An earnout makes part of the purchase price contingent on the business hitting agreed targets after closing, usually over one to three years. Buyers and sellers use earnouts to bridge a valuation gap: the seller gets credit for growth it believes is coming, and the buyer pays for that growth only if it actually arrives. Earnouts appear in roughly one in five private-company deals, and no other piece of deal consideration generates post-closing disputes as reliably.
What an Earnout Is and When It Bridges a Valuation Gap
An earnout, which lawyers call contingent consideration, is a purchase-agreement provision obligating the buyer to pay additional amounts after closing if the acquired business achieves defined financial or operational targets. It exists because buyers price businesses on demonstrated results while sellers price them on expected results.
A concrete example. A distribution company earned $3 million of EBITDA last year, and the owner projects $4 million next year on the strength of a new contract. The buyer offers $15 million based on trailing performance. The seller wants $20 million based on the projection. A common bridge: $15 million in cash at closing, plus up to $5 million paid over two years if EBITDA reaches the projected levels. The seller is paid for the growth story only if the story comes true.
Earnouts work best when the gap comes from a specific, measurable uncertainty: a pending customer contract, a new product launch, customer concentration that may or may not persist, or a founder transition. They work worst when the seller will have no influence over results after closing, because the seller is then betting deferred money on someone else's management.
Earnout use moves with the market. In the American Bar Association's Private Target Deal Points Study, the share of private-target deals with earnouts fell from 26 percent in the 2023 study to 18 percent in the 2025 study, a sign that buyer and seller price expectations converged. Well-prepared sellers design the earnout before buyers propose one; sell-side platforms such as Bankerly model earnout scenarios alongside the base valuation for this reason.
Revenue vs. EBITDA vs. Milestones: Choosing the Metric
The metric drives everything else in the earnout, including how likely it is to end in a fight.
Revenue is the cleanest number. A buyer cannot easily suppress top-line sales without hurting itself, so revenue-based earnouts produce fewer accounting disputes. The tradeoff runs against the buyer: a revenue target can force the buyer to pay for growth that is unprofitable.
EBITDA, meaning earnings before interest, taxes, depreciation, and amortization, tracks the profitability the buyer actually bought, so buyers prefer it. But EBITDA is the sum of dozens of judgment calls, and after closing the buyer controls all of them: how much corporate overhead gets allocated to the acquired unit, whether integration costs count as operating expenses, and when items are recognized. Each judgment call is a potential dispute.
Gross profit is a frequent compromise. It captures pricing and direct costs but sits above most of the overhead-allocation battleground.
Milestones are discrete, often non-financial triggers: a regulatory clearance, a signed contract renewal, a product release, retention of named customers. They dominate life-sciences deals and show up in smaller deals whenever a single identifiable event carries most of the uncertainty.
Blends are now the norm. In SRS Acquiom's 2025 M&A Deal Terms Study, 68 percent of the earnout deals that closed in 2024 used more than one metric.
| Metric | What it measures | Main seller risk | Typical use |
|---|---|---|---|
| Revenue | Top-line sales | Buyer redirects customers, bundles the product, or reprices | Growth-story gaps; recurring-revenue businesses |
| EBITDA | Operating profitability | Buyer's cost allocations and accounting judgment compress the number | Buyers unwilling to pay for unprofitable growth |
| Gross profit | Sales minus direct costs | Post-closing pricing and input-cost decisions | Middle ground between revenue and EBITDA |
| Milestones | Defined events achieved or not | All-or-nothing; a near miss pays zero | Regulatory, contract, or product-launch uncertainty |
Typical Duration, Caps, and Payout Reality
Most earnout periods run one to three years, measured annually, cumulatively, or both. Longer periods raise the odds that integration, management turnover, or a strategy shift contaminates the measurement. The trend is toward shorter windows: SRS Acquiom reported that among deals in its 2025 study, none that closed in 2024 carried an earnout period longer than four years.
Earnouts are almost always capped at a stated maximum, which matters for tax reasons discussed below. Within the cap, the payment formula takes a few standard shapes:
- Cliff: hit the target and receive the full payment; miss it by a dollar and receive nothing.
- Graduated or linear: payment scales proportionally between a floor and the cap, which softens the near-miss problem.
- Tiered: set payments become due at set thresholds, sometimes with a catch-up provision letting a strong later year recover a missed earlier one.
Sellers should be sober about the odds. SRS Acquiom's claims data shows that outside life sciences, earnouts have paid about 21 cents of each maximum earnout dollar across all deals with earnouts, and even the deals that achieved at least one threshold collected only about half the maximum. The practical rule: evaluate competing offers on cash paid at closing, and treat the earnout as upside rather than as purchase price.
The Classic Disputes
Post-Closing Operations
After closing the buyer runs the business, and the seller's remaining payment depends on how. The recurring pattern: the buyer integrates the company, reassigns its salespeople, folds its product into a bundle, or deprioritizes it in favor of the buyer's own projects, and the targets are missed. Whether the seller has a claim depends almost entirely on the words of the agreement.
Delaware courts, which decide many of these cases, enforce whatever operating standard the parties wrote. An agreement giving the buyer sole discretion, limited only by a prohibition on acting with the primary purpose of defeating the earnout, imposes very light obligations. An agreement requiring commercially reasonable efforts measured against the buyer's own practice for comparable priority products can bite hard: in one closely watched Delaware case, a large medical-device buyer faced roughly $1 billion in liability after shifting strategy away from an acquired surgical-robotics program. Courts sometimes apply the implied covenant of good faith and fair dealing, a doctrine that fills true gaps in a contract, to police bad-faith conduct, but they will not use it to insert operating covenants the seller failed to negotiate.
Accounting Discretion
The second classic fight is over how the number gets computed. Post-closing, the buyer prepares the financial statements that determine whether the target was met. Disputes cluster around changed accounting policies, allocations of group overhead to the acquired business, treatment of one-time integration costs, and the timing of revenue or expense recognition. A buyer that shifts a large expense into the measurement period can quietly erase an EBITDA earnout without touching the underlying business.
Most agreements route calculation disagreements to an independent accountant acting as an expert rather than an arbitrator. Delaware decisions give near-total deference to an expert determination the contract labels final and binding, so the scope of what that accountant may decide, and who pays for the process, should be drafted deliberately.
Protective Covenants Sellers Should Negotiate
Because courts enforce the written deal, seller protection lives in the covenants. The most common asks:
- Operating covenant: run the acquired business consistent with past practice during the earnout period, or at minimum as a distinct unit with its own profit-and-loss statement.
- Frozen accounting rules: compute the metric under GAAP as historically applied by the target, with express exclusions such as no new corporate overhead allocations and no integration or transaction costs.
- A defined efforts standard: commercially reasonable efforts tied to objective benchmarks, such as maintaining sales headcount or a stated marketing budget, rather than an undefined phrase.
- Negative covenants: no diverting customers, revenue, or opportunities to the buyer's affiliates, and no actions taken with the intent of reducing the earnout.
- Information and audit rights: periodic financial statements for the unit, a detailed earnout calculation with supporting workpapers, and inspection rights.
- Documentation of decisions: a requirement that the buyer keep records of its commercial reasons for major decisions affecting the earnout, which disciplines behavior and preserves evidence.
- Acceleration: the maximum earnout becomes payable if the buyer resells the business or discontinues the relevant product line during the earnout period.
- Setoff limits: restrictions on the buyer's ability to offset indemnification claims against earnout payments.
Buyers resist most of these and concede operating covenants sparingly. The realistic goal is not a buyer handcuffed to maximizing the earnout; it is a measurement the buyer cannot quietly manipulate.
Tax Treatment at a High Level
This section is educational, not legal or tax advice; earnout taxation turns on facts and drafting, so involve a qualified tax advisor before signing a letter of intent.
Default treatment: installment sale. An earnout received as contingent purchase price is generally reported under the installment method, which applies whenever at least one payment lands after the tax year of the sale. The seller recognizes gain as payments are received rather than all at closing. Because the total price is unknown at signing, the contingent payment sale rules under the Treasury regulations govern how the seller recovers basis, and the mechanics differ depending on whether the agreement states a maximum price, sets a fixed payment period, or does neither. A stated cap is the cleanest structure.
Imputed interest. If the agreement does not charge adequate stated interest on the deferred payments, the IRS treats a portion of each payment as interest at the applicable federal rate. That slice is ordinary income to the seller regardless of how the rest of the payment is characterized.
The recharacterization trap. If the earnout is conditioned on the seller's continued employment, the IRS and courts may treat it as compensation rather than purchase price: ordinary income at rates up to 37 percent plus employment taxes, instead of long-term capital gain, though the buyer gets a deduction. Case law looks at whether payments track employment or track ownership percentages. Accounting firm guidance urges sellers to decouple earnout rights from employment agreements and to watch letter-of-intent language, since a casual employment condition written at the LOI stage tends to survive into the purchase agreement.
Electing out. A seller can elect out of the installment method and instead report the value of the earnout right in the year of sale. That occasionally makes sense, for example to use expiring losses, but it means paying tax on money that may never arrive.
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Frequently asked questions
- What is an earnout in the sale of a business?
- An earnout is a purchase-agreement provision that defers part of the price and pays it only if the business hits agreed targets after closing, such as revenue, EBITDA, or specific milestones. Buyers use earnouts to avoid overpaying for projected growth; sellers use them to get credit for value the trailing financials do not yet show.
- How long does a typical earnout period last?
- Most earnout periods run one to three years, measured annually or cumulatively. Longer windows have become rare; SRS Acquiom found no earnout period over four years among study deals that closed in 2024. Shorter periods reduce the chance that integration or buyer strategy changes distort the measurement, while longer ones stretch seller risk across events the seller cannot control.
- Are earnout payments taxed as capital gains or ordinary income?
- It depends on structure. Earnouts paid as contingent purchase price are generally reported under the installment method, with gain recognized as payments arrive, typically at capital-gains rates plus imputed interest on the deferred portion. Earnouts conditioned on the seller's continued employment risk recharacterization as compensation, taxed at ordinary rates plus employment taxes. This is educational, not tax advice; consult a tax advisor.
- Why do earnouts cause so many disputes?
- Because after closing the buyer controls both the business and the bookkeeping that decides whether targets were met. The classic fights involve post-closing operations, such as deprioritizing the acquired product or redirecting customers, and accounting discretion, such as overhead allocations and expense timing. Courts generally enforce only the covenants actually written into the agreement, so vague earnout language invites litigation.
- How often do earnouts actually pay out in full?
- Far less often than face value suggests. SRS Acquiom's claims data shows earnouts outside life sciences have paid about 21 cents of each maximum earnout dollar across all deals with earnouts, and even deals that achieved at least one threshold collected roughly half the maximum. Experienced sellers treat the earnout as upside and compare offers on cash paid at closing.
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