but thirty percent of the purchase price is tied up in a three-year EBITDA earnout. How do we structure earnout covenants to prevent the buyer from manipulating expenses and cheating us out of the payout?

Question

Tyler Smith · Accepted Answer

An earnout is often promoted by buyers as a fair way to bridge a valuation gap, but in practice, earnouts are litigated more frequently than any other deal structure element. When thirty percent of your enterprise valuation is tied to future performance, you are effectively financing the acquisition while handing operational control to someone else.

If you must accept an earnout structure to hit your number, you have to write airtight covenants into the purchase agreement to eliminate gaming by the buyer.

First, tie the payout to top-line gross revenue or gross margin rather than bottom-line EBITDA. EBITDA is far too easy for a buyer to manipulate post-close through shared corporate overhead allocations, inflated executive salaries, aggressive marketing experiments, or arbitrary IT licensing fees. Revenue is clean, objective, and difficult to conceal.

Second, demand negative operational covenants. The purchase agreement must legally prohibit the buyer from diverting customers to other subsidiaries, discontinuing your core marketing channels, or stripping delivery resources away from your division during the measurement period.

Third, require an acceleration clause. If the buyer sells the company, undergoes a major recapitalization, or terminates your operational leadership without cause, the full undiscounted earnout amount must become immediately due and payable.

Fourth, insist on quarterly audit rights and a binding third-party dispute mechanism. If the buyer controls the operational ledger, you must have the legal authority to inspect their general ledger and contest calculations without spending hundreds of thousands of dollars in commercial court. If a buyer refuses these covenants, walk away from the earnout and reset your enterprise valuation to a cash-only baseline.