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The phone call always starts the same way: "Brett, we're $2 million apart on price, and neither side will budge. What do we do?"
In today's market, that conversation is happening more often than ever. With valuations compressed and financing still challenging, buyers and sellers are further apart on price than we've seen since 2008. The solution that's getting deals across the finish line? Earnouts.
But here's what most brokers won't tell you: earnouts pay an average of just 21 cents on the dollar. When they do pay something, sellers typically get about half of what they expected.
That doesn't mean earnouts are broken—it means most are poorly structured. After diving deep into recent market data, court decisions, and industry best practices, here's how to build earnouts that work for everyone and avoid the litigation disasters that are exploding in Delaware courts.
The Current Reality: Earnouts Are Everywhere
Earnouts are now used in approximately 22% of M&A transactions—well above pre-pandemic levels. In some industries like life sciences, they appear in over 80% of deals.
Why the surge? Simple math. Market multiples compressed from 11.9x (2016-2021) to 9.8x (2022-2024), creating persistent valuation gaps. Earnouts let the business performance settle the argument instead of walking away from deals.
But the earnouts being structured today look very different from the past:
Today's Earnout Profile
Shorter duration: Median 24 months (down from 36+ months historically)
Revenue-focused: 62% now use revenue metrics vs. 22% using EBITDA
More complex: 68% use multiple measurement criteria
Significant size: Median earnout represents 31% of total consideration
Why Most Earnouts Fail (And the Delaware Wake-Up Call)
Recent court decisions are reshaping how earnouts should be structured, and the lessons are expensive:
Johnson & Johnson: $1+ Billion Mistake
J&J lost over $1 billion when a court found they failed "commercially reasonable efforts" standards. The lesson? Vague "efforts" language is a litigation time bomb.
Pacira v. Fortis: Ambiguity Kills
The buyer won because "CMS Reimbursement" was ambiguously defined. The court had to interpret what the parties "meant"—and sided with the buyer's reading.
SRS v. Alexion: No Automatic Payouts
Even when buyers breach earnout obligations, courts now calculate damages based on probability of success, not automatic full milestone amounts.
The pattern is clear: Ambiguous terms, elastic standards, and poorly defined metrics lead to years of expensive litigation with uncertain outcomes.
The Earnout Structures That Actually Work
1. Revenue-Based Earnouts: The New Gold Standard
Why revenue beats EBITDA: Revenue is harder to manipulate, easier to audit, and survives integration better than profit metrics.
Sample revenue definition:
"Revenue" means GAAP net revenue recognized by the Target Business from contracts entered into in the ordinary course, excluding: intercompany sales, pass-through taxes, one-time fees, and revenue from product lines discontinued pre-closing. GAAP policies shall remain consistent with the 12 months pre-closing as set forth in Schedule X.
2. Laddered Thresholds Instead of Binary All-or-Nothing
Replace "hit $10M or get nothing" with:
$8M (80% of target): 50% of earnout pays
$9M (90% of target): 75% of earnout pays
$10M (100% of target): 100% of earnout pays
$11M (110% of target): 125% of earnout pays (upside participation)
This reduces "binary failure" disputes and keeps both parties motivated.
3. Frozen Accounting Policies (Critical for EBITDA Earnouts)
If you must use EBITDA metrics, lock down the accounting:
Buyer shall maintain the Accounting Policies set forth in Schedule X, including fixed rules for: revenue recognition, cost allocations (no new corporate overhead), inventory costing, and reserves. No changes without Seller consent, except as required by new GAAP.
Essential Guardrails That Prevent Disputes
Replace "Efforts" with Objective Commitments
Instead of: "Buyer will use commercially reasonable efforts..."
Use: "Buyer will: (a) maintain staffing at minimum X FTEs; (b) invest at least $Y in development activities; (c) maintain marketing spend at Z% of revenue; and (d) not take actions with the primary purpose of reducing earnout achievement."
Robust Reporting and Audit Rights
Monthly: KPI dashboard with variance explanations Quarterly: Detailed earnout calculation with CFO certification
Audit rights: Up to 2 audits per year with access to underlying systems Expert determination: Independent accounting firm for calculation disputes
Change-of-Control Protection
If Buyer sells the Earnout Business or integrates it in a way that makes measurement impracticable, the earnout shall accelerate at the greater of (i) target amount or (ii) trailing-12-month run-rate prorated for the remaining period.
Industry-Specific Playbooks
Technology Companies
Focus on ARR/subscription metrics rather than GAAP revenue
Include customer retention thresholds (e.g., 90% logo retention)
Carve out pricing changes from earnout calculations
Address churn normalization in SaaS models
Manufacturing/Industrial
Use unit metrics or gross margin measures
Lock cost allocation methodologies upfront
Include input cost volatility collars for raw materials
Limit new corporate overhead allocations
Service Businesses
Focus on revenue or EBITDA per location
Account for customer concentration changes
Lock key employee definitions and compensation
Address regulatory/reimbursement changes
Buyer and Seller Strategies
For Sellers: Protect Your Interests
Reality-check the odds: With 21-cent average payouts, negotiate for more cash at close when possible.
Essential protections:
Objective, measurable performance metrics
Robust monthly reporting requirements
Semi-annual audit rights with system access
"No manipulation" covenants with teeth
Change-of-control acceleration provisions
Early buyout rights at pre-agreed discounts
Red flags to avoid:
Periods longer than 3 years
Pure EBITDA metrics without frozen accounting
Vague "best efforts" language
No audit or verification rights
For Buyers: Structure for Success
Keep it simple:
Revenue metrics over profit measures when integrating
24-month periods maximum to reduce variables
Clear carve-outs for necessary business changes
Objective compliance standards you can actually meet
Document everything: Maintain contemporaneous decision memos. In litigation, courts examine the entire contract and internal communications.
The Tax and Accounting Reality
For Sellers (Tax)
Earnouts typically qualify for installment sale treatment
Capital gains recognized as payments are received
Critical: Avoid employment-related triggers that convert to ordinary income
Consider interest/OID treatment on deferred payments
For Buyers (Accounting)
Earnouts are contingent consideration measured at fair value
Liability classification creates quarterly P&L volatility
Equity classification avoids remeasurement but limits structure
Budget for ongoing fair value adjustments
The 10-Point Earnout Safety Checklist
Before signing any earnout agreement:
✓ Metric: Revenue/units preferred over EBITDA
✓ Duration: 24 months maximum with quarterly measurement
✓ Definitions: Clear examples and exclusions specified
✓ Covenants: Objective commitments, not vague "efforts"
✓ Accounting: Policies frozen in writing if using profit metrics
✓ Reporting: Monthly KPIs, quarterly detailed calculations
✓ Audit rights: Semi-annual access with expert determination
✓ Change-of-control: Acceleration or tracking preservation
✓ Thresholds: Laddered payouts, not binary all-or-nothing
✓ Security: Consider escrow/LOC for earnouts >30% of deal value
Real-World Example: How It Should Work
The situation: $8M business, $2M valuation gap
Traditional approach: Walk away or seller takes lower price
Smart earnout structure:
Base price: $8M cash at closing
Earnout: Up to $2M over 24 months based on revenue
Metrics: Quarterly GAAP revenue, consistent accounting policies
Thresholds:
$4M annual revenue: $1M earnout (50%)
$4.5M annual revenue: $1.5M earnout (75%)
$5M annual revenue: $2M earnout (100%)
Protection: Monthly reporting, semi-annual audit rights, no manipulation covenant
Result: Deal closes with aligned incentives and clear measurement criteria.
When Earnouts Make Sense (And When They Don't)
Good Earnout Candidates
Valuation gap based on growth projections
Business with standalone measurement capability
Objective, verifiable performance metrics available
Strong historical financial tracking
Both parties committed to making it work
Avoid Earnouts When
Integration will make measurement impossible
Performance depends heavily on buyer's other operations
Metrics are subjective or buyer-controlled
Either party views it as "play money"
Compliance costs exceed potential benefit
The Bottom Line
Earnouts aren't going away. In uncertain markets with persistent valuation gaps, they're often the only bridge that gets deals done. But success requires precision in structure, clarity in measurement, and discipline in execution.
The winning formula:
Simple metrics (revenue over EBITDA)
Short periods (24 months maximum)
Objective standards (specific commitments over vague "efforts")
Robust verification (reporting and audit rights)
Fair thresholds (laddered payouts, not binary)
Remember: Earnouts are insurance against business performance, not guarantees of payment. Structure them with the assumption that disputes are possible, and build in mechanisms to resolve them quickly and fairly.
Most importantly: Don't let the perfect earnout structure prevent a good deal from closing. Sometimes 21 cents on the dollar from an earnout plus certainty of cash at closing beats holding out for a higher price that never comes.
Your Next Step
Every earnout situation is unique, but the principles above can save years of litigation and failed expectations. The key is recognizing that earnouts are as much about relationship management and clear communication as they are about legal structure.
Facing a valuation gap in your current deal? The templates and guardrails above can bridge the difference while protecting both parties' interests. But the details matter enormously—and getting them wrong is expensive.
Let's discuss how to structure an earnout that actually works for your specific situation. In this market, the deals that close are often the ones with the smartest risk-sharing mechanisms.
Brett Vogeler
Business & Commercial Real Estate Broker
"Straight-shooting advice for complex transactions"
P.S. - The Delaware courts have made it clear: ambiguous earnout terms lead to expensive litigation with uncertain outcomes. Invest in proper structure upfront, or pay for it in legal fees later. The choice is yours.
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