Quick facts
- What it is: part of the purchase price, paid later and only if targets are met
- Why buyers want it: it reduces the risk of overpaying
- Why sellers accept it: it bridges a disagreement about value
- The risk: the seller loses operational control the day the deal closes
- What decides disputes: the efforts covenant, read as written
An earnout defers part of the purchase price and makes it contingent on the acquired business hitting agreed targets after closing.
It is how buyers and sellers who cannot agree on value close a deal anyway. It is also how they postpone the argument rather than resolve it.
In plain English
The Delaware Court of Chancery put the structure plainly in Fortis Advisors LLC v. Johnson & Johnson. An earnout means "a sum and an additional amount if the seller's business achieves specific targets by a deadline," and this "contingent approach lessens the buyer's risk of overpaying where the seller's future performance is uncertain."1
Then the sentence sellers should read twice: "The seller, however, risks losing the earnout payment along with operational control after closing."1
That is the asymmetry. You are paid based on future performance, in a business you no longer run, by the party who decides how much support it receives.
The clause the whole thing turns on
Because the buyer controls the business after closing, every earnout carries a covenant about the effort the buyer must apply. That covenant, not the targets, is where disputes are won and lost.
Fortis shows what a well-drafted one looks like. Johnson & Johnson offered "$3.4 billion up front and another $2.35 billion upon the achievement of two commercial and eight regulatory milestones" for Auris Health. Critically, "Auris agreed to an earnout component after securing J&J's commitment to devote commercially reasonable efforts befitting a 'priority medical device' in furtherance of the milestones."1
Auris did not simply accept milestones. It bought a standard of effort, tied to a defined internal priority level. The court found that "J&J's promise to Auris was broken almost immediately after closing."1
Why the drafting matters more than the fairness
Delaware reads these clauses as written, and the contrast between two cases makes the point.
In Lazard Technology Partners, LLC v. Qinetiq North America Operations LLC, the buyer "paid $40 million up-front to the company and promised to pay up to another $40 million if the company's revenues reached a certain level." The merger agreement prohibited the buyer from "tak[ing] any action to divert or defer [revenue] with the intent of reducing or limiting the Earn-Out Payment."2
The revenues fell short. The seller sued for breach and argued the implied covenant of good faith and fair dealing required the buyer to take steps that would have generated sufficient revenue.2 The Delaware Supreme Court affirmed against the seller.
Look at the difference in language. Lazard had an intent standard, which requires proving the buyer deliberately suppressed revenue to avoid paying. Fortis had an affirmative commercially reasonable efforts obligation pegged to a named priority, which requires the buyer to actually do something.
One clause prohibits sabotage. The other requires effort. Sellers frequently sign the first believing they have the second.
Why the implied covenant will not rescue you
Sellers reach for the implied covenant of good faith and fair dealing when the express words fail them. It rarely works, for the reason Delaware gives in a related context: acquisition agreements "are heavily negotiated and cover a large number of specific risks explicitly."3
Where sophisticated parties addressed a risk expressly, courts are reluctant to supply a better bargain than the one that was struck. The implied covenant fills genuine gaps. It does not upgrade an intent standard into an efforts standard.
What to negotiate
The efforts standard. Commercially reasonable efforts, defined, beats good faith. Better still when tied to something objective: a named priority level, a specified budget, or efforts comparable to those the buyer applies to its own similar products.
Operational protections. Restrictions on the buyer moving the team, folding the product into a competing line, changing accounting treatment, or reallocating sales resources away from the acquired business.
Measurement. Who calculates achievement, on what accounting basis, and what happens when the parties disagree. An independent expert with a defined remit is worth more than a dispute clause pointing at litigation.
Information rights. You cannot enforce a covenant you cannot observe. Regular reporting against milestones is the minimum.
Acceleration. What happens if the buyer resells the business, discontinues the product, or reorganises it out of existence. Without an acceleration clause, those events can extinguish the earnout entirely.
What this means for a founder
Treat the up-front number as the price, and treat the earnout as an option you might never exercise.
This matters most where a liquidation preference sits above you. If preferred stock absorbs most of the closing payment, the common stock's actual return may depend almost entirely on earnout payments arriving years later, from a business you no longer control, under a covenant nobody read closely because the headline number looked adequate.
Model the deal at the up-front amount alone. If that outcome is unacceptable, the earnout is not a bridge to a higher price. It is the reason you accepted a lower one.
Related reading
- Material Adverse Change Clause covers the other clause that keeps price open after signing
- Liquidation Preference covers who receives the closing payment before common stock does
- Break-Up Fee covers what is owed when a deal dies before closing
- Go-Shop Provision covers testing the price before accepting a contingent one