An earn-out clause makes part of a business’s purchase price contingent on how the company performs after the deal closes. The buyer pays a fixed amount at closing and holds back the rest, releasing it only if the business hits agreed targets during a defined measurement period. If the targets are met, the seller collects the additional payments. If not, the buyer keeps that money. Earn-outs appear in roughly 20–30% of private acquisitions outside life sciences and in over 80% of pharmaceutical deals, where future value is hardest to pin down at closing.
How an Earn-Out Works
The logic is a compromise. Buyer and seller disagree about what the company is worth, so they bridge the gap by making part of the price contingent on actual results. The seller accepts some risk of not receiving the full price. The buyer avoids overpaying for projections that may never materialize. Both sides keep skin in the game after closing, which is exactly what makes earn-outs useful and exactly why they generate so many disputes.
The arrangement is documented either inside the purchase agreement or in a standalone earn-out agreement that cross-references it.1U.S. Securities and Exchange Commission. Earn-Out Agreement Once signed, the deal is no longer a clean ownership transfer. The seller becomes a contingent creditor waiting to see whether the numbers land.
Performance Metrics
The metric shapes everything. Revenue-based targets are the most popular because revenue is harder for a buyer to manipulate through accounting choices. EBITDA is next. Net income is used less often because it can be distorted by financing decisions, tax strategies, and depreciation methods the seller never agreed to.
Non-financial milestones dominate where the acquired business hasn’t yet generated meaningful revenue. In life sciences, earn-outs are frequently tied to regulatory approvals or clinical trial results. Over 60% of private pharmaceutical acquisitions use earn-out structures built around milestones of this kind. More complex deals layer multiple metrics, combining financial targets with operational benchmarks like customer retention or commodity price thresholds.
EBITDA Adjustments
When EBITDA is the metric, the adjustments are the most heavily negotiated terms. Raw EBITDA can be pushed around by costs the seller had nothing to do with. Experienced sellers push to exclude management or monitoring fees charged by the buyer’s parent, transaction-related insurance costs, restructuring expenses, and one-time legal fees from integration. The purchase agreement should include an accounting exhibit that spells out exactly which expenses get added back and which stay in.1U.S. Securities and Exchange Commission. Earn-Out Agreement
Corporate overhead allocation is another flashpoint. Once the buyer folds the acquired company in, it may start charging the unit for shared services like IT, HR, or accounting. Those charges reduce EBITDA and shrink the seller’s payout. Better agreements lock in the allocation methodology before closing, often capping charges at the target’s historical cost levels.
Measurement Standards
Both parties need to agree on accounting standards up front. Most earn-out agreements require calculations to follow Generally Accepted Accounting Principles applied consistently with the target’s pre-closing practices. Without that consistency requirement, a buyer could switch accounting methods after closing in ways that depress reported earnings without changing anything about the actual business.
Duration, Caps, and Payment Structures
Outside life sciences, the median earn-out period runs about 24 months. Life-sciences deals typically use three to five years because regulatory timelines don’t move on a buyer’s preferred schedule. Shorter windows suit targets tied to specific near-term events like product launches or integration milestones. Longer windows test whether profitability or growth can be sustained.
Payment structures fall into two shapes. A cliff makes the entire earn-out contingent on hitting a final target at the end of the period: miss the number, get nothing. Tiered structures break the earn-out into annual or milestone-based payments, so partial performance still generates partial payouts. Tiered arrangements are friendlier to sellers and tend to produce fewer disputes.
Well-drafted agreements also include caps and floors. The cap limits the buyer’s maximum exposure. The floor sets a minimum performance threshold below which nothing is owed. A collar combines both, creating a band where payments scale between the two. In the median deal outside life sciences, the earn-out portion is roughly 30% of the closing payment. In life sciences, the median earn-out can exceed 60% of total consideration.
Post-Closing Operating Covenants
This is where most of the tension lives. The buyer now owns the company and wants to run it as part of a larger organization. The seller needs the business to hit specific numbers and doesn’t want the buyer making decisions that torpedo the earn-out. Those competing interests are managed through operating covenants in the purchase agreement.
Common seller-protective covenants require the buyer to operate the business consistent with past practices, keep it as a standalone unit or division, maintain separate books and records, avoid bad-faith actions that would impair earn-out achievement, and maintain a minimum level of working capital. Some agreements go further and require the buyer to use commercially reasonable efforts to help the business hit the targets.
Buyers resist aggressive covenants because they limit the operational flexibility that justified the acquisition. Integration is often the whole point. The buyer wants to consolidate back-office functions, cross-sell products, and restructure teams. The agreement needs to define which integration activities are permitted and which are off-limits. Vague language like “operate in the ordinary course” without further definition invites litigation.
Sellers should also negotiate restrictions on the buyer’s ability to divert customers, employees, or product lines away from the earn-out entity, incur debt against the target, or dispose of significant assets. Any of these can gut earn-out performance even if the underlying business is healthy.
Where the contract is silent, the implied covenant of good faith and fair dealing offers some backstop. A buyer cannot take arbitrary or unreasonable actions that prevent the seller from receiving the benefit of the bargain. But the covenant has real limits. Courts won’t use it to require a buyer to maximize the earn-out or to impose obligations the parties could have negotiated but didn’t. If the agreement specifically permits certain buyer actions, the implied covenant won’t override those permissions. Relying on it means you’re already in litigation. Explicit covenants covering foreseeable risks are the better answer.
If the Buyer Sells or Is Acquired
One scenario sellers frequently overlook: the buyer sells the acquired business or gets acquired itself before the earn-out period ends. Without contractual protection, the seller can lose the earn-out entirely because a new owner has no obligation to honor the arrangement or run the business in a way that would trigger the remaining payments.
Acceleration clauses solve this by requiring the buyer to pay a predetermined amount if a qualifying event occurs during the earn-out period. Those events typically include a sale of the acquired business, an acquisition of the buyer itself, or a fundamental change in the buyer’s ownership structure.2U.S. Securities and Exchange Commission. Earnout Agreement The accelerated amount is usually a fixed liquidated figure negotiated at closing, reflecting what the parties agreed the earn-out would likely have been worth if the business had kept operating normally.
For a seller, acceleration provisions are not optional. They are the single most important protection against a buyer who decides to flip the business or restructure in ways that eliminate the ability to earn contingent payments.
Making Sure the Money Is There
An earn-out is only worth something if the buyer can actually pay. If the buyer runs into financial trouble during the measurement period, hitting every target means nothing because the money isn’t there. Several mechanisms address this risk.
Parent company guarantees are the most common protection in deals involving subsidiaries or portfolio companies, with the buyer’s parent backstopping the payment obligation. Escrow accounts set aside a portion of the purchase price in a segregated fund reserved for earn-out payments. Letters of credit from a bank provide another layer of assurance. For high-value earn-outs, specialized earn-out insurance policies are available, though they add cost.
If the buyer enters bankruptcy, an unsecured earn-out obligation would be treated like any other general creditor claim, which often means pennies on the dollar. Sellers with significant earn-out exposure should negotiate secured interests or escrow arrangements that survive a bankruptcy filing.
When Disputes Happen
Earn-out disputes are common and growing more frequent. Many are resolved privately, but court filings mentioning earn-out disputes have risen significantly in recent years. Disputes cluster around two issues: disagreements over how the financial calculations were done, and allegations that the buyer interfered with the seller’s ability to hit the targets.
For calculation disagreements, most agreements require the parties to first try to resolve the issue themselves within a set window, then submit the dispute to an independent accounting firm. That firm typically acts as an expert rather than an arbitrator, meaning its role is limited to determining whether the numbers were calculated according to the agreed standards. The firm’s decision is usually binding, and courts give substantial deference to its findings.
Procedural questions cause their own fights. Can the firm only choose between the buyer’s calculation and the seller’s, or can it determine its own figure? Can it hear arguments about whether the buyer’s post-closing decisions violated the agreement? These need to be answered in the contract, not discovered during a dispute.
Allegations that the buyer breached operating covenants or the implied covenant of good faith typically fall outside the accounting expert’s authority and go to arbitration or litigation. The more money allocated to the earn-out relative to the upfront price, and the longer the earn-out period, the more likely a dispute will arise.
Tax Treatment for the Seller
Tax consequences can meaningfully change the economics of the deal. Three issues intersect, and getting any one wrong can produce an unexpected bill.
Capital Gains or Ordinary Income
The threshold question is whether the IRS treats earn-out payments as part of the purchase price, taxed at capital gains rates, or as compensation for post-closing services, taxed at ordinary income rates. Several factors drive the answer. If the earn-out is conditioned on the seller continuing to work for the buyer, or if the seller’s employment term matches the earn-out period, those facts point toward compensation treatment. If the seller already receives market-rate compensation for post-closing services and the earn-out payments are proportional to the former equity stake, those facts support capital gains treatment. If the buyer must still pay the earn-out even if the seller’s employment is terminated, that also favors purchase-price treatment.
Deals where the seller stays on as an employee are where the classification risk is highest. The more the earn-out looks like a bonus tied to future work rather than a payment for the value of the business at closing, the more likely the IRS is to recharacterize it.
Installment Sale Reporting
Because the total price isn’t known at closing, the IRS treats an earn-out as a contingent payment sale.3Internal Revenue Service. Publication 537, Installment Sales Under the installment method, gain is spread across the years payments are actually received, in proportion to those payments.4Office of the Law Revision Counsel. 26 USC 453 – Installment Method When the total selling price can’t be determined at closing, the regulations require you to recover basis ratably over the earn-out period rather than front-loading it. You can elect out on your tax return for the year of sale, but reversing that election requires IRS consent.
If the sale involves depreciable property, gain attributable to prior depreciation deductions must be recognized as ordinary income in the year of sale, regardless of when payments are received.4Office of the Law Revision Counsel. 26 USC 453 – Installment Method
Imputed Interest
If the agreement doesn’t charge adequate stated interest on deferred payments, the IRS will impute interest on any payment due more than six months after the sale.5Office of the Law Revision Counsel. 26 USC 483 – Interest on Certain Deferred Payments The imputed interest is calculated using the applicable federal rate and is taxed as ordinary income. A portion of what the seller thought was a capital-gains-eligible payment gets recharacterized as interest income at ordinary rates. The agreement should either include an adequate stated interest rate or account for the tax impact of imputed interest in the overall economics.