Earnouts in a Volatile Market

When valuation gaps widen, earnouts come back. We are seeing them in roughly 38% of middle-market deals we tracked in the second half of 2025, up from 22% a year earlier. The conditions driving the resurgence are familiar: rate uncertainty, choppy revenue trajectories in growth companies, and a generation of sponsor-owned assets where the seller's price expectation reflects a 2021 multiple and the buyer's bid reflects 2025 reality.

An earnout, properly structured, can bridge that gap. Improperly structured, it converts a closed deal into a multi-year dispute. The Delaware Court of Chancery's docket continues to be heavy with earnout litigation, and the published opinions teach a consistent lesson: the disputes that reach trial almost always trace back to drafting choices that were knowable - and avoidable - at signing.

Five principles consistently separate the earnouts that close cleanly from the ones that end in litigation.

First, the metric must be unambiguous. Revenue, gross profit, EBITDA, and unit volume each behave differently under accounting choice and operational change. The most litigated earnouts are the ones tied to ambiguous metrics - 'adjusted EBITDA' without a defined adjustment list, 'net revenue' without a defined cost-of-revenue treatment, or 'new customer revenue' without a defined customer. Pick a metric the parties can compute the same way without consulting each other.

Second, the accounting framework must be specified at the level of detail that an auditor - not just a CFO - can apply. A reference to 'GAAP, consistently applied with the seller's historical practice' is a starting point, not a finish line. The agreement should attach an exhibit listing the specific accounting policies, an illustrative calculation against a recent period, and a clear hierarchy when GAAP, historical practice, and a specifically-negotiated treatment conflict.

Third, the conduct-of-business covenants must be aligned with the metric. If the earnout is on revenue, the buyer cannot have unilateral discretion to reorganize the sales force, change pricing, or repoint distribution channels in a way that suppresses revenue without consequence. The clauses we see work best are those that distinguish between ordinary-course operating decisions (buyer's discretion) and changes that materially and adversely affect the metric (subject to consent or to a make-whole). Outright 'best efforts to maximize the earnout' covenants invite litigation; structured covenants that anticipate the actual operating decisions invite cooperation.

Fourth, the audit right must be real. The seller's representative should have access to the underlying books and records - not just the calculation - within a defined window, with a defined dispute-resolution path, and with a defined fee-shifting rule. The all-too-common 'thirty days to dispute, with all disputes referred to an independent accounting firm' clause works in principle but routinely fails in practice when the records are slow to arrive and the thirty days run out before review is complete.

Fifth, the dispute-resolution path should not default to general litigation. An expert determination by a named accounting firm, with a defined scope (computational disputes only) and a separate path for breach-of-covenant claims (litigation in a chosen forum), keeps the small disputes small and the large disputes manageable.

Beyond the drafting, two structural choices matter at least as much. The duration of the earnout should match the operational reality of the metric - a one-year revenue earnout in a long-sales-cycle business is rarely a fair test, and a five-year earnout in a fast-moving consumer business invites years of operational tension. And the size of the earnout relative to the up-front purchase price should reflect a defensible probability-weighted view of the outcomes - not a price the seller will only feel paid if everything goes right.

We continue to advise clients that an earnout is a useful tool for bridging genuine differences of view about the trajectory of the business. It is a poor tool for splitting the difference on a price negotiation in which the parties have not actually agreed on what the business will do. When in doubt, we push for a smaller, shorter, simpler earnout against a clearer metric, with a larger up-front cash component. The deals that close on those terms tend to be the deals we never hear about again.

What we are watching

We will return to this topic across the coming quarter. If you are actively negotiating a transaction where these issues are live, we'd welcome a confidential conversation.

Three takeaways

• The market is settling, but the diligence bar is rising.
• Preparation, not posture, is the source of speed.
• The right structure can move price more than another round of negotiation.