When an Earn-Out Depends on the Buyer's Cooperation

The situation

Bohdan had run his plumbing business out of Cambridge for close to thirty years, building it from a one-van operation into a company with six employees and a steady base of residential and light commercial clients. Amina, his wife, had done the books and managed scheduling for most of that time, and both of their names were on the shares. At sixty-one and fifty-eight, they were ready to retire, and they found a buyer in Abdi, an IT support lead who wanted a career change into owning and running a trades business himself.

The business was worth roughly $1.4 million by the valuation both sides eventually accepted, but Abdi could not finance that entire amount upfront. Like many buyers in his position, he could arrange financing and savings to cover about $1 million at closing, with the remaining $400,000 structured as an earn-out — a portion of the purchase price paid later, contingent on the business hitting agreed financial targets after the sale. Earn-outs are common when a buyer cannot pay the full price at closing, or when a seller wants some assurance that the price reflects how the business actually performs going forward rather than a number both sides are simply hoping is right. Bohdan and Amina retained our firm to structure the sale, including the earn-out terms that would govern the next two years.

The risk built into the deal

An earn-out sounds like a reasonable compromise, and often it is, but it carries a structural problem that every seller needs to understand before agreeing to one: once the sale closes, the seller no longer controls the business. The buyer does. And the buyer's incentives during the earn-out period are not always aligned with hitting the targets that trigger a further payment to the seller. A buyer who defers marketing spending, cuts staff, or changes how the business operates may be making reasonable decisions for the business's long-term future — or may be, deliberately or not, suppressing the very numbers the earn-out depends on.

Because that risk is well known, we did not simply write a clause tying the $400,000 to a revenue target and leave it there. The earn-out agreement included several protections specifically aimed at this problem: a covenant requiring Abdi to operate the business in the ordinary course — meaning consistent with how it had historically been run, rather than making major changes that could depress the numbers — during the earn-out period; a requirement that he maintain marketing and staffing levels within a defined range of historical spending; monthly financial reporting to Bohdan and Amina; and an audit right allowing them to review the underlying books if the numbers came in materially below target. None of this guaranteed the earn-out would be paid. It guaranteed that if it was not paid, Bohdan and Amina would be able to find out why, and would have a contractual basis to challenge the reason if it did not hold up.

That distinction mattered less than a year later. Six months after closing, revenue was running noticeably behind the first earn-out benchmark. By the twelve-month mark, when the first earn-out installment was due to be calculated, the business had missed the target by a wide enough margin that no payment was owed under the formula as written. Abdi's explanation was that the trades market had softened and that he had made cost-cutting decisions any reasonable owner would make. Bohdan and Amina's view, watching from the outside, was that Abdi had let two experienced technicians go without replacing them and had cut the marketing budget by more than half almost immediately after closing — decisions that looked less like a response to a soft market and more like choices that happened to keep the earn-out from being triggered.

What we did

1. Exercised the audit right before assuming bad faith. The earn-out agreement gave Bohdan and Amina the right to review the financial records underlying the missed target, and we used it immediately rather than escalating on assumptions. This produced actual numbers instead of competing impressions of what had happened.
2. Compared spending against the ordinary-course covenant. The audit showed marketing spend at roughly 45 percent of the prior three-year average and staffing levels reduced by two full-time technicians within the first four months of ownership — both material departures from how the business had historically run, and both plausibly connected to the revenue shortfall.
3. Sent formal notice of the covenant breach. Rather than filing a lawsuit immediately, we put Abdi on written notice that the spending and staffing cuts appeared to breach the ordinary-course obligation he had agreed to, and that Bohdan and Amina considered this relevant to whether the missed target should reduce the earn-out payment at all.
4. Opened settlement negotiations instead of going straight to court. A dispute over whether specific business decisions breached an operating covenant is exactly the kind of fact-heavy disagreement that is expensive and slow to litigate, and neither side had an interest in years of proceedings against a business both of them still needed to function. We proposed a negotiated resolution based on the evidence the audit had produced.
5. Negotiated a partial earn-out payment tied to the strongest evidence. Abdi disputed that the staffing cuts alone explained the full shortfall, and that was a fair point — some of the softness was real. The eventual settlement reflected that: rather than the full $400,000 or nothing, Abdi agreed to pay roughly $175,000, calculated against the portion of the target that internal projections suggested would likely have been met absent the spending cuts.
6. Documented the settlement to close out the earn-out period cleanly. The agreement released both sides from further claims tied to the first-year target and reset expectations for the second and final earn-out year, with the reporting and audit rights carried forward unchanged.

The outcome

Bohdan and Amina did not receive the full $400,000 earn-out they had hoped for. They received roughly $175,000 of it, on top of the $1 million already paid at closing, bringing their total to about $1.175 million against an original $1.4 million valuation — a real shortfall of roughly $225,000 from what the deal had been priced to deliver. That is not a result either of them would call a win, and we did not present it as one. It was a loss, contained.

What kept it from being worse was not luck. Without the ordinary-course covenant, the audit right, and the monthly reporting requirement, Bohdan and Amina would have had a missed target, a plausible-sounding explanation from the new owner, and no contractual basis to challenge it — nothing but a formula that said zero was owed, and no way to test whether that formula had been fairly triggered. The protections did not stop Abdi from cutting spending. They gave Bohdan and Amina the evidence and the leverage to argue that some of the shortfall was his doing rather than the market's, and to settle on that basis instead of accepting the full loss or spending years and legal costs trying to prove it in court.

The second earn-out year played out differently. With the reporting and audit terms reaffirmed and a settlement on record establishing what had happened the first time, spending stayed closer to historical levels and the business came within a narrow margin of the second-year target, triggering a payment close to what the formula called for. Bohdan and Amina finished the earn-out period having recovered most, though not all, of the price they had originally agreed to.

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