Understanding Earnouts: Key Strategies for M&A Success

Introduction: The Ticking Clock in M&A Contracts

Earnouts are attractive. They align interests, bridge valuation gaps, and allow buyers to pay for performance. But they are also legal powder kegs. At the center of most earnout litigation lies a deceptively vague phrase: “commercially reasonable efforts.” This blog explores how to draft these clauses, anticipate disputes, and implement resolution mechanisms that preserve deal value.

The Ambiguity of Reasonable Efforts

What constitutes “commercially reasonable efforts”? Courts have interpreted this differently across jurisdictions. Some equate it to good faith; others see it as a measurable obligation akin to what a reasonable business would do in similar circumstances.

In one transaction I worked on, the seller claimed that the buyer did not pursue a key product launch aggressively enough, leading to a missed earnout. The buyer argued market conditions had shifted. We had no benchmarks in the agreement. That omission led to a costly arbitration.

Drafting with Specificity

To reduce ambiguity, earnout clauses should include:

• Objective performance targets (e.g., revenue, EBITDA)
• Clear timeframes and calculation methodologies
• Defined efforts standards with examples (e.g., maintain sales team headcount)
• Reporting frequency and transparency rights for sellers

In one software deal, we included a covenant that required the buyer to maintain a minimum R&D budget for the acquired product line. That clause became the keystone in avoiding litigation.

Governance Rights and Audit Access

Earnout contracts often grant sellers the right to monitor performance. This includes:

• Board observer rights
• Access to monthly financials
• Independent audit triggers if disputes arise

One seller negotiated a right to appoint an audit firm if earnout targets were not met. That right, though rarely exercised, served as a deterrent to manipulation.

Dispute Resolution Mechanisms

Avoiding court battles requires upfront clarity. Mechanisms include:

• Accounting arbitration (“baseball arbitration”)
• Mediation before litigation
• Use of neutral third-party experts

We now routinely include a 45-day mediation clause followed by binding arbitration to resolve earnout disputes. It keeps parties focused and timelines tight.

Interplay with GAAP and Accounting Choices

Buyers must be careful about post-close accounting that affects earnout triggers. Revenue recognition, reserve policies, or changes to cost allocations can distort earnout metrics.

One seller sued when the acquirer reclassified customer incentives as contra-revenue, reducing the top line and eliminating the earnout. The court sided with the seller, citing deviation from past accounting policies.

Conclusion: Earnouts Are Not Self-Executing

They require foresight, discipline, and trust—backed by legal architecture. CFOs should treat earnout mechanics as part of the financial model, legal framework, and governance plan. When done right, earnouts build alignment. When done wrong, they destroy value.

Insight

Over the last three decades, I have negotiated, structured, and lived through dozens of earnout arrangements. These tools of deferred consideration are deceptively attractive. They promise alignment and upside, but without precision and mutual trust, they quickly become a source of friction, mistrust, and litigation. As a CFO, I have come to regard earnouts as both a financial engineering tool and a psychological contract. They sit at the intersection of math, law, and human behavior.

The problem begins with the phrase “commercially reasonable efforts.” It sounds businesslike, even reassuring. Yet courts have shown remarkable inconsistency in interpreting what this standard actually means. In some jurisdictions, it implies a minimal level of good faith; in others, it suggests a rigorous, almost fiduciary-level obligation. In one high-stakes SaaS acquisition I was involved in, we missed the earnout by a razor-thin margin. The seller alleged that we had not allocated sufficient marketing dollars, even though we exceeded our overall budget. There were no minimum spend thresholds or marketing KPIs in the contract. We had a seven-month arbitration, and the legal fees dwarfed the earnout at issue. Since then, I insist on embedding numerical and operational thresholds into every earnout clause I touch.

The biggest mistake I see in earnout structuring is the assumption that parties will behave in post-close harmony. That is a dangerous bet. Even the most cordial of buyers and sellers find themselves at odds once integration stress, cultural differences, and financial pressure come into play. That is why the drafting process must not only define performance metrics clearly—typically revenue or EBITDA—but also lay out the operating conduct that governs how those metrics are achieved. Does the acquirer have to maintain the sales team? Retain the product line? Fund R&D at a specific level? These are not minor questions. They go to the heart of earnout achievement.

In one software acquisition, we learned this the hard way. The product had niche appeal and required a highly trained pre-sales force. Post-close, our integration team restructured the sales org and reassigned key personnel. Unsurprisingly, the earnout was missed. The seller sued, claiming a breach of the implied duty of good faith. They had a point. There was no clause protecting continuity. That was an expensive omission.

Now, we use a playbook that includes language like “buyer shall maintain no less than 90% of the seller’s salesforce for the earnout period” or “R&D funding for the acquired product line shall not fall below a three-month average of pre-close levels.” These provisions may seem heavy-handed, but they provide clarity. And clarity, in earnouts, is the antidote to litigation.

Sellers also need visibility. Many earnout disputes arise not from actual manipulation but from lack of trust. That trust erodes when sellers feel they are operating in the dark. Giving them periodic access to financial reports, sales data, and operational dashboards can prevent disputes before they start. I have used board observer roles and quarterly business reviews with sellers to maintain alignment. In one case, we included a provision that allowed the seller to hire an independent auditor if they disputed the earnout calculation. We never triggered that clause, but its mere existence ensured rigor in our reporting.

Dispute resolution is another area that requires proactive thinking. Traditional litigation is slow, expensive, and public. I prefer multi-tiered mechanisms that escalate sensibly: start with informal resolution, proceed to mediation within 30 to 45 days, and if necessary, go to binding arbitration. In accounting disputes, we often use baseball arbitration—each side submits a number, and the arbitrator picks one. This discourages extreme positions and keeps the process focused. We also pre-designate acceptable arbitrators in the purchase agreement. That removes negotiation friction when tensions are high.

One overlooked area is the accounting framework. Changes to revenue recognition, expense timing, or reserve policies post-close can significantly impact whether earnout targets are hit. GAAP allows for judgment in many areas. That discretion becomes contentious if the earnout is tied to financials. In one transaction, our buyer-side team changed how we accounted for discounts, moving from gross to net revenue. That change reduced recognized revenue and nullified the earnout. We were sued. The court looked at our past policies and sided with the seller. Since then, we tie earnout calculations to pre-close accounting policies and explicitly prohibit material changes without mutual agreement.

Another critical element is how earnouts are modeled. Too often, they are built as add-ons in the financial model, rather than as integrated scenarios. I require our finance teams to build multiple post-close operating cases with earnout sensitivities included. This allows the board to understand what behaviors lead to earnout payouts and whether those behaviors are aligned with our strategy. It also ensures that the purchase price is properly bifurcated between fixed and contingent elements in both accounting and cash planning.

CFOs must also assess the signaling effect of earnouts. Investors, lenders, and employees look at the structure and interpret it. If the earnout is overly aggressive, it may suggest lack of confidence in projections. If it is too generous, it may raise questions about capital discipline. I once had a board member ask why we had structured a $20 million earnout when the base case probability of payout was under 15%. That led to a reevaluation and a more nuanced structure, with stepped thresholds and equity-based consideration.

We must also consider how earnouts interact with cultural integration. Sellers often stay on as leaders of the acquired business. Their motivation is linked to the earnout. If they feel the target is unattainable, their morale declines, turnover increases, and integration suffers. We use periodic alignment sessions to recalibrate expectations and reinforce shared goals. When possible, we structure earnouts over shorter periods—12 to 18 months—and use graduated targets rather than binary thresholds. This preserves momentum and reduces adversarial tension.

In conclusion, earnouts are not self-executing. They require engineering, foresight, and governance. CFOs must approach them not just as a financial clause but as a multi-dimensional instrument that affects behavior, risk, and value. The best earnouts I have seen are those where both sides believe the structure is fair, achievable, and transparent. That only happens when every term is scrutinized, every ambiguity resolved, and every dispute mechanism stress-tested.

Disclaimer: This article is for informational purposes only and does not constitute legal, tax, or financial advice. Always consult qualified advisors before structuring or negotiating earnouts.

Disclaimer: This article is for informational purposes only and does not constitute legal, tax, or financial advice. Always consult qualified advisors before structuring or negotiating earnouts.