Earnouts: tying the last piece of the price to what happens after closing
An earnout is a portion of the purchase price paid after closing, contingent on the business hitting agreed performance targets. Earnouts bridge valuation gaps and keep a seller involved during transition. They also shift risk onto the seller, so the contract terms are where the deal is actually won or lost.
What an earnout is and when it shows up
An earnout is a payment (or series of payments) the buyer makes after closing, calculated against a financial target the business has to hit. The most common triggers are revenue, gross profit, or EBITDA over a defined period. If the business hits the target, the seller gets paid. If it misses, the payment shrinks or goes to zero.
Earnouts typically appear in 1 of 3 situations. The buyer and seller disagree on valuation and an earnout bridges the gap. The buyer wants the seller to stay involved during transition and the earnout aligns both sides. The buyer does not have the full cash at closing and the earnout defers part of the payment.
The IBBA Market Pulse Survey reports earnouts are a common element in small-business sale structures, especially when the deal includes a transition period. The specific percentage of deals with earnouts varies by sector and deal size.
Typical size and period
Earnouts commonly represent 10% to 30% of total deal consideration in small-business sales, though the range is wide. Larger earnouts (above 30%) concentrate more risk on the seller and are more common when the buyer has concerns about customer or revenue continuity.
Periods typically run 1 to 3 years after closing. Shorter periods favor the seller (less time for things to go wrong). Longer periods favor the buyer (more time to earn the contingent payment out of actual cash flow). Three years is a common compromise.
What the seller has to protect against
The earnout is only worth what the contract enforces. The risk is not that the buyer is dishonest. The risk is that the buyer, after closing, runs the business in a way that reduces the measured metric without doing anything the contract prohibits.
Common examples. Buyer adds corporate overhead allocations that reduce EBITDA. Buyer reinvests aggressively, which reduces near-term earnings. Buyer rebrands and loses customers who were loyal to the original name. Buyer cuts advertising that was driving revenue. Each of these can be legitimate business decisions that happen to erode the seller's earnout.
The protection is specific contract language. Define the metric precisely (which revenue counts, which expenses are in or out, how allocations work). Require audit rights so the seller can verify the calculation. Specify the accounting standard (typically GAAP or the same method used pre-close). Include conduct covenants that limit the buyer's ability to take actions that predictably reduce the metric during the earnout period.
Acceleration and default
Good earnout contracts specify what happens if the buyer sells the business, merges it, or shuts it down during the earnout period. The typical protection is acceleration: if any of those events occur, the full remaining earnout becomes payable immediately, sometimes at a specified multiple.
The contract should also specify what happens if the buyer defaults on the earnout payment itself. Typical remedies include interest on overdue amounts, the right to audit the buyer's books at the buyer's expense, and in extreme cases, the right to force a sale of the business.
None of this is standard boilerplate. Every earnout contract is negotiated. The attorney drafting the provisions should be experienced in small-business M&A, not a general-purpose business attorney.
Tax treatment
Earnout payments are typically treated as additional purchase price for the business, which means the seller reports them under the IRS Installment Method (Form 6252) in the year received. Each payment is part return of basis, part capital gain, part interest.
If the earnout is contingent and the maximum payment is uncertain, the IRS rules for contingent-payment installment sales apply, which are more complex. IRS Publication 537 covers the basic installment-sale rules; a deal CPA should model the specific earnout structure before closing.
If an earnout payment is structured as compensation for the seller's continued services after closing (rather than as purchase price), it may be treated as ordinary income rather than capital gain. This is a material tax difference and should be negotiated and documented deliberately, not by accident.
The structures, side by side
Revenue-based earnout
Payment is tied to top-line revenue hitting specified thresholds.
How it works
The contract sets annual revenue targets (often a baseline plus a growth rate) for the earnout period. If revenue meets or exceeds the target, the earnout is paid, often with a sliding scale above and below the target.
Best for
Deals where the seller is confident in the customer book continuing and the buyer wants a simple metric that is hard to manipulate.
Watch-outs
Revenue-based earnouts incentivize the buyer to grow the top line even at the expense of margin. A buyer who discounts heavily to hit revenue can hurt the business while still earning out. Define revenue tightly (net of discounts and returns) and consider a minimum gross margin floor.
EBITDA-based earnout
Payment is tied to earnings before interest, taxes, depreciation, and amortization.
How it works
The contract sets annual EBITDA targets. The seller is paid when the business hits the bottom-line target, not just top-line revenue.
Best for
Deals where the seller wants to be paid on profitable growth, not just growth. More common in larger deals.
Watch-outs
EBITDA can be manipulated through accounting choices in ways revenue cannot. The buyer controls allocations of corporate overhead, management fees, and capital expenditure decisions. The contract needs specific language about what is in and out of EBITDA, audit rights, and dispute resolution.
Milestone-based earnout
Payment is tied to specific non-financial events (customer retention, license retention, key-employee retention).
How it works
The contract defines discrete events that trigger payment. Examples for trades businesses: retaining at least 80% of the top 20 customers 12 months after closing; keeping the master-licensed employee on payroll for 24 months; passing a state contractor-board renewal without incident.
Best for
Deals where continuity risks are specific and identifiable. Common when the seller stays on as a consultant during transition and the milestones align with things the seller can influence.
Watch-outs
Milestones need to be objective and verifiable. Subjective milestones (customer satisfaction, buyer discretion) are unenforceable and should be avoided. The contract should spell out how each milestone is measured, by whom, and how disputes are resolved.
The checklist
Define the metric in exact terms (which revenue, which costs, which accounting method).
Specify the measurement period and payment schedule.
Include audit rights with a defined process and cost-allocation rule.
Add conduct covenants limiting buyer actions that predictably reduce the metric.
Include acceleration language for sale, merger, or shutdown during the earnout period.
Specify what happens on buyer default (interest, remedies, dispute resolution).
Clarify whether the earnout is purchase price or compensation (tax treatment differs).
Have the deal CPA model after-tax outcome under the installment method.
Have an M&A attorney draft the earnout provisions, not a general business attorney.