This is Part 2 of a two-part series on structuring and enforcing earnouts in middle-market M&A transactions. If you missed it, read Part 1: Revenue vs. EBITDA: Choosing the Right Earnout Metric to see how setting the right financial targets impacts the deal.
When a merger or acquisition utilizes an earnout to bridge a valuation gap, the closing date does not mark the end of risk for the seller. Once ownership transfers, the buyer controls the operational levers that dictate whether revenue, gross margin, or EBITDA targets will actually be reached. Sellers frequently assume that if a buyer later sets aside the target company, redirects business opportunities, or alters accounting practices post-closing, Washington contract law provides an automatic fix.
In practice, relying on general principles of contract law after a dispute arises is a precarious legal strategy. While Washington courts recognize the implied covenant of good faith and fair dealing in every contract, this covenant cannot be used to create new obligations that were omitted from the definitive agreement or to rewrite the bargain struck by sophisticated parties. If a purchase agreement grants the buyer complete discretion to manage the business following the transaction, Washington courts will generally enforce that grant of authority, even if the buyer’s decisions negatively affect the contingent consideration.
To effectively protect earnout consideration under Washington law, sellers and their counsel must negotiate specific, detailed operational covenants within the purchase agreement.
1. Operational Autonomy and Standalone Business Covenants
A major point of failure with earnouts occurs when a buyer integrates the acquired business into its existing corporate enterprise. Once operational functions, sales teams, supply chains, and customer bases are merged, isolating the specific financial performance of the target entity becomes nearly impossible.
To safeguard the calculation of earnout targets, sellers must negotiate affirmative covenants requiring the buyer to operate the business as a distinct, standalone subsidiary or operating unit during the earnout period. This provision should explicitly limit the buyer’s right to reallocate sales representatives, transfer key customer contracts to affiliate entities, or discontinue core product lines without the seller’s written consent.
2. Detailed Accounting Definitions and Overhead Allocation Rules
Earnout calculations based on financial metrics like EBITDA or net income are inherently subject to post-closing accounting adjustments. Without explicit contractual guardrails, buyers can load the target company with corporate overhead fees, management service charges, or extraordinary expenses that reduce net earnings on paper.
Purchase agreements should define accounting practices with meticulous detail, specifying that financial performance must be calculated consistently with the seller’s historical accounting methods or GAAP as applied prior to closing. Furthermore, the contract should explicitly restrict the allocation of parent company overhead, prohibit administrative management fees from being charged against the target entity, and exclude transaction expenses, integration costs, and non-recurring capital expenditures from the calculation of earnout metrics.
3. Affirmative Support Covenants and Capital Commitments
An earnout target cannot be achieved if the buyer systematically starves the newly acquired business of working capital, inventory, or marketing resources. While buyers reasonably seek flexibility to respond to market shifts, sellers require assurance that the business will receive sufficient financial backing to pursue agreed growth plans.
Definitive agreements should incorporate affirmative covenants that obligate the buyer to provide working capital and capital expenditure levels substantially consistent with the historical budgets or financial projections agreed upon during due diligence. In addition, the agreement should prohibit the buyer from deliberately diverting corporate opportunities away from the acquired entity or taking actions whose primary purpose or predictable effect is to reduce or eliminate the earnout payment.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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