Today, dealmakers continue to reach for earnouts to bridge valuation gaps between buyers and sellers.
Those gaps come as no surprise given the whiplash the market delivered in recent years.
Merger and acquisition deals secured an average transaction multiple of 11.9 from 2016-2021, according to data from the London Stock Exchange Group.
More recently, from 2022 to 2024, that multiple has averaged 9.8.
To paper over that difference, dealmakers often utilize earnouts, which were part of 22% of all M&A deals in 2024, according to SRS Acquiom, which excludes the life sciences sector.
And on the ground in 2025, we continue to see a steady reliance on earnouts to get deals done in the face of market uncertainty.
Yet, earnouts rarely receive the careful consideration and negotiation they deserve given their critical role in creating common ground between buyer and seller.
If an earnout is poorly crafted, when it expires, the pain that was delayed is likely to return, magnified many times over.
The result can be an ugly dispute among individuals now working under the same roof. And conflicts are mounting. Delaware courts have seen an increase in earnout litigation, as the earnouts negotiated a few short years ago have come to the end of calculation periods, with disputes centering on whether earnout targets were satisfied.
Frequently, the result is protracted and costly litigation with unpredictable results.
To avoid the worst case — litigation over the earnout — consider specific deal points and benchmarks, and ensure all parties are aware of the risks.
The Earnout Environment
Increasingly, letters of intent include earnouts to entice the seller with a stronger top line number.
While the earnout concept may appear in the early days of discussions, the earnout details are often the final element of the negotiation, when the parties are eager and ready to sign and close.
At this late stage of negotiation, buyers and sellers tend to be focused on their future success together. Human nature makes it difficult to contemplate worst-case scenarios under such circumstances.
Moreover, when legal teams begin exploring earnout scenarios and their challenges, and then design documents to protect clients, buyers and sellers who are ready to sign and close a deal often express concerns with overlawyering.
Under these circumstances, negotiators may be tempted to resort to broad language and behavior guidelines. They may write that the acquired unit is to be operated consistent with past practice until the company hits certain targets, triggering the earnout.
Or they may stipulate the buyer will use its commercially reasonable efforts, or CREs, or another similar standard to meet a milestone like bringing a product to market. This is sometimes coupled with retention of key seller personnel who can, in principle, pursue and secure the earnout targets.
At signing, both sides are usually optimistic that these targets are on their way to being met, otherwise they would not likely agree to the earnout in the first place. But as we see too often, for any number of reasons, things may not work out as expected.
Disputes When the Earnout Expires
If the seller feels the earnout remuneration does not meet expectations, the parties return to review the legal document, which is often several years old.
And they may well ask: What is consistent with past practice, how do you measure it and what are CREs? The Delaware courts have generally told us that these are all reasonable steps to achieve the outcome. But again, in any specific company, what does that really mean?
Disputes often rest on different assumptions and perceptions about what the business was before the sale, and what the combined business is today.
Has the board changed the course of the company? Have the goals of the company changed? Were resources fairly allocated to meet the goals? Has the product mix evolved? Have operations shifted? Were sales and profits or other metrics of success properly booked? Has some external and unpredictable factor — think COVID-19 — altered the landscape?
In many cases, these disagreements can be long and expensive, with drawn-out discovery and complex arguments over what the parties meant to say when they drafted the earnout and how the business operated previously.
They often involve heavy scrutiny of any number of company changes and business trends since the earnout was signed, and competing experts are hired to opine on what the company should and should not have done.
Delaware courts have seen several major cases on these matters in the last year, with rulings in favor of both buyers and sellers. These include the Jan. 25 decision in Pacira Biosciences Inc. v. Fortis Advisors LLC.
There, the buyer persuaded the Delaware Chancery Court to adopt its view of which specific medical reimbursement rates an earnout clause was supposed to reference. The matter involved nearly five years of litigation, a detailed review of negotiation and internal emails, and a bench trial.1
Conversely, the seller prevailed in the Sept. 4, 2024, decision in Fortis Advisors LLC v. Johnson & Johnson, and secured damages of over $1 billion for a buyer's failure to use CREs, consistent with its usual practice for priority medical device products, following four years of litigation and a 10-day Chancery trial.2 The $1 billion in damages are the largest-ever award in a Delaware earnouts case, according to Ross Aronstam & Moritz LLP, one of the law firms involved in the matter.3
Cases like these reaffirm that earnout clauses — even those that rely on efforts clauses — will be taken seriously and enforced in the right circumstances, which should give both sides some comfort. But both cases involved years of litigation, thousands of exhibits, dozens of witnesses, and ultimately distraction from running the business — all things buyers and sellers would prefer to avoid.
Building Better Earnouts
Despite their challenges, earnouts remain a valuable tool in negotiations and deals and they are here to stay.
Earnouts in 2024 utilized a handful of popular covenant and diligence standards, per SRS Acquiom's transaction data, which excludes the life sciences sector. For example, 90% of these earnouts in 2024 included both reporting requirements and a covenant stating that the buyer would take no action to directly harm the earnout achievement.
The same data set showed that 10% or fewer of deals included:
- A covenant to run the business in accordance with seller's past practice (included in just 3% of 2024 earnouts);
- A covenant to run the business to maximize earnout payments (included in just 5% of 2024 earnouts); and
- A CRE standard (included in just 10% of 2024 earnouts, which marks a significant drop from 2023 when over 30% of earnouts included a CRE standard).
The trend lines are clear: The dealmaker community is continuing to learn and evolve, moving away from the seller's past practice covenant and the CRE standard.
Even as certain clauses fall out of favor, the demand for earnouts persists and it remains incumbent on M&A dealmakers and their legal counsel to build better documents. To reduce the likelihood of earnout disputes, the following best practices are recommended.
Get to know the buyer.
Given the difficulty of enforcing an earnout clause through litigation, it is especially important that sellers have confidence that the buyer will live by its bargain. Sellers need to be comfortable with management, their business track record and their treatment of other acquisitions, among other issues. Unfortunately, buyers are generally not receptive to extensive seller diligence and may counter with a take-it-or-leave-it offer.
Use objective standards.
Seek third-party milestones. The pharmaceutical industry, for example, often utilizes government benchmarks such as successful Phase 1 testing or the U.S. Food and Drug Administration approval of a particular drug.
This is only half the story, as the buyer still needs to pursue and devote resources to achieving this milestone for the earnout to work. But having an objective target at least provides clarity on the end goal and avoids disputes about if and when the goal has been met.
Take caution when utilizing internal company metrics.
Internal company metrics come with a host of problems because they almost always involve some measure of discretion. Booking sales or expenses, for example, may be delayed or advanced into different quarters, which can dramatically affect results.
Setting the milestone of growing earnings before interest, taxes, depreciation and amortization, or EBITDA, by, for example, X% in three years, is especially problematic as both the denominator and the numerator are subject to human judgment calls — at best — and manipulation — at worst.
According to SRS Acquiom, just 22% of 2024 earnouts utilized earnings or EBITDA, while 62% relied on revenue as their earnout metric.
Where such metrics cannot be avoided, the earnout clause should include an examination of accounting policies. The earnout should also contemplate an agreed set of financials prepared upon the agreed accounting principles, allowing sellers to review and evaluate the calculations that determine the payout.
Keep it short.
This one is just a fact of life. The longer the earnout period, the more likely that circumstances will change, business priorities or markets will shift, key personnel will leave, and unexpected events will occur.
A shorter period also reduces the time that the buyer is committed to pursuing the particular courses of action dictated by the earnout, after which the buyer can run the acquired business with greater freedom. Try to arrive at an earnout period that winds down as quickly as possible in light of the valuation goals of the earnout.
The median earnout length for earnout deals struck in 2024 was 24 months, with only 15% of earnouts stretching three or four years, a continuing shift toward shorter performance periods, according to SRS Acquiom.
Consider dispute resolution venues.
Should these conflicts be resolved in the courtroom? This is the most common and the most reliable forum for most types of M&A disputes. Although, a court proceeding can mean a longer and more complex process, potentially with a judge that does not have specific technical experience in the relevant industry.
What about arbitration? This forum offers the possibility of designating arbitrators with specific industry experience if relevant. But arbitration is not always less expensive and may still involve a significant and painful discovery process.
Should the earnout designate an expert, like an accounting firm, to resolve any issues? Maybe, but the arguments are not always about calculations. Rather, they often revolve around business judgments and actions, or nonactions, made by company leadership, or differing interpretations of the earnout itself.
Each deal has its own dynamics based on parties, industries and jurisdictions involved. All of these should be considered.
Equity may be an alternative.
Sellers may consider requesting, and buyers might consider offering, equity in lieu of a cash-based earnout. This could take the form of equity at closing as part of the purchase price, or funding all or a portion of the earnout with equity.
Using equity as currency may allow the buyer to bridge the value gap without parting with potentially expensive capital, creates alignment between buyer and seller on incentives, and allows the seller to see gains from growth in the overall business rather than just the performance of their former business in new hands.
Even if equity constitutes only a portion of the earnout, it can reduce the likelihood of conflict, serving as a cushion to the seller if other benchmarks are missed.
But equity is not without drawbacks. Sellers must do their due diligence on the buyer and of course must be prepared to forego cash and take a risk on the company's longer-term success.
Buyers may not want to part with equity for dilution and control reasons, especially as they seek to transition the asset into new management. Equity also may not adequately incentivize the sellers with respect to the acquired business in a situation where the acquisition is a smaller add-on to a much larger organization.
Conclusion
As long as today's potential sellers remain focused on the high multiple values of a few years ago, earnouts will remain a popular tool at deal time.
Properly crafting those earnouts will help ensure they still remain popular once the payout calculations begin.
1 Pacira Biosciences, Inc. v. Fortis Advisors LLC, C.A. No. 2020-0694-PAF (Del. Ch. Jan. 21, 2025).
2 Fortis Advisors LLC v. Johnson & Johnson, C.A. No. 2020-0881-LWW (Del. Ch. Sept. 4, 2024).
3 https://www.ramllp.com/news-94.html.
Reproduced with permission from Law360.
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