The buyer believes your projections are optimistic; you believe they are conservative. An earnout resolves the standoff by making part of the price contingent: the seller receives additional payments if the business hits agreed targets after closing. It is an elegant idea that produces more post-closing disputes than any other deal term — usually because the drafting never answered the questions the parties were avoiding. Here is how earnouts work and where they go wrong.
The basic architecture
An earnout has four moving parts: a metric (revenue, gross profit, EBITDA, or a milestone such as regulatory approval or customer retention), a measurement period (commonly one to three years after closing), a payment formula (all-or-nothing targets, tiered thresholds, or a percentage of results above a floor), and a cap. Each choice allocates risk. All-or-nothing targets create cliff-edge fights over small accounting differences; graduated formulas cost more to draft but far less to live with. Sellers should also push for a shorter measurement period — the longer the earnout runs, the more the results reflect the buyer's decisions rather than the business the seller built.
Choosing the metric: fight high on the income statement
The central seller-side insight is that the further down the income statement the metric sits, the more the buyer controls it. Revenue is hard to manipulate; EBITDA is soft clay — it moves with allocated overhead, management fees, integration costs, and accounting judgment calls. If the buyer insists on a profitability metric, the contract needs a defined accounting rulebook: measurement on the seller's historical practices (or specified GAAP elections), the business tracked as a separate reporting unit, and an agreed list of exclusions — buyer overhead allocations, transaction and integration costs, purchase-accounting adjustments — so the target is measured on the business, not on the buyer's bookkeeping.
The real risk: the buyer runs the business now
After closing, every driver of the earnout — pricing, hiring, marketing spend, which products get sold first — belongs to the buyer. Buyers resist any duty to maximize the earnout, and courts in the leading M&A jurisdictions have generally declined to invent one, enforcing instead whatever standard the parties wrote, with only a thin implied covenant of good faith behind it. The protection must therefore be drafted, not assumed:
- Operating covenants: run the business in the ordinary course consistent with past practice; do not divert customers or opportunities to affiliates; maintain agreed funding levels for the unit;
- Negative covenants: no shifting of revenue outside the measured business, no above-market intercompany charges;
- Acceleration: the earnout pays out in full if the buyer resells the business, shuts down the unit, or terminates the seller-founder without cause during the period;
- Information rights: periodic financial reports on the metric and audit rights, so the seller is not litigating blind.
Dispute mechanics and payment protection
Build the fight into the contract before it happens: the buyer delivers an earnout statement, the seller has a defined objection window, the parties negotiate, and unresolved accounting disagreements go to an independent accounting firm acting as expert rather than arbitrator — faster and cheaper than full litigation for calculation disputes, while legal questions (like covenant breaches) stay with the courts or arbitration. Sellers should also think about credit risk: an earnout is an unsecured promise from the buyer unless you negotiate security, a parent-company obligation, or setoff limits. Speaking of setoff — buyers routinely want to deduct indemnity claims from earnout payments; sellers should cap or condition that right, or an aggressive indemnity claim becomes a tool to hold the earnout hostage.
Tax and employment wrinkles
Earnout payments to a seller are generally additional purchase price, with their tax character depending on the assets sold, and they are often reported under the installment method as payments arrive. But if the payments are tied to the seller's continued employment, the IRS and the documents may treat them as compensation: ordinary income to the seller, subject to employment taxes, deductible to the buyer. Founders staying on after closing should keep purchase-price earnouts and compensation packages clearly separate in the documents. Interest imputation on deferred payments and the character of milestone payments deserve advice from your tax professional alongside M&A counsel — the drafting and the tax treatment have to match.
When to accept an earnout at all
An earnout is worth most when the gap is genuinely about the future — a product mid-launch, a pending approval, unproven customer expansion — and the seller retains real influence over results, ideally by staying in an operating role. It is worth least when it papers over a buyer who simply will not pay the price: a seller who expects little from the earnout should negotiate the closing payment as if the earnout were zero, and treat anything received as upside. However it is structured, the earnout terms belong in the letter of intent in real detail, because contract leverage on these points evaporates once exclusivity begins.
Talk to a California business attorney
If a buyer has proposed an earnout — or you are considering offering one to close a valuation gap — the structure and covenants deserve scrutiny before you commit to a term sheet. Schedule a free consultation or call (949) 418-2113.
This article is attorney advertising and provides general information only. It is not legal advice and does not create an attorney–client relationship. Facts matter; consult a lawyer about your specific situation.
