Earnouts are the most-litigated provision in US M&A. They defer a portion of the purchase price for an acquired business until post-closing performance milestones are achieved. For sellers, they are a way to bridge a valuation gap and capture upside; for buyers, they align price with actual realised value. The economic logic is sound — but the operational reality is fraught with disputes about how the business should be run after closing, what counts as revenue or EBITDA, and whether the buyer has frustrated the earnout intentionally. Delaware courts (where many US M&A deals are governed) have developed a sophisticated body of law on earnouts, including the implied covenant of good faith and fair dealing — which limits the buyer's freedom to operate the acquired business in ways that depress the earnout. But the statutory rules are limited, and the contract terms are paramount. The most important provisions are: (1) the earnout metric definition, (2) operating covenants restricting buyer's behaviour, (3) integration and allocation rules, and (4) dispute resolution mechanics.
What is a Earnout Clause?
An earnout clause in a US share purchase agreement is a contractual provision deferring a portion of the consideration for an M&A transaction until specified post-closing performance milestones are achieved over a defined period (typically 1–5 years). It is governed by Delaware General Corporation Law and Delaware contract case law (most US M&A deals are governed by Delaware law); California Corporations Code; New York General Business Law; and applicable federal securities laws (Securities Act of 1933, Exchange Act of 1934) where the consideration includes registered or restricted securities. Disputes are typically heard in the Delaware Chancery Court or applicable arbitral forum.
Red flags to watch for
EBITDA is defined many ways in M&A. 'Adjusted' EBITDA can include or exclude restructuring charges, transaction fees, integration costs, non-recurring items, and management compensation changes. Without a precise definition — typically with examples worked through on the seller's historical financials — the buyer can manipulate the metric post-closing.
If the buyer can lay off staff, redirect customers to its other businesses, integrate the acquired business into a larger product line, or change pricing — all without restriction — the earnout becomes a fiction. Operating covenants typically require the buyer to maintain the business 'consistent with past practice' or 'in the ordinary course' for the earnout period.
If the buyer prepares the earnout calculation and the seller has limited audit rights, the buyer effectively determines the earnout. A balanced earnout includes seller audit rights (with reasonable scope), an independent accountant for disputes, and a binding determination process with clear timelines.
Some agreements attempt to exclude the implied covenant of good faith and fair dealing — saying the buyer's decisions are 'in its sole discretion' or 'no implied covenants apply.' Delaware courts have been reluctant to enforce such exclusions for fundamental obligations like running an acquired business in good faith — but the language adds litigation cost and uncertainty.
If the buyer is itself acquired during the earnout period, the new owner may have different incentives and may not honor the earnout. Acceleration provisions trigger immediate payment (often at a discount) on buyer change of control, protecting the seller against this risk.
If earnout is paid in buyer stock — particularly for a private buyer — liquidity is an issue. The agreement should specify registration rights, lock-up periods, and tag-along rights consistent with a real exit path. Without these, the seller may receive nominally valuable stock with no realistic ability to monetise.
Your legal rights
US sellers in M&A transactions with earnouts are protected by: Delaware General Corporation Law (DGCL); Delaware contract case law on earnouts (e.g., Lazard Technology Partners v. Qinetiq, 114 A.3d 193 (Del. 2015); Winshall v. Viacom, 76 A.3d 808 (Del. 2013); Fortis Advisors v. Dialog Semiconductor, 2015 WL 401371 (Del. Ch.)); the Delaware implied covenant of good faith and fair dealing; the Securities Act of 1933 (15 U.S.C. § 77a et seq.) and Exchange Act of 1934 (15 U.S.C. § 78a et seq.) for transactions involving registered securities; FTC Hart-Scott-Rodino antitrust review provisions; and state-specific blue sky laws where applicable. Disputes are typically heard in Delaware Chancery Court (for Delaware-governed agreements) or applicable arbitral forum.
Questions to ask before you sign
- 1How is the earnout metric (typically EBITDA, revenue, or unit volume) defined, with what specific exclusions and inclusions?
- 2What operating covenants restrict buyer's behaviour during the earnout period?
- 3What audit rights and dispute resolution procedure apply to the earnout calculation?
- 4Is the implied covenant of good faith preserved, or have any 'sole discretion' or 'no implied covenants' clauses been inserted?
- 5What happens to unpaid earnout on a buyer change of control, and is there acceleration?
- 6If earnout is paid in stock, what are the liquidity, registration, and lock-up provisions?
Disclaimer: This guide is for educational purposes only and does not constitute legal advice. Contract law varies by jurisdiction and individual circumstances. Always consult a qualified legal professional before making decisions based on this information.