An earnout is a portion of the purchase price in a business sale that is paid later, only if the acquired business hits agreed performance targets — usually revenue or EBITDA over one to three years. It bridges a valuation gap between an optimistic seller and a cautious buyer by tying part of the price to actual results.
How is an earnout calculated?
A typical earnout pays the seller a defined rate on performance above a target — for example, 50% of revenue exceeding a threshold — often subject to a maximum cap. To estimate its expected value, multiply the potential payout by the probability the business will hit the target, since the payment is contingent and not guaranteed.
Why do earnouts cause disputes?
Because payment depends on how performance is measured, and the buyer controls the business after closing. Sellers and buyers fight over accounting definitions, allocation of overhead, whether the buyer under-invested, and whether revenue was diverted to affiliates. Precise definitions and operating covenants in the purchase agreement reduce these disputes.
What metric should an earnout use?
Revenue-based earnouts are simpler and harder to manipulate but ignore profitability. EBITDA-based earnouts reward profitable growth but invite disputes over cost allocation and add-backs. Whichever metric is chosen, the agreement should specify the accounting standard, exclusions, and how extraordinary items are treated.
Tax treatment is complex and jurisdiction-specific. Earnout receipts may be treated as additional capital gain on the sale or, in some structures, as ordinary income — with timing rules that can spread the gain over the payment period. Because the characterization affects the after-tax result significantly, obtain professional tax advice before agreeing terms.