Earnouts in a Business Sale: What Buyers and Sellers Should Define Before Closing

Buyers and sellers do not always agree on what a business is worth today.

The seller may expect strong future growth and want value for that potential. The buyer may be willing to pay more only if that performance actually occurs after closing.

An earnout is one transaction structure that can help bridge this gap by making part of the consideration dependent on future results.

Because future performance can be affected by post-closing decisions, earnouts require careful drafting and should be reviewed with qualified legal, financial, and tax professionals.

What Is an Earnout?

An earnout generally provides for additional payments to the seller if the acquired business reaches specified performance conditions after closing.

The conditions may be based on measures such as:

• Revenue
• Gross profit
• EBITDA or another earnings measure
• Customer retention
• Specific contracts
• Product or regulatory milestones

The specific metric should reflect the economics of the transaction and be defined carefully.

Why Would a Buyer Use an Earnout?

A buyer may be uncertain whether the seller’s growth expectations will occur.

Rather than paying the entire expected value at closing, the buyer can agree to additional consideration if specified performance is achieved.

This can reduce the buyer’s risk of paying upfront for results that never materialize.

Why Would a Seller Accept an Earnout?

A seller may accept an earnout when it provides a path to receiving additional value beyond the amount the buyer is willing to pay at closing.

This may be particularly relevant when:

• Growth is accelerating
• A major contract is expected
• New locations are ramping
• The buyer and seller disagree about future earnings
• Recent performance does not yet reflect expected potential

The Metric Must Be Defined Precisely

Terms such as “revenue” or “EBITDA” can appear straightforward but still create disputes if the agreement does not define how they will be calculated.

Questions can include:

• Which accounting policies apply?
• Are intercompany charges included?
• How are extraordinary expenses treated?
• What happens to acquired or discontinued operations?
• How are refunds or returns handled?
• Which period determines performance?

The parties should avoid relying on assumptions that are not reflected in the agreement.

Measurement Period Matters

An earnout may cover one year, several years, or another defined period.

A short period may not capture longer-term performance. A long period may keep the seller financially connected to a business no longer under the seller’s control.

The appropriate period depends on the metric and the reason the earnout exists.

Who Controls the Business After Closing?

This is one of the most significant earnout issues.

After closing, the buyer typically controls the company. The buyer may change:

• Pricing
• Marketing
• Staffing
• Locations
• Product strategy
• Expenses
• Customer focus
• Accounting practices

Those decisions can affect whether an earnout target is achieved.

The parties may negotiate standards addressing how the business will be operated during the earnout period, subject to the specific transaction and applicable law.

What Happens if the Seller Continues Working?

Some earnouts are combined with consulting or employment arrangements.

The seller may continue leading sales, maintaining customer relationships, or supporting transition.

The documents should distinguish between purchase-price payments and compensation for post-closing services where appropriate.

Legal and tax treatment can be important and should be reviewed professionally.

Revenue Earnouts vs. Earnings Earnouts

A revenue target can be easier to observe but does not necessarily reflect profitability.

An earnings-based target considers expenses but can create more disagreement about how costs are allocated after closing.

Neither method is universally superior.

The appropriate metric should connect to the business risk the parties are trying to resolve.

Should There Be a Minimum or Maximum Earnout?

The agreement may establish:

• Thresholds before any payment is earned
• Graduated payments
• Maximum payment caps
• Multiple performance levels

The formula should be understandable enough that both parties can model possible outcomes before signing.

How Will Performance Be Reported?

A seller expecting future payments may require access to information showing how the earnout calculation was determined.

The transaction documents can address:

• Reporting frequency
• Financial statements
• Calculation notices
• Inspection rights
• Time allowed to object
• Dispute procedures

What Happens if the Buyer Resells the Business?

The earnout period may still be open when the buyer later sells or restructures the company.

The agreement should address what happens to unpaid potential earnout amounts if ownership changes again.

What Happens if the Business Is Integrated Into a Larger Company?

Integration can make performance measurement more complicated.

Customers, employees, expenses, brands, or systems may be combined with other operations.

The parties should consider whether the earnout metric can still be measured fairly after integration.

Earnouts Can Create Post-Closing Disputes

The buyer and seller have different economic interests after closing.

The seller may want the business operated to maximize the earnout. The buyer may make decisions for longer-term strategic reasons that reduce short-term performance.

Clear definitions and dispute procedures can reduce uncertainty, but no contract can eliminate every commercial disagreement.

Earnout Is Different From Seller Financing

Seller financing generally involves a fixed payment obligation subject to agreed debt terms.

An earnout is contingent on specified future performance.

A transaction can contain both structures, but they create different legal and economic risks.

Do Not Use an Earnout to Avoid Solving a Fundamental Valuation Problem

An earnout can bridge genuine uncertainty. It should not replace careful analysis of the company’s current value, sustainable earnings, transition risk, and likely future performance.

Both parties should understand what portion of the transaction is certain at closing and what portion remains conditional.

Define the Rules Before the Seller Gives Up Control

Once the transaction closes, the seller may have limited ability to influence how the company operates.

That makes pre-closing definition especially important.

Legal counsel can help buyers and sellers translate the commercial earnout concept into clear contractual terms addressing calculation, operation, reporting, disputes, and payment.

Frequently Asked Questions

What is an earnout in a business sale?

An earnout generally makes part of the transaction consideration dependent on the acquired business reaching specified future performance conditions.

Is an earnout the same as seller financing?

No. Seller financing generally creates a defined payment obligation, while an earnout is contingent on future performance according to the transaction agreement.

What can an earnout be based on?

Depending on the transaction, it may be tied to revenue, earnings, customers, contracts, regulatory milestones, or another specifically defined performance measure.

Why are earnouts sometimes disputed?

Disputes can arise over calculation methods, expenses, post-closing operating decisions, accounting treatment, reporting, or whether the agreed performance conditions were satisfied.

Earnouts can bridge valuation differences, but future performance, calculation methods, and post-closing control should be defined carefully.