Earnout provisions are among the most frequently litigated terms in business sale agreements. When a buyer and seller cannot agree on the value of a business at the time of sale, earnout arrangements offer a compromise: the seller receives an initial payment at closing plus additional payments tied to the acquired business’s future performance. In theory, this aligns the interests of both parties. In practice, earnouts frequently become the source of bitter disputes after the deal closes.
This article explains how earnout provisions work, why they so often lead to litigation, the legal standards courts apply to earnout disputes, and how business owners in Houston, The Woodlands, Spring, Cypress, Sugar Land, Missouri City, and Richmond can protect themselves both when negotiating a deal and when a dispute arises after the fact.
How Earnout Provisions Work
An earnout is a contractual arrangement in which the purchase price for a business includes a contingent component based on the future performance of the acquired company. After the deal closes, the seller receives additional payments if the business meets agreed-upon performance milestones, which are typically expressed in financial terms such as revenue, EBITDA, or net income over a specified period.
Earnouts are particularly common when there is a valuation gap between buyer and seller. The seller believes the business will perform well going forward and deserves a high price. The buyer is skeptical and unwilling to pay a premium based on future performance that has not yet materialized. An earnout bridges this gap by allowing the seller to participate in the upside if their projections prove correct, while limiting the buyer’s risk if the business underperforms.
Why Earnout Disputes Are So Common
The fundamental problem with earnouts is that after the deal closes, the buyer controls the business. The buyer makes all operating decisions, including those that directly affect the financial metrics on which the earnout payment is calculated. If the buyer has an incentive to minimize earnout payments, they can do so through a variety of decisions that are entirely within their authority as the business owner: cutting expenses that boost short-term earnings, redirecting customers to other business units, changing accounting methodologies, or simply failing to invest in growing the acquired business.
Sellers, who no longer control the business, often see these post-closing management decisions as deliberate manipulation of the earnout metrics rather than legitimate business judgment. The result is litigation over whether the buyer managed the business in good faith and in a manner consistent with the earnout provisions.
The Implied Covenant of Good Faith
Most earnout disputes center on the implied covenant of good faith and fair dealing and any express operating covenants in the purchase agreement. Courts have consistently held that a buyer cannot deliberately take actions designed to prevent the seller from earning earnout payments that the seller would otherwise have earned.
However, defining what constitutes bad faith in the management of an acquired business is challenging. Buyers have the right to make legitimate business decisions, including ones that negatively affect earnout performance. The line between legitimate business judgment and bad faith manipulation of earnout metrics is often disputed and requires careful examination of the specific facts of the transaction.
Express Operating Covenants
Well-drafted purchase agreements include express operating covenants that specifically constrain the buyer’s management of the business during the earnout period. These covenants might require the buyer to:
- Operate the acquired business as a separate unit
- Maintain specified staffing levels
- Continue marketing efforts at levels consistent with pre-closing practices
- Not merge the acquired business into another unit
- Maintain accounting methodologies consistent with the seller’s historical practices
- Pursue business opportunities in the acquired company’s market segment
The specificity of these covenants is critical. Vague promises to use commercially reasonable efforts or to operate the business in the ordinary course often provide insufficient protection to sellers in earnout disputes.
Accounting and Definitional Disputes
Earnout disputes frequently involve technical disputes about how financial metrics should be calculated. What counts as revenue? Are intercompany transactions between the acquired business and other business units included? How are expenses allocated between the acquired business and the buyer’s other operations? What accounting principles apply to revenue recognition?
These definitional disputes can be enormous in their financial impact. A change in how the buyer allocates overhead expenses, for example, can dramatically reduce the EBITDA on which an earnout is calculated, transforming a significant earnout payment into nothing. Courts examine the purchase agreement carefully to determine how these calculations should be made, and disputes often require expert accountants to analyze the relevant books and records.
Dispute Resolution Mechanisms
Purchase agreements often include specific dispute resolution mechanisms for earnout disputes. These typically provide that if the parties disagree about the earnout calculation, they submit the dispute to an accounting firm or an independent expert for resolution. These independent expert provisions are designed to provide a faster, cheaper alternative to full litigation for accounting-based disputes.
However, independent expert provisions have their own limitations. Questions about whether the buyer operated the business in good faith, or whether the purchase agreement’s operating covenants were violated, are legal questions that may not fall within the scope of an independent accounting expert’s authority. These issues may still require litigation even if the accounting disputes are resolved through the contractual mechanism.
Remedies in Earnout Disputes
Sellers who prevail in earnout disputes can typically recover the unpaid earnout amounts, plus interest. In cases where the buyer’s conduct was particularly egregious, courts may also award consequential damages or, in cases involving fraud or intentional misconduct, potentially punitive damages.
Sellers may also seek specific performance of earnout provisions, asking the court to order the buyer to take the actions required to give the earnout a fair opportunity to be earned. However, courts are sometimes reluctant to supervise ongoing business operations through specific performance orders, and monetary damages are often the more practical remedy.
Protecting Yourself When Negotiating an Earnout
The best protection against earnout disputes is careful drafting at the time the deal is negotiated. Sellers should insist on:
- Clear, objective, and unambiguous definitions of the financial metrics on which the earnout is based
- Specific operating covenants restricting the buyer’s management discretion during the earnout period
- Accounting methodology provisions requiring consistency with historical practices
- Audit rights that allow the seller to verify the accuracy of the buyer’s earnout calculations
- Anti-sandbagging provisions preventing the buyer from crediting pre-closing representations against earnout obligations
Buyers, on the other hand, should resist overly specific operating covenants that unduly restrict their management flexibility, ensure that the earnout metrics are clearly defined and calculated consistently with how they expect to manage the business, and establish clear dispute resolution procedures.
How Anunobi Law Can Help
Earnout disputes can be complex, fact-intensive, and financially significant. Anunobi Law represents both buyers and sellers in M&A earnout disputes throughout Houston, The Woodlands, Spring, Cypress, Sugar Land, Missouri City, and Richmond. Whether you are negotiating an earnout provision or litigating a post-closing dispute, our attorneys have the experience to protect your interests. Call us at 1-855-538-0863 today.
Legal Disclaimer: This article is provided for informational purposes only and does not constitute legal advice. The information contained herein is general in nature and may not apply to your specific situation. Reading this article does not create an attorney-client relationship between you and Anunobi Law. Laws and regulations vary by jurisdiction and are subject to change. You should consult a qualified attorney regarding your specific legal circumstances before taking any action. Anunobi Law makes no representations or warranties regarding the accuracy or completeness of the information in this article.
Metadata Description:
Understand earnout disputes in mergers and acquisitions, including how earnouts work, why they lead to litigation, and how to protect your rights. Anunobi Law represents buyers and sellers in M&A disputes throughout Houston, The Woodlands, Spring, Cypress, Sugar Land, Missouri City, and Richmond.
Keywords:
earnout dispute Texas, M&A earnout litigation Houston, post-closing dispute Texas, earnout fraud buyer, operating covenants earnout, earnout attorney Texas, business sale dispute Houston, mergers acquisitions attorney Texas, Anunobi Law M&A disputes, earnout calculation dispute