Anonymised, illustrative composite. A $4,000,000 base-price deal carried up to $800,000 of earn-out tied to Year 1 gross margin. The buyer reallocated shared customers into its own account codes post-closing, and the earn-out paid a fraction of what pre-close numbers implied.
At a glance
A strategic buyer acquired a regional distributor for a $4,000,000 base price, with an additional earn-out of up to $800,000 tied to the target’s Year 1 gross-margin dollars against a $2,000,000 threshold. The seller’s diligence-stage financials showed a trailing run-rate of $1,950,000 in gross margin, just under the target and well inside the range that would have triggered a substantial earn-out payment if the business simply continued as it had been operating.
The purchase agreement defined the earn-out metric and its calculation methodology in detail, but — unlike a well-drafted operating covenant — it said nothing about how the buyer had to run the business during the measurement period. Treadstone Law’s own account of how these disputes arise names exactly this gap. Its list of how earn-outs come apart includes a buyer who “changes pricing, product lines, or service offerings in ways that depress the metrics the earn-out is measured against” and a buyer who “diverts customers, referrals, or resources” — neither of which breaches anything a silent contract prohibits.
After closing, the buyer integrated several of the target’s largest shared customers into its own national account structure, reassigning $340,000 of gross margin from the target’s books to the buyer’s existing entity’s SKU codes — a purchasing-allocation decision, not a loss of business. Organic growth elsewhere added $90,000. The measured metric landed at $1,700,000 (pre-close run-rate of $1,950,000, minus the $340,000 reallocation, plus $90,000 of organic growth), or 85% of the $2,000,000 target. Under the agreement’s sliding scale, which started paying out at 80% of target, that produced a $200,000 earn-out payment against an $800,000 maximum — a $600,000 shortfall from what the pre-close run-rate would have implied had it simply continued unchanged.
What decided the outcome was the absence of a rule, not the presence of one. Treadstone Law’s guidance describes the standard protection as an operating covenant requiring the buyer to run the acquired business “in good faith, in the ordinary course, or without taking actions specifically intended to reduce the earn-out payment” — and this agreement had none of it. Without that covenant, reallocating shared-customer margin into the buyer’s own account codes was neither bad faith nor a breach of anything written down; it was simply how the buyer chose to run its combined business. The same guidance describes the usual dispute route as “referral of financial disputes to an independent accountant, or arbitration or litigation for broader disputes” — and an independent accountant tests whether the calculation was done correctly, which here it was. There was no metric-calculation error to refer; there was only a business decision the contract never restricted. No statute governs any of this: an earn-out is a contract term, and a seller’s protection is whatever the seller negotiated. A buyer who now owns the business “generally has the right to run it as it sees fit after closing”, pending earn-out or not.
The seller’s counsel reviewed the calculation and confirmed it was performed correctly under the defined methodology — the $200,000 payout was accurate on its own terms. Because there was no operating covenant to point to, the seller had no contractual basis for a dispute and no independent-accountant referral to invoke; the $600,000 gap between the pre-close run-rate and the earn-out actually paid was absorbed entirely by the seller. See the contrasting case where a sales-team-specific covenant produced a different outcome on a structurally similar earn-out, and how an earn-out is typically structured for the underlying mechanics.
Had the agreement included the operating covenant Treadstone Law describes as standard — barring the buyer from reallocating existing customer volume into its own account codes during the measurement period — the metric would have tracked closer to the $1,950,000 pre-close run-rate plus the $90,000 of organic growth, or $2,040,000, above the $2,000,000 target and worth the full $800,000 earn-out. The $600,000 difference between the $200,000 actually paid and the $800,000 that a covenant-protected version of the same deal would likely have delivered is the value of a clause that costs nothing to negotiate at signing and everything to have skipped.
An earn-out metric with a precisely defined accounting methodology but no operating covenant is protecting the arithmetic while leaving the inputs to the arithmetic entirely in the buyer’s hands. A seller negotiating an earn-out should treat the covenant restricting post-closing operating conduct as at least as important as the formula itself — the formula only matters if the buyer is required to run the business in a way that lets the formula measure anything real.
A 30-minute call is enough to tell you whether AI pays for itself here.
