Earnouts Done Right

Earnouts have quietly become one of the most common features of lower middle market M&A transactions. The reason is straightforward; the valuation gap between what sellers believe their business is worth and what buyers are willing to pay at close has not changed meaningfully since the peak deal-making environment of 2021. Earnouts are how both sides agree to disagree and still get to the table.

That is a legitimate function. The problem is not the earnout itself. The problem is how most of them are built.

The Metric Is Everything

I’ve heard it said, "The earnout is the headline in the lawsuit."

This is increasingly common in the current market. Even with parties’ best intentions, earnout disputes have risen sharply as the transactions structured during the post-2021 valuation crunch have reached the end of their calculation periods. Delaware courts have seen a steady increase in earnout litigation, with most conflicts centering on a version of the same question: did the business hit the target, and who is responsible for the outcome?

Most of the time, the answer depends less on what actually happened in the business than on how the earnout metric was written. A poorly chosen metric does not just create ambiguity. It creates perverse incentives that work against the very outcome both sides shook hands on.

Revenue is the most common earnout metric, and it carries a specific risk that is easy to overlook. A leadership team can hit a revenue target by chasing low-margin contracts or offering aggressive terms to existing customers, collecting the earnout while quietly leaving behind a business with a weaker margin profile than the one that was sold. The seller gets paid. The business suffers. This is not a hypothetical. It is a predictable consequence of measuring the wrong thing.

EBITDA sits at the other end of the problem. According to SRS Acquiom, only 22% of earnouts in 2024 used EBITDA as the primary metric [1], and with good reason. Once a buyer controls the business, they also control every line item below gross profit. New hires, technology investments, headquarters allocations, accounting treatment on capital expenditures, all of which flows through EBITDA. A buyer can make entirely reasonable, entirely legitimate operating decisions that happen to push EBITDA below the earnout threshold, and the seller has almost no recourse. The metric itself opened the door.

That is not necessarily bad faith. It is a structural problem that poor metric selection creates, and one that better alignment up front can prevent.

A Cleaner Approach

At West Elk, we tend to build earnouts around gross profit or contribution margin. The logic is simple. Gross profit captures the core economic performance of the business. It rewards the seller for genuine growth, it is largely within the seller's influence during the earnout period, and it sits above the line where buyer discretion over OPEX investment lives. When we make decisions about hiring, technology, or infrastructure in year one, those are our decisions to make and our dollars to spend. They should not determine whether a founder gets paid for the pipeline they handed us.

We also keep earnout periods short. The longer the period, the more variables accumulate that neither party can fully control: markets shift, personnel changes, and unexpected events create noise that obscures whether the underlying business actually performed. A well-structured twelve-month earnout tied to a clear gross profit target gives both sides a clean answer at the end of the year.

This approach requires something from us too. Building an earnout on gross profit means we have to be transparent about the operating plan at the outset. We sit down with the seller before close and design a spending plan that fits the growth thesis. That conversation is harder than handing someone an EBITDA target. But it is the right one to have, and it is a better signal of partnership than any language in the purchase agreement.

At West Elk, we are committed to partnering with people we like, trust, and respect. That matters in an earnout context because no contract eliminates every gray area. When a question arises during the earnout period, the relationship is often what determines whether it gets resolved over a conversation or over a courtroom table. Structure and trust work together. Neither one substitutes for the other.

The Signal in the Structure

Founders do not always get a long runway to evaluate the buyer sitting across from them. The sale process moves quickly, and by the time earnout terms are on the table, both sides are usually ready to get to closing. But the earnout conversation is one of the clearest signals a seller will receive about who they are actually partnering with.

A buyer who insists on measuring EBITDA while reserving full discretion over operating decisions is asking the seller to trust a metric the buyer controls. A buyer who is willing to be measured on gross profit, who collaborates on an operating plan early, and who keeps the earnout period short enough to be meaningful is sending a different message entirely.

Before signing, sellers and their advisors should ask a simple question: does the earnout metric reflect performance I can actually see, influence, and verify? The answer to that question will tell you a great deal about what the next few years with your new partner are likely to look like.

[1] SRS Acquiom 2025 M&A Deal Terms Study, analyzing more than 2,200 private-target acquisitions that closed from 2019 through 2024. Data excludes life sciences transactions.