Why Earnouts Are a Heavily Litigated Feature of M&A Transactions
In small-market mergers and acquisitions (under $50,000,000), closing day feels like the finish line. The purchase agreement is executed, funds are wired, and both buyer and seller pause to celebrate a successful transaction.
Yet with an earnout provision, closing day marks a beginning rather than an end. When part of the purchase price depends on hitting post-closing financial targets, parties enter a whole new chapter. Far too often, that chapter ends in litigation.
Bridging the Valuation Gap
An earnout is a risk-sharing mechanism where part of the purchase price is deferred and contingent on the business meeting agreed-upon targets post-closing. Usually tied to metrics such as revenue, EBITDA, or operational milestones over a one- to three-year period, it bridges the valuation gap between an optimistic seller and a cautious buyer. For instance, an earnout might promise the seller an extra $1 million if the company hits $5 million in EBITDA over the next two years.
Though an ideal compromise on paper, earnouts are in practice among the most heavily litigated structures in transaction law.
The Shift in Operational Control
The root cause of most earnout disputes is simple: control changes hands.
Once a deal closes, management of the operating environment shifts entirely to the buyer. Key decisions regarding marketing budgets, hiring, capital expenditures, and product strategy now rest in new hands. If performance later falls short of the earnout threshold, disputes almost inevitably arise over why.
When an earnout fails to pay out, two major legal flashpoints routinely emerge:
1. Accounting Methodology & Revenue Allocation
The contract may state that EBITDA will be calculated in accordance with Generally Accepted Accounting Principles (GAAP) consistent with past practice. However, GAAP leaves ample room for interpretation.
- How are revenues recognized on multi-year customer contracts?
- Were discretionary expenditures delayed or accelerated to shift numbers across fiscal periods?
Without detailed accounting rules written into the purchase agreement, post-closing earnout calculations frequently devolve into a battle of accounting experts.
2. Post-Close Integration & Changes in Strategy
If a buyer pivots the business model post-closing, such as discontinuing a legacy product line to integrate its underlying technology into a broader software suite, the legacy entity’s standalone EBITDA may collapse, even if the integration is a resounding commercial success for the buyer.
The Bottom Line for Buyers and Sellers
Earnouts should never be viewed as “easy money” or a quick fix to get past a deadlock over valuation. If you use an earnout to close a deal, you must anticipate how the post-closing business will be operated and accounted for down to the line item.
If you are contemplating a business purchase or sale, or currently face a post-closing transaction dispute, contact C. Michael Kvistad and the Business & Real Estate team at Beresford Booth. 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.