Earnouts in Business Sales Explained
An earnout is an arrangement in which part of a business’s purchase price depends on agreed results after closing. The buyer pays an initial amount, with additional payments contingent on defined financial targets or milestones. Earnouts can bridge valuation disagreements, but sellers should distinguish the maximum possible payment from the amount payable at closing.
For a business owner, an offer of “up to $1.15 million” may sound better than a $1 million offer. However, if $150,000 depends on future performance, the two offers cannot be compared by headline price alone.
The seller needs to understand how the additional payment is earned, who controls the business during the measurement period, and what happens if results fall short.
This guide explains earnouts in business sales, including calculations, common structures, and questions to discuss with your advisers. Consult your attorney and accountant before agreeing to transaction terms.
What Is an Earnout in a Business Sale?
An earnout makes additional purchase consideration contingent on a defined outcome. The agreement establishes what must happen before the buyer owes that payment.
The outcome might involve revenue, EBITDA, customer retention, or a specific operating milestone. The terms should identify the measurement period, calculation method, payment deadline, and maximum amount.
Earnouts can help when a seller expects growth that a buyer is unwilling to pay for immediately. Rather than resolving the entire disagreement through the closing payment, the parties connect additional consideration to subsequent results.
Before discussing contingent payments, identify the assumptions behind the price difference. A business valuation can help frame that conversation.
An earnout does not remove uncertainty. It allocates some of that uncertainty between the parties.
How Does an Earnout Work?
An earnout generally follows a sequence established in the transaction documents.
First, the parties negotiate the payment structure. They identify the initial purchase payment and the additional amount potentially available.
Next, they define the performance measure and period. “Revenue growth” or “maintaining profitability” is not a complete formula. The agreement needs enough detail for the parties to calculate the result consistently.
After closing, the business operates during the measurement period. The responsible party prepares the agreed reports and calculation.
The seller then receives the information and review opportunity specified in the agreement. Payment follows the contractual process, including any procedures for resolving disagreements.
For example, the documents might require a calculation within a defined number of days after the measurement period ends. They should also address when payment becomes due and how objections are handled.
Those details should be negotiated before closing.
Earnout Example With a Payment Calculation
Consider this hypothetical sale of a Florida service business. The figures illustrate one possible structure, not a market benchmark or a KMF client transaction.
Assume the parties agree to:
- A $1 million purchase payment at closing.
- One 12-month earnout measurement period beginning after closing.
- An additional payment equal to 30% of qualifying revenue above $2 million.
- A maximum earnout payment of $150,000.
- No earnout payment when qualifying revenue is $2 million or less.
For this example, qualifying revenue means revenue determined under the specific accounting and transaction rules agreed by the parties.
The calculation is:
Earnout payment = 30% × qualifying revenue above $2 million, subject to a $150,000 cap.
| Qualifying revenue during the measurement period | Revenue above $2 million | Earnout payment | Combined purchase payments |
| $1,900,000 | $0 | $0 | $1,000,000 |
| $2,000,000 | $0 | $0 | $1,000,000 |
| $2,250,000 | $250,000 | $75,000 | $1,075,000 |
| $2,500,000 | $500,000 | $150,000 | $1,150,000 |
| $2,700,000 | $700,000 | $150,000 | $1,150,000 |
At $2.25 million of qualifying revenue, the calculation is $250,000 × 30%, producing a $75,000 earnout.
At $2.7 million, the uncapped calculation would produce $210,000. The contractual cap limits payment to $150,000.
These combined payments are not the seller’s after-tax proceeds. Debt repayment, expenses, taxes, other adjustments, and the complete agreement require separate consideration.
Why the Formula Needs More Than a Target
The parties still need to define how revenue is measured.
Questions include whether discounts, refunds, credits, customer deposits, related-party sales, or acquired operations affect qualifying revenue. They should also address sales involving customers served by another part of the buyer’s organization.
Without those definitions, the same business activity could produce different calculations.
Holland & Knight’s discussion of drafting earnout provisions explains why financial definitions, accounting methods, and operating decisions deserve attention in the agreement.
Earnout vs. Seller Financing vs. Holdback
These arrangements can all involve payments after closing, but they serve different purposes.
| Structure | Basic purpose | Main question |
| Earnout | Make additional consideration depend on agreed future results | Was the performance condition satisfied? |
| Seller financing | Defer payment of an agreed debt under a seller note | When and under what terms must the debt be paid? |
| Holdback | Retain part of the consideration pending specified matters | What conditions govern release or deduction? |
A fixed seller note does not automatically become an earnout because payments occur later. Likewise, money held pending a purchase-price adjustment or claim is not necessarily performance-based consideration.
Some agreements combine these features. Ask your attorney to explain each obligation, its conditions, payment priority, and available remedies.
Which Earnout Structure Fits the Transaction?
The metric should reflect the commercial issue the parties are trying to resolve.
Revenue-Based Earnouts
Revenue-based earnouts connect payment to sales. They can be useful when the disagreement concerns customer retention or future revenue.
However, revenue alone does not establish profitability. Discounting or changes in customer terms may increase sales without producing the financial outcome the buyer expected.
A revenue formula therefore needs clear definitions and consideration of the incentives it creates.
EBITDA-Based Earnouts
EBITDA-based earnouts connect payment to earnings before interest, taxes, depreciation, and amortization, as specifically defined in the agreement.
Expense allocations, management fees, integration costs, and accounting adjustments can affect the calculation.
Before setting a target, understand the starting earnings figure. Our guide to a quality of earnings report explains how financial diligence examines reported results and proposed adjustments.
Milestone-Based Earnouts
Milestone earnouts depend on defined events, such as securing a specified contract or completing an agreed development milestone.
Define what counts as completion, the evidence required, and the deadline. Address dependencies outside the seller’s control rather than assuming the parties will resolve them later.
Beresford Booth’s comparison of revenue and EBITDA earnout metrics provides additional background on their different risks.
The appropriate structure depends on the transaction, available records, operating arrangements, and professional advice.
What Terms Should Buyers and Sellers Negotiate?
A useful earnout agreement explains how the payment will be calculated and how the arrangement will operate after closing. Agreeing on a target is only the beginning.
Use the following questions to prepare for discussions with your attorney and accountant.
Define the Metric and Accounting Methods
Specify which revenue, expenses, customers, products, locations, or activities belong in the calculation.
For an EBITDA earnout, discuss adjustments for management fees, integration expenses, related-party charges, and other potentially disputed items. For a revenue earnout, address recognition timing, refunds, discounts, and customer attribution.
Ask your accountant to prepare sample calculations and your attorney to ensure the agreement accurately captures the intended methodology.
Establish Measurement Periods and Payment Rules
Identify when measurement begins and ends. Explain whether results are calculated annually, cumulatively, or across several separate periods.
Clarify thresholds, payment caps, and whether partial payments are possible. If performance exceeds a target in one period but falls short in another, explain whether the results offset each other.
Also distinguish the calculation deadline from the payment deadline.
Agree on Reporting and Record Access
The seller needs a defined way to evaluate the calculation.
Discuss which reports will be provided, how frequently they will arrive, and what supporting records may be reviewed. Address confidentiality and access arrangements without assuming the seller will retain unrestricted access to the buyer’s accounting systems.
Address Disagreements and Business Changes
Agree on an objection process, deadlines, and the information needed to support a challenge.
Ask your attorney how accounting disputes will be distinguished from contractual disputes. An accountant’s calculation expertise does not necessarily resolve questions about whether a party breached an operating obligation.
Also consider what happens if the buyer sells, combines, relocates, or closes the acquired business during the measurement period. Holland & Knight discusses these issues in its guidance on drafting earnout provisions.
What Are the Risks When the Buyer Controls Operations?
The seller’s payment may depend on results influenced by decisions the buyer makes after closing.
For example, the buyer might increase staffing, change prices, discontinue products, or move customer accounts into another business unit. Those decisions may have legitimate commercial purposes while also affecting the earnout.
Consider this hypothetical situation: a buyer adds a management team and increases marketing spending to support long-term growth. Revenue improves, but the added expenses reduce EBITDA during the earnout period.
Whether those expenses affect payment should follow the agreed definitions and contractual obligations.
Before signing, discuss:
- Which operating decisions the buyer may make.
- Whether any decisions require consultation or consent.
- How shared customers, employees, and overhead will be treated.
- What responsibilities the seller will retain.
- What happens if the seller’s employment or consulting role ends.
Do not assume that remaining involved gives the seller control over the outcome. Have your attorney explain the rights actually provided by the agreement.
How Can Buyers Evaluate an Earnout Proposal?
Buyers should evaluate both the payment obligation and the behavior the formula may encourage.
A revenue target could encourage sales that generate little profit. A short measurement period might reward actions that improve immediate results while creating later costs.
Before accepting a formula, test several scenarios:
| Scenario | Question to investigate |
| Revenue rises while margins fall | Does the payment still reflect the intended economics? |
| The largest customer leaves | How does the formula respond? |
| Integration increases expenses | Which costs affect the calculation? |
| Performance reaches the maximum payout | Can the buyer fund the payment? |
| Results fall between targets | Is the partial-payment calculation clear? |
Compare the earnout with alternatives, including a different initial price or other negotiated payment arrangements.
An earnout should be evaluated alongside the business’s existing risks. Use a seller due diligence checklist to organize information that prospective buyers may request.
What Financing and Tax Questions Need Professional Review?
Confirm financing requirements before committing to contingent payments.
If SBA financing is involved, ask the lender and transaction attorney to verify the proposed structure against the applicable SBA requirements. Do not assume that describing an obligation as a seller note or placing it on standby establishes that it is permitted.
For any financing arrangement, clarify whether lender consent, payment restrictions, or subordination provisions affect the proposed obligation.
Tax treatment also requires individual advice. Ask your accountant and attorney to review how the payments relate to the purchase price, any continuing services, and the transaction structure. Holland & Knight identifies payment classification and coordination with tax advisers as important earnout considerations.
Evaluate expected proceeds after professional review rather than treating the maximum contingent payment as money already available to the seller.
What Should You Review Before Signing?
Prepare a short decision package containing the proposed formula, supporting financial information, and worked examples.
Organized records make it easier to explain historical performance and discuss achievable targets. Our guide to preparing your business for sale outlines additional preparation steps.
Before signing, confirm that you understand:
- The amount payable at closing and the amount remaining contingent.
- The evidence supporting the performance targets.
- Your responsibilities after closing.
- Reporting, calculation, and payment deadlines.
- The identity and financial capacity of the payment obligor.
- The consequences of missed targets, operational changes, or disputes.
Ask your advisers to explain the agreement using the same scenarios you used during negotiations. Resolve differences between the commercial understanding and the written documents before proceeding.
Frequently Asked Questions About Earnouts
Is an Earnout Guaranteed?
No. Payment depends on the conditions in the agreement. Even when a payment becomes contractually due, collection may involve additional risks. Distinguish potential consideration from money received at closing.
What Happens if Performance Targets Are Missed?
The agreement determines the result. Some formulas provide partial payments, while others require a threshold before any payment is earned. Review examples immediately above and below each threshold.
Can a Seller Refuse an Earnout?
Yes. A seller can negotiate for different terms or decline the proposal. The buyer may respond with a different price, structure, or decision about whether to proceed.
How Long Should an Earnout Last?
Choose a period that fits the uncertainty being measured and the parties’ operating plans. Consider seasonality, customer cycles, reporting capabilities, and how long the seller is comfortable retaining payment risk.
What Happens if the Buyer Sells the Business?
The agreement should address that possibility. Ask your attorney about payment obligations, assumption by a successor, acceleration provisions, and any other negotiated protections.
Is an Earnout the Same as a Seller Note?
No. An earnout makes consideration contingent on specified results. A seller note documents a debt obligation under its terms. Agreements can contain additional conditions, so review the actual documents rather than relying on labels.
Does the Seller Have to Remain Employed?
That depends on the arrangement. Some sellers remain involved; others do not. Clarify whether employment termination affects payment and obtain accounting, tax, and legal advice before linking the two.
Planning Your Business Sale
An earnout proposal should be evaluated through its formula, operating assumptions, payment risks, and written terms.
If you are considering selling your business in Florida, KMF Business Advisors can help you discuss preparation, valuation, and commercial terms. Your attorney and accountant should review the proposed structure before you sign.
Disclaimer
This article is provided for general educational purposes and does not constitute legal, tax, accounting, or financing advice. Earnout terms and their consequences depend on the transaction, applicable law, and lender requirements. Examples are hypothetical and do not guarantee payment or results. Consult a qualified attorney and accountant, and confirm financing requirements directly with your lender, before signing an agreement.
About the Author
John C. Bucher is Broker and President of KMF Business Advisors LLC, based in Boca Raton, Florida. He works with business owners and buyers on business sales, acquisitions, and business valuation discussions.
This article provides general educational information. Consult a qualified attorney and accountant for advice about your specific transaction.