Definition
Earnout
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What it is
An earnout is a contingent slice of the purchase price. The buyer pays part at closing and the rest later, but only if the business does something specific that the parties agree in advance and can measure afterwards.
It exists to solve one problem: the buyer and the seller disagree about the future, and neither can prove their case today.
When it is the right tool
An earnout works when the disagreement is narrow, specific and measurable:
- A large customer is up for renewal three months after closing, and the whole valuation argument is about whether they stay.
- A second location opened recently and has not yet reached a steady state.
- A new contract has been signed but not yet performed.
- Revenue is genuinely growing and the seller wants credit for growth they believe is already locked in.
In each case there is a single fact that will be known by a specific date, and the parties can write down what happens either way.
When it is a mistake
When the disagreement is broad. “We think it is worth $1.4M, you think $1.1M, let us put $300K in an earnout” is not a bridge — it is a decision deferred to a point where the parties have less goodwill, less contact, and a live financial dispute. If you cannot name the single uncertainty the earnout resolves, you do not have an earnout; you have an unresolved negotiation with a payment date attached.
The four terms that decide the outcome
- The metric. Revenue is easy to measure and easy to game. Gross profit is harder to game and harder to argue about. Net profit invites a fight about every cost decision you make as the new owner. Choose the metric closest to the actual uncertainty, and define it in accounting terms rather than in ordinary English.
- Control. After closing you run the business, and every decision you make can move the seller’s number — pricing, hiring, marketing spend, whether to chase a marginal contract. Either constrain your own discretion in writing or accept that the seller will question your choices. Sellers should expect a covenant about operating in the ordinary course; buyers should expect to be held to it.
- Reporting. The seller needs to see how the metric is tracking on a defined cadence, in a defined format. A seller who receives nothing for twelve months and then a number they disagree with will dispute it, and they will be reasonable to do so.
- Dispute resolution. Name the mechanism before you need it: who calculates, how the seller objects, what independent determination applies. This is the clause everyone skips and the one that decides what happens when the earnout matters.
How it interacts with your lender
An earnout is a future claim on the business’s cash. A lender financing the acquisition cares about that, and may have views on how it ranks against their debt and how it is treated in your covenants. Raise it with your lender before you agree it, not after — the same discipline that applies to a seller note.
The tax treatment of contingent payments is its own subject, on both sides, and belongs with your CPA before signing.
Where to write it down
The metric, the measurement period, the reporting obligation and the dispute mechanism all belong in the letter of intent in outline, not just in the definitive agreement. An earnout agreed in principle and drafted later is an earnout drafted by whoever has more leverage at the end. The full treatment, with a worked tiered example, is in the earnout guide.
Frequently asked questions
What percentage of the price should be in an earnout?
There is no standard figure, and a number that sounds normal is not evidence of anything. The better question is what proportion of the value genuinely depends on the uncertainty the earnout is resolving. If the answer is "most of it", the disagreement is about the business rather than about one event, and an earnout is the wrong instrument.
Which metric causes the fewest disputes?
Generally the one closest to the actual uncertainty and hardest to manipulate. Revenue is simple to measure but easy to inflate with unprofitable sales; net profit exposes every cost decision the new owner makes to argument. Gross profit often sits in a useful middle. Define whichever you choose in accounting terms, not plain English.
Can the seller stay involved to protect their earnout?
Often, and it can help — continuity for customers, and a seller motivated to make the number. It needs its own agreement covering role, authority, duration and pay, because an ambiguous post-closing role between the old and new owner creates problems beyond the earnout itself.
What happens to the earnout if I sell the business during the period?
Whatever the agreement says, which is why it needs to say something. An unaddressed sale, refinancing or major restructuring during the earnout period is a predictable source of litigation. Deal with acceleration or protection explicitly.
Educational only — not legal, tax, lending, or investment advice. Confirm specific rules, rates, and forms with the relevant New York State agency, attorney, CPA, lender, or insurer before acting. See the editorial policy and methodology for how sourcing and review work.