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An earnout is a part of a business’s sale price that the buyer pays later, and only if the company hits agreed targets after closing. You receive a guaranteed amount at the closing table, plus a contingent amount tied to revenue, profit or another milestone over a set period, often one to three years.
Buyers propose this structure when they like a company but doubt the seller’s growth forecast. For an owner, it can mean a higher headline price. It can also mean money that never arrives. This guide explains how these deals work, what to negotiate before you sign and when it makes sense to push back on the offer.
Key Takeaways
- The contingent portion is paid only if the business meets targets agreed before closing, usually measured over one to three years.
- Buyers use it to bridge a valuation gap and to share the risk that projected growth does not happen.
- Industry data shows contingent payments often pay well below their maximum, so treat that amount as upside rather than part of the price you count on.
- The definitions matter most: the metric, the accounting rules, who controls operations and what information you receive.
- Tax treatment depends on how the payments are documented, so involve a CPA and a deal attorney before you sign a letter of intent.
What is an earnout in a business sale?
In a typical deal, the purchase price is split into parts. The buyer pays cash at closing, may ask the seller to carry a note, and may hold back money in escrow for indemnification claims. A performance-based payment adds one more layer: money that depends on how the business does after the buyer takes over.
The terms sit in the purchase agreement as an “earnout provision.” That clause names the metric (for example, gross revenue or EBITDA), the measurement period, the targets, how each payment is calculated and when it is due. If a target is missed, the buyer owes nothing for that period unless the agreement says otherwise.
Contingent consideration is common in mid-market M&A. SRS Acquiom, a firm that tracks private-target transactions, reports that roughly one in five deals in its data set included one, with a median measurement period of about 24 months. Smaller Main Street deals use them too, especially when the seller stays on through a transition.
Why buyers propose earnouts
Most offers that include contingent payments start with a disagreement about value. You see the new contract you just signed, the product launch planned for next quarter or the sales hire who is finally ramping up. The buyer sees a trailing twelve months of financials and a forecast that has not been proven.
- Valuation gaps. Paying part of the price later lets the buyer meet your number if the business delivers it.
- Concentration or transition risk. If a large share of revenue comes from a few customers or from your personal relationships, the buyer wants proof those relationships survive the change of ownership.
- Financing limits. A lender may cap how much it will fund at closing, and deferring part of the price keeps the deal inside those limits.
- Keeping the owner engaged. Tying money to performance gives you a reason to help with the handover.
None of these reasons is unreasonable. The real questions are whether the structure on the table is fair to you, and whether you can realistically reach the targets once you no longer control the company.
How an earnout works: a hypothetical example
Picture a services company with steady profits and a growing contract pipeline. The owner asks for $3 million. The buyer offers $2.4 million at closing plus up to $600,000 more over two years, paid against revenue targets. Every figure in this example is hypothetical and only illustrates the mechanics.
| Year | Revenue target | Payment if met | Partial payment rule |
|---|---|---|---|
| Year 1 | $4.0 million | $300,000 | Pro rata if revenue is at least $3.6 million |
| Year 2 | $4.4 million | $300,000 | Pro rata if revenue is at least $4.0 million |
If revenue reaches $3.8 million in year one, a pro rata clause might pay half of the first installment, depending on how the formula is written. Without that clause, a near miss pays zero. This choice between a “cliff” and a sliding scale is one of the biggest drivers of what a seller actually collects.
Notice what the example leaves open: whose accounting policies define revenue, what happens if the buyer folds the company into another division, and whether a missed year can be made up the following year. Each of those gaps can cost a seller real money.
Common earnout metrics and how they compare
The yardstick you are measured against shapes how much influence the buyer has over the result.
| Metric | Why buyers like it | Risk for the seller |
|---|---|---|
| Revenue or gross sales | Simple to measure and hard to manipulate | The buyer may discount prices or move customers, but costs below the top line do not reduce your payout |
| Gross profit | Reflects pricing and direct costs | The buyer controls supplier terms and pricing decisions |
| EBITDA or net income | Ties the payout to actual profit | Overhead allocations, new hires and integration costs can push earnings down |
| Customer retention or renewals | Tests whether relationships survive the sale | What counts as an active or retained customer needs careful definition |
| Operational milestones | Fits product launches, licenses or permits | Timing often depends on the buyer’s own priorities |
As a rule of thumb, sellers prefer measures higher on the income statement, because there are fewer lines the new owner can change. Buyers prefer profit measures, because revenue growth bought with heavy spending is worth little to them. Many agreements combine two or more measures to balance those interests.
Pros and cons for sellers
Potential benefits
- A higher total price than an all-cash offer would support.
- A way to be paid for growth you believe in but cannot yet prove.
- A deal that might otherwise stall, because the buyer’s lender or investment committee can approve it.
- In some cases, taxable income spread across more than one year.
Risks to weigh
- You give up control. After closing, the buyer decides on staffing, pricing, marketing and capital spending, all of which affect your targets.
- Payouts often fall short. SRS Acquiom’s deal data has found that these provisions paid out only around 21 cents per dollar of potential value, and that a meaningful share were contested.
- Disputes are expensive. Accounting disagreements after closing can lead to arbitration or litigation that eats into whatever you collect.
- Collection depends on the buyer. If the buyer runs into financial trouble, a contingent payment can be hard to recover.
A practical test many advisors use: would you accept the guaranteed portion alone? If the answer is no, the deal may not be right for you, however attractive the headline figure looks. Treat the contingent amount as possible upside.
Key earnout terms to negotiate
Careful drafting prevents most problems. Get the basic structure written into the letter of intent, then leave the detailed language for the purchase agreement your attorney negotiates.
- A precise metric definition. Spell out which accounting principles apply, how one-time items are treated and whether the buyer’s corporate overhead can be charged to the business.
- Measurement period and payment dates. Shorter periods leave less time for the business to drift away from its old model.
- Sliding scales and catch-up rights. A pro rata formula, plus the right to recover a missed payment if a later period beats plan, reduces cliff risk.
- Operating covenants. Ask the buyer to run the business consistently with past practice, keep it as a separate reporting unit or use commercially reasonable efforts to reach the targets.
- Information rights. You should receive regular financial reports and be able to review the calculation behind each payment.
- Acceleration triggers. If the buyer sells the company, merges it away or terminates you without cause, the remaining amount could become payable at once.
- Limits on offsets. Buyers often want to deduct indemnification claims from contingent payments, so cap or narrow that right where you can.
- Dispute resolution. Name an independent accountant to settle calculation disagreements quickly, before lawyers get involved.
- Security for payment. An escrow, a parent company guarantee or an agreement with the buyer’s lender can protect you if the buyer struggles.
How earnouts are taxed
Taxes on contingent payments can be complicated, and the result depends on how the deal is documented. In general, payments that form part of the purchase price can be reported under the installment method for contingent payment sales, which spreads your gain across the years in which you actually receive money. Part of each deferred payment may also be treated as interest.
Payments tied to your continued employment, rather than to the company’s results, may be taxed as compensation at ordinary income rates. Deal structure matters as well, and our guide to an asset sale vs stock sale explains how each option affects your tax position. Ask your CPA to model the after-tax value of any offer before you negotiate.
Earnout vs seller financing vs all-cash
Contingent payments are one of several ways to close the distance between what you want and what a buyer will pay up front.
| Structure | When you get paid | Is the amount guaranteed? | Main risk to the seller |
|---|---|---|---|
| All cash at closing | At closing | Yes | Usually a lower headline price |
| Seller financing | Over the note term, with interest | Yes, subject to the buyer’s ability to pay | Buyer default |
| Earnout | After each target is measured | No | Targets missed or disputed |
| Escrow or holdback | After the claims period ends | Yes, less any valid claims | Indemnification claims |
A seller note is a debt the buyer owes regardless of results, while a performance payment is owed only if the results arrive. Many deals combine the two. Our guide to seller financing a business covers notes, interest and security in more detail.
When an earnout makes sense, and when it does not
A contingent payment tends to work when growth drivers are already in motion and easy to measure, when you plan to stay involved through the measurement period, and when the business will keep its own books after closing.
Be more cautious in these situations:
- The buyer plans to merge the company into a larger operation right away.
- The metric depends on decisions you will not influence after the sale.
- The contingent portion is a large share of the total price.
- The buyer resists information rights or a clear dispute process.
In those cases, negotiating a higher guaranteed amount, a shorter period or a seller note may protect you better than a larger contingent figure.
When to talk to a broker
The best time to get advice is before the first offer arrives, not after a buyer has framed the deal around deferred payments. An experienced broker can help you document growth so that more of the value is paid at closing, compare offers on a like-for-like basis and push back on vague terms. See how our service and process supports owners from valuation to closing, and why many owners decide that business brokers are worth it when deal structure gets complicated. You will also want a deal attorney, and this guide on what kind of lawyer you need to sell your business explains who to look for.
Next step
If a buyer has proposed an earnout, or you expect one, start with a clear view of what your company is worth today. A professional business valuation gives you a benchmark for judging how much of an offer is guaranteed and how much is contingent. When you are ready to sell your business, contact SellerForce for a free valuation and exit preparation consultation.
