Who Runs Your Earnout: The Efforts Covenant That Decides Whether You Get Paid
A founder sold a commercial mechanical service business for 34 million dollars, 27 at close and up to 7 more over two years, tied to growth in recurring service contract revenue. He had built that line from nothing to 11.4 million dollars over nine years and he was confident, because it was the part of the business he understood best. In the first four months after closing the buyer consolidated dispatch into a regional call center two states away, moved two of his four senior service sellers onto a different product line, and quietly stopped quoting small municipal work at his historical pricing because it did not clear the buyer's margin threshold. Company revenue grew. His metric came in 9 percent under the year one threshold. He collected 1.1 million dollars of the 3.5 million available. None of it was a breach, because the agreement said the buyer would use reasonable efforts to operate the business and said nothing else at all.
That is the whole problem with earnouts in one paragraph. An earnout is the only part of your purchase price that gets paid out of a business you no longer control, measured by someone whose interests are opposed to yours on that specific line, using books you no longer keep. Founders spend the negotiation arguing about the size of the earnout and the height of the threshold. Those are the two least important variables in the clause. What decides whether the money arrives is the efforts covenant, the definition of the metric, and the list of things the buyer promised not to do.
Start with the efforts covenant, because it is the load-bearing sentence and almost no founder reads it. Somewhere in the earnout section there will be a promise by the buyer to operate the business using some standard of effort. It might say reasonable efforts, commercially reasonable efforts, or best efforts. Those phrases are not interchangeable filler. They are the entire measure of what a buyer is obligated to do for you after it owns the company, and courts treat the difference as real.
The best illustration available right now sits at the top end of the market. In January 2026 the Delaware Supreme Court decided Johnson & Johnson v. Fortis Advisors LLC, arising out of the 5.75 billion dollar acquisition of the surgical robotics company Auris Health, which carried up to 2.35 billion dollars of earnouts tied to regulatory milestones. The milestones were missed. After a ten day trial the Court of Chancery entered judgment for the former Auris stockholders exceeding one billion dollars, and the Supreme Court affirmed most of it, including the finding that the buyer had breached the agreement's commercially reasonable efforts clause. A clear summary of the decision is in Arnold and Porter's advisory on the case. I am not a lawyer and this is not legal advice, but every founder considering an earnout should understand why the sellers won that point, because the reason is portable down to a 34 million dollar deal.
They won it because the contract gave the court something to measure against. The agreement did not just say commercially reasonable efforts and stop. It required the buyer to devote efforts commensurate with the treatment of its own priority products, and it separately prohibited the buyer from taking action with the intent of avoiding an earnout payment. Those two additions turned an adjective into a benchmark. The court held that the buyer's discretion was not free floating and that it was not permitted to prioritize its own commercialization plans, product differentiation, or short-term profitability at the expense of hitting the milestones. That is exactly what happened to my client in the paragraph above, and he had no benchmark, so he had no claim.
The lesson is not to hire litigators. It is that an efforts standard only protects you if you give it something concrete to compare to. In a lower middle market deal that usually means naming a baseline out of your own history and the buyer's own conduct: maintain the sales headcount dedicated to this line at no fewer than the number at closing, keep pricing authority for this service category with the existing team, operate the business as a separate profit center with its own chart of accounts through the earnout period, and do not take action with the purpose of reducing the earnout. Any of those is worth more than upgrading reasonable efforts to best efforts and leaving the rest blank.
Do not expect the law to fill the gap you left. The same Delaware decision reversed the sellers on their implied covenant of good faith claim for the first milestone, on the ground that the contract had expressly conditioned payment on one specific regulatory pathway, so the risk that the agency would require a different pathway was foreseeable and had been allocated to the sellers by the words they signed. The implied covenant only reaches genuine gaps. If you accepted a metric and a mechanism, you accepted the risks visible in them. I have watched founders assume a court will do the fairness work later. It will not, and even where it might, you are financing years of litigation against a buyer with a larger legal budget than your entire earnout.
Then fix the metric. I push clients toward revenue or gross profit on a defined revenue stream, not EBITDA, because EBITDA is the number a new owner can most easily move without touching the business. Corporate overhead allocations, management fees, shared services charges, a new insurance program, reallocated bonus accruals, and purchase accounting adjustments can all reduce your EBITDA without anyone doing anything improper. If EBITDA is unavoidable, the agreement needs to state the accounting policies in effect at closing, say that they will be applied consistently, and expressly exclude allocations, fees, and charges that did not exist before the deal. Define the metric to the line item. Two pages of definition is cheap.
Next, the negative covenants, which are where founders get the most protection for the least negotiating capital. Common ones worth asking for: no transfer of the business or its assets out of the earnout entity, no merger of the operations into another division, no reduction of the dedicated sales or delivery headcount below a stated floor, no change to the commission plan for the relevant team, no discontinuation of a named product or service line, and no diversion of customer opportunities to an affiliate. Pair that list with acceleration: if the buyer breaches a covenant, sells the business, or terminates you without cause during the earnout period, the remaining earnout becomes immediately payable at target. Acceleration is what converts a list of promises into something a buyer actually has to plan around.
You also need to be able to see the scoreboard. Ask for a quarterly statement showing the metric computed with supporting detail, the right to inspect the underlying records with your accountant, a defined window of at least 30 days to object, and an independent accountant to resolve disputes with the loser paying costs. Without inspection rights you find out how the earnout was calculated from a one-page memo eighteen months after the fact. One detail from the Delaware case that is easy to miss and worth raising with your own counsel: the buyer's fraud defense failed in part because the agreement's anti-reliance language ran one way, so only the buyer had disclaimed reliance on statements made outside the contract. Provisions like that get inserted as boilerplate and are not symmetrical by accident.
Finally, price the thing honestly in your own head. An earnout is not price, it is an option on price, and it should be discounted the way you would discount any payment that depends on another party's behavior. When I build the proceeds picture for a founder I separate cash at close from every contingent and deferred component, which is the exercise I described in the equity value bridge. An earnout sits in the same family as the escrow holdback, the seller note, and rollover equity, and the mix of those four is usually what actually separates two offers that look similar on the cover page, a distinction I worked through in strategic buyer or private equity. If you want the mechanics of how earnout structures are built in the first place, start with earnouts explained.
My client recovered some of it. In year two his counsel used the one covenant he did have, an obligation to maintain the service business as a separate reporting unit, to force disclosure of how accounts had been reassigned, and the parties settled the remaining 2.4 million dollars at roughly half. He netted about 1.2 million dollars more than he would have and spent seven months on it. He told me afterward that he would have traded the entire 7 million dollar earnout for 3 million at close, which is worth remembering the next time a buyer offers to bridge a valuation gap with contingent money. If you are heading into a process with an earnout likely to be part of the structure, the work of deciding what you will require in that clause belongs in the preparation year, not in week nine of exclusivity. Getting founders to that clause with leverage still intact is a large part of what we do at Cordis Group.