How Buyers and Sellers Can Mitigate Earnout Risk Before Closing
As discussed in my previous post, earnouts can bridge significant valuation gaps between buyers and sellers in middle-market M&A. However, because operational control shifts to the buyer after closing, these provisions frequently lead to bitter post-sale litigation if the financial targets are not met.
The best time to prevent earnout litigation is not after the earnings report comes in. It is during the drafting phase of the Purchase and Sale Agreement.
When structuring an earnout, both parties can protect themselves by focusing on three critical contractual areas:
1. Define the Duty to Operate (Efforts Clauses)
Sellers routinely allege that buyers deliberately mismanaged the business post-closing or withheld promised resources to avoid hitting earnout triggers. Litigation frequently centers on the contractual standard governing buyer conduct:
- Sole Operational Discretion: Protects the buyer’s right to run the business as they see fit, provided they do not act in bad faith to intentionally defeat the earnout.
- “Commercially Reasonable Efforts”: Requires the buyer to operate the business in a manner consistent with industry standards, but leaves significant room for interpretation.
- “Best Efforts”: A higher standard that can severely restrict a buyer’s flexibility to adapt to changing market conditions.
Unless explicitly defined in the agreement, Washington courts are left to interpret what “commercially reasonable” means within the context of the specific industry and economic climate.
2. Define Accounting Rules Explicitly
Do not rely solely on boilerplate phrases like “GAAP applied consistent with past practice.” GAAP is a broad framework, not a precise set of instructions for every line item.
To prevent post-closing disputes, attach an explicit accounting schedule to the agreement detailing:
- How intercompany expenses and corporate overhead will be allocated.
- How capital expenditures will impact EBITDA calculations.
- Which revenue recognition rules apply to ongoing or multi-year contracts.
3. Establish a Dedicated Dispute Resolution Mechanism
If a dispute arises over an earnout calculation, taking the matter straight to court is expensive, public, and time-consuming.
Instead, build an expedited, specialized dispute resolution procedure into the contract. Requiring an independent accounting firm, acting as an expert rather than an arbitrator, to review the calculations and render a binding decision within 30 to 60 days can save hundreds of thousands of dollars in legal fees.
Final Thoughts
Earnouts can save a deal, but poorly drafted earnouts invite costly litigation long after the champagne has gone flat. Whether you are buying or selling a business in Washington, working alongside an experienced attorney during negotiations is the single best way to ensure your earnout works as intended.
Whether you are preparing to negotiate an M&A agreement or navigating a post-closing dispute, C. Michael Kvistad and the Business & Real Estate team at Beresford Booth are here to assist. The lawyers at Beresford Booth have extensive experience dealing with all types of business and real estate issues. Contact us at info@beresfordlaw.com or call (425) 776-4100 to see how we can help.