An earnout is an acquisition structure where a portion of the purchase price is paid contingent on the acquired business meeting future performance targets (revenue, EBITDA, milestones) over a specified period. Earnouts bridge valuation gaps between buyer and seller when future performance is uncertain.
Earnouts are used in M&A transactions when the buyer and seller disagree on the business's value — typically because the seller believes in strong future growth that the buyer cannot yet verify. Instead of deadlocking, the parties agree on a base payment at closing plus contingent payments tied to achieving defined targets. Typical earnout structure: Upfront payment at closing = agreed base value (e.g., $5M for a $10M target). Earnout period = 2–4 years post-closing. Earnout metrics: revenue thresholds, EBITDA targets, contract milestones, customer retention rates. If targets are met, seller receives additional consideration (cash, stock, or notes) per the agreed formula. Earnouts are especially common in: (1) Professional services and services businesses where revenue is customer-relationship dependent — buyer wants to verify relationships survive the ownership transition. (2) Technology companies with nascent revenue but promising pipelines. (3) Healthcare practices where patient base retention is uncertain. (4) Businesses with key-person risk where the seller/founder is critical to revenue generation. Complications: Earnouts are among the most litigated provisions in M&A. Common disputes: the buyer changes the business strategy or structure post-closing in ways that prevent the seller from achieving targets. The accounting metrics are interpreted differently by buyer and seller. The buyer refuses to provide the resources needed to hit targets. Clear drafting — detailed definitions of metrics, anti-sandbagging provisions, operating covenants requiring the buyer to run the business consistently — is essential. Accounting under ASC 805 (Business Combinations): Earnout consideration is classified as either contingent consideration (liability measured at fair value, re-measured at each reporting date with changes through earnings) or compensation (expensed over the earnout period if tied to ongoing employment). This distinction has material income statement impact for the acquirer.
Generally yes — earnout payments are treated as installment sale proceeds and taxed in the year received. The character (capital gain vs. ordinary income) depends on what the earnout payments relate to: payments for goodwill and appreciated assets generate long-term capital gain (if held over 1 year); payments allocable to consulting agreements or non-competes for the seller's continued services are ordinary income. The allocation of purchase price (Form 8594) governs the tax treatment. IRS Publication 537 covers installment sales. Consult a tax advisor before signing.
Key protections: (1) Define metrics precisely — use accounting definitions in the contract, not generic terms like 'revenue' or 'EBITDA.' (2) Operating covenants — require the buyer to run the acquired business consistently (not load it with corporate overhead, not divert its customers). (3) Access to records — contractual right to audit the earnout calculations. (4) Dispute resolution — pre-agreed mechanism (accounting firm arbitration for metric disputes, separate from general contract disputes). (5) Anti-assignment — earnout obligation should not be transferable if buyer sells the business.
Earnout usage varies significantly with market conditions. In seller's markets (high valuations, competitive processes), earnouts are less common — sellers prefer clean upfront consideration. In buyer's markets or for higher-risk acquisitions, earnouts appear in 20–35% of private company M&A transactions. Healthcare, technology, and professional services sectors have higher earnout prevalence than manufacturing or real estate. Data from the American Bar Association's M&A Deal Points Studies tracks prevalence by industry.