The Hidden Dangers of Earnouts: A Cautionary Tale for Founders

What would you do if the company that promised to make you rich was systematically destroying everything you'd built?

Read to discover how to…

1.       Demand Specific Operating Standards and Approval Rights

2.      Lock Down Accounting Standards and Audit Access

3.      Only Accept Earnouts for Two Specific Situations

Allison stared at the production floor she'd designed twenty years ago, watching strangers in corporate polo shirts dismantle the equipment that was the core of her life’s work. Nine months earlier, this same floor had hummed with the rhythm of her key product lines. Now, it was being torn down to make room for someone else’s products.

She pulled out her phone and scrolled to her lawyer’s number – just staring at it with a dark, overwhelming feeling coming over her. This Fortune 500 company that had promised her up to $3 million in earnout payments had just terminated her employment and dismantled her entire production line—and they'd done it all while staying technically within their contract.

Following years of brutal loss and litigation, Allison discovered that even when buyers follow the letter of the law, they can still destroy the spirit of your deal. And if you're not prepared, your earnout could become their weapon.

When A Selling Founder’s Dream Meets a Buyer’s Post-Closing Optimization

Allison's story starts like so many successful exits do— with a deal that seemed too good to be true.

After two decades of building her manufacturing company from a garage startup to a multi-million-dollar operation, she'd attracted the attention of a Fortune 500 corporation. Their offer was seductive: $2 million upfront, plus an earnout structure that could deliver another $3 million over five years based on revenue performance.

The earnout metrics seemed straightforward. Payments would be tied to sales of her products and manufacturing services at her facility. She'd stay on as president, maintaining operational control while gaining access to their massive resources and distribution network.

"I thought I was getting the best of both worlds," Allison later recalled. "Financial security from the upfront payment, plus the potential for serious wealth if we could scale using their resources."

Sound familiar? If you're a founder considering an earnout structure, you're probably familiar with that same mixture of excitement and nervous energy.

An Exit Sale Is Not A "Partnership", It’s A Takeover

Within sixty days of closing, Allison noticed the first subtle shift.

The acquiring company began pushing their own premium product lines through her facility. Not alongside her products, but instead of them. When she raised concerns in the weekly operations meetings, the response was always the same: "These premium lines have to take priority. They're strategic for the parent company." Her team—the same engineers who'd spent years perfecting her product designs—were suddenly pulled into developing entirely new products for the parent company.

"I started to realize they weren't buying my business to grow it," Allison said. "They were buying it to eliminate it."

Here's the devastating reality that most founders never see coming: your buyer's definition of "success" will be completely different from yours, and you won’t find out until the buyer is in control. Before then, you will be sold on whatever skewed definitions it takes to close the deal.

How Numbers Tell the Story

The numbers became brutal, fast. The parent company paid Allison's facility standard manufacturing costs for producing their premium products — with zero profit margin. Meanwhile, her original products, the ones that generated revenues counting toward her earnout, were systematically pushed to the back burner.

Allison's facility had missed revenue targets by 62% through no fault of her own. "Every week, I'd sit in meetings watching the buyer’s executives make decisions that I knew would hurt the earnout," Allison remembered. "But when I objected, they'd point to the contract language about 'operational efficiency' and 'strategic alignment.'"

The buyer wasn't breaking any explicit rules. They were just pursuing a strategy that happened to make Allison's earnout impossible to achieve.

It wasn’t long before Allison and her key team members were terminated "for operational efficiency,” and the parent company converted her entire distribution network to sell their other products. These reckless changes failed quickly, ultimately shutting down her facility for good. The earnout she'd been promised? Zero dollars.

If you are reading this and getting a knot in your stomach, you're starting to understand the real risk hiding in those earnout clauses. Regardless of what was promised, there will always be misalignment – it’s naturally built-in to the buyout relationship.

Winning In Court, But Losing In Terms of Time, Money and Peace

Instead of accepting defeat, Allison sued. Not for breach of contract—the parent company had been too careful for that—but for violation of the implied covenant of good faith and fair dealing. Her legal theory was simple but powerful: even when parties don't violate specific contract terms, they can't deliberately undermine the fundamental purpose of their agreements.

After three years of litigation, depositions, expert testimony and paying over $1,000,000 in legal fees to her lawyers (almost all the after-tax money she received in the upfront cash price), Allison finally got her day in court. The jury heard how the parent company had systematically diverted opportunities away from her facility. They learned about internal emails discussing strategies to "optimize the earnout structure" (corporate speak for minimizing payouts). Most damning, they discovered the parent company had lost three times the full earnout amount on Allison's facility operations. The buyer became obsessed with strategy that ultimately cost them their reputation and money by being overfocused on limiting her earnout compensation.

The verdict? The jury awarded Allison half the maximum earnout she'd been promised—$1.5 million plus legal fees. To this day Allison believes she would have gotten $3.5 million upfront at closing if she pushed it and she’ll never get back those 4 years of her life.

The lesson? Even when you win in court, you lose. Earnouts should be a last resort for solving hard problems.

Tips for Earnout Protection

Allison's experience reveals why earnouts fail, but it also shows how smart founders can better protect themselves. If an earnout is necessary, here are the specific contractual safeguards that help:

1. Lock In Operating Standards and Approval Rights Before You Need Them

Don't accept vague language about maintaining "normal operations." Instead, demand specific covenants that require the buyer to operate your business "consistent with past practices" using "commercially reasonable efforts" to maximize earnout potential.

These provisions should explicitly prohibit opportunity diversion and pricing changes that artificially depress your performance metrics.

Also include approval right protections to prevent the buyer from undermining performance through material resource allocation, strategic decisions, or material operational changes that could impede earnout achievement.

Remember: specificity is your friend as a seller – ambiguities only favor the buyer.

2. Control the Numbers That Control Your Future

Specify that all financial calculations must follow "GAAP consistently applied" using your historical accounting practices as the baseline. This isn't just accounting minutiae, it's protection against creative bookkeeping designed to minimize your payouts.

Include explicit exclusions for integration expenses, overhead allocation changes, and intercompany pricing adjustments. Grant yourself comprehensive audit rights with access to all relevant financial records.

Why does this matter? Because buyers often try to burden earnout calculations with costs and allocation methods that didn't exist pre-closing. Your historical baseline becomes your shield against these manipulations.

Situations When Earnouts Actually Make Sense

My advice to clients is simple: no earnouts unless it is necessary to solve one of the following two unique problems:

·       Binary Risk Allocation: When specific, material risks could fundamentally alter business value—pending regulatory approvals, critical patents, essential permits—earnouts effectively allocate these deal-killer risks between parties. You may not have a deal with anyone unless you do this.

·    Growth Trajectory Gaps: Businesses with limited operating history but demonstrated high growth potential present valuation challenges that earnouts address effectively. This structure bridges the gap between conservative historical valuations and optimistic growth projections. There is no other way to capture that near-certain future growth.

You can’t eliminate all risks, but the goal is to keep the balance of power in your favor. Even with bulletproof earnout language, litigation risks persist.

If you're preparing for a strategic exit to fuel your second act, your deal structure today determines your investment capacity tomorrow – and importantly, how soon you can start living your dream.

Remember: every dollar in an earnout is a dollar you may never see due to buyer strategy shifts, accounting manipulations, and interpretation disputes. Make sure it is necessary and the potential reward justifies those risks.