An earn-out is a provision in a business sale agreement that makes part of the purchase price contingent on how the business performs after closing. The buyer pays a guaranteed amount up front and promises additional payments later if the business hits agreed targets during a defined window. The structure bridges a valuation gap: the seller gets a shot at a higher total price, and the buyer avoids overpaying for a business that underperforms. Earn-outs appear in roughly a quarter of private-company acquisitions, and the fine print determines whether they work smoothly or end up in court.
The Two Parts of the Purchase Price
Every earn-out splits the deal value in two. The fixed portion transfers on the closing date no matter what happens next. The contingent portion is a promise. If the business performs well enough during the measurement period, the buyer owes more; if it does not, the buyer typically owes nothing beyond the base price.
Because the buyer runs the business after closing, this structure shifts risk in a particular way. The seller carries the risk that the business will underperform. The seller also carries a subtler risk: that the new owner will operate the business in ways that suppress the very numbers the earn-out is measured against. That tension is why earn-out agreements spend so much ink on protective covenants.
What Triggers the Contingent Payment
The targets written into an earn-out fall into two broad categories: financial metrics and operational milestones.
Revenue, EBITDA, and Other Financial Metrics
Revenue is the most common benchmark. Recent deal data shows roughly 60 percent of earn-outs outside the life sciences sector are tied to revenue, largely because it is straightforward to measure and hard to manipulate through accounting choices. A buyer cannot easily make revenue disappear by reclassifying expenses.
Profit-based metrics like EBITDA or net income appear in a smaller share of deals, around 20 percent outside life sciences, and they serve a different purpose: making sure the business is not growing revenue at the expense of margin. EBITDA earn-outs demand careful drafting because the definition varies from deal to deal. The agreement needs to spell out which expenses are included and which are excluded. Common add-backs include one-time transaction costs, restructuring expenses the buyer initiates after closing, and integration costs. Without those adjustments, a buyer could load the acquired business with corporate overhead allocations or integration charges that artificially depress EBITDA and shrink the payment. Each add-back belongs in the disclosure schedules so there is no ambiguity when the number is run.
Operational Milestones
Non-financial targets can supplement or replace financial metrics. These include completing development of a product, securing regulatory approval, retaining a specified percentage of key employees, or signing a set number of enterprise clients. Milestones work well when the acquired business is early-stage and traditional financial numbers would be unreliable. Each milestone is assigned a specific dollar value or percentage of the total contingent payment so both sides know what the achievement is worth.
How Long an Earn-Out Lasts
Most measurement periods run between one and three years after closing, with a median of 24 months outside life sciences. That window gives the buyer time to integrate the business and lets the metrics be meaningfully tested, without leaving the final price unresolved for so long that it becomes unmanageable.
The agreement needs to say whether the period is treated as a single cumulative window or broken into separate annual intervals. In a cumulative structure, only the total performance matters. In an annual structure, each year gets its own calculation and its own payment. Some agreements add catch-up provisions that let a strong second year offset a weak first year, which matters for businesses with seasonal or cyclical revenue.
Once the measurement period ends and the final calculation is done, the buyer’s obligation to track performance and pay anything further terminates.
Seller Protections After Closing
Because the buyer controls day-to-day operations once the deal closes, sellers negotiate contractual safeguards to prevent the buyer from running the business in ways that undercut the targets.
Operating Covenants
Common operating covenants require the buyer to:
- Use commercially reasonable efforts to achieve the earn-out targets
- Run the acquired business as a stand-alone entity or separate division so the metrics remain trackable
- Maintain separate books and records and give the seller access to them
- Preserve minimum working capital levels
- Avoid loading the business with new debt above a specified threshold
- Refrain from disposing of the business or its key assets
Not every deal includes all of these. Recent studies show only about a quarter of earn-out transactions include explicit covenants requiring the buyer to operate the business consistently with past practices or as a stand-alone unit. A larger share, roughly 58 percent, contain more general protective language such as commercially reasonable efforts obligations or prohibitions on bad faith conduct.
The Implied Covenant of Good Faith
Even when an agreement is silent on a specific issue, courts in most jurisdictions recognize an implied covenant of good faith and fair dealing that stops either party from deliberately undermining the other’s benefit of the bargain. Sellers have used this doctrine to argue that a buyer sabotaged earn-out targets by diverting customers to other business units, slashing the sales budget, or delaying lucrative contracts until after the measurement period expired.
The doctrine has real limits. Courts generally will not use it to add obligations the parties could have negotiated but chose not to include. A recent Delaware Supreme Court decision reinforced the point, holding that the implied covenant does not rescue sellers from foreseeable risks they failed to address in the agreement. The practical lesson: negotiate the explicit covenant rather than rely on a court to imply one later.
Acceleration on a Change of Control
Acceleration provisions specify events that trigger immediate payment of part or all of the remaining earn-out. The most common trigger is a change of control: if the buyer resells the acquired business to a third party before the measurement period ends, the seller should not lose the earn-out simply because a new owner has taken over. Nearly 25 percent of non-life-sciences earn-out transactions include a change-of-control acceleration clause. Other possible triggers include termination of key employees without cause and material breaches of the operating covenants. Buyers typically insist that acceleration not apply when an employee is terminated for cause or resigns voluntarily.
Calculating and Disputing the Payment
After the measurement period ends, the buyer prepares a detailed calculation and delivers a formal notice to the seller. The seller then has a contractual window, typically 30 days, to review the financial data, ask questions, and either accept the calculation or deliver a notice of disagreement.
If the parties cannot agree, most earn-out agreements send the dispute to an independent accounting firm. The scope of that review depends entirely on the drafting. A narrow provision might limit the accountant to checking whether the calculation followed the agreed accounting methods. A broader provision might authorize the accountant to evaluate whether the buyer operated the business in good faith. Getting this language right during negotiations matters, because a narrowly drafted clause can force the seller into expensive litigation for anything the accountant is not authorized to touch. The accountant’s determination is typically binding, and courts generally give significant deference to the findings. The agreement should also specify how the accountant’s costs are allocated; common approaches include requiring the losing side to pay or splitting costs based on how close each party’s position was to the final number.
Throughout the earn-out period, the seller should have the right to periodic financial statements showing how the metrics are being calculated, with supporting schedules and explanations for significant variances. Payment itself can come as cash, buyer stock, or installment notes, depending on what the agreement specifies.
Security for the Earn-Out
An earn-out is only as valuable as the buyer’s ability and willingness to pay it. If the buyer runs into financial trouble or is itself acquired during the earn-out period, the contingent payment can become uncollectible. Sellers can negotiate security mechanisms to reduce that credit risk: an escrow account funded at closing, a parent-company guaranty if the buyer is a subsidiary, a security interest in the acquired business’s assets, or a bank letter of credit. These add cost and complexity, and buyers resist them because they reduce the financial flexibility earn-outs are partly designed to provide. For sellers in deals where the contingent portion is a large share of the total price, some form of security can be the difference between getting paid and holding an uncollectible contractual right.
Tax Treatment for Sellers
How earn-out payments are taxed depends on how the deal is structured and whether the seller continues working for the buyer after closing.
Capital Gain or Ordinary Income
When an earn-out is tied purely to the performance of the business and represents additional purchase price for a capital asset such as stock or long-held business assets, payments are generally treated as capital gains. If the earn-out is conditioned on the seller’s continued employment, the IRS may recharacterize some or all of it as compensation, which is taxed as ordinary income and subject to employment taxes. A clause that forfeits the earn-out if the seller leaves employment strengthens that recharacterization argument considerably. The safer approach is to separate the two: tie the earn-out to business results that are achievable regardless of the seller’s personal involvement, and document any post-closing services in a separate employment agreement with its own compensation terms.
Installment Method Reporting
Because the total price in an earn-out deal is not known at closing, the sale is treated as a contingent payment sale for federal tax purposes. Under IRC Section 453, income is reported using the installment method, meaning the seller recognizes gain as payments are actually received rather than all at once in the year of closing.1Office of the Law Revision Counsel. 26 USC 453 – Installment Method That can meaningfully reduce the tax burden in the sale year by spreading gain across multiple years. Treasury Regulations provide specific rules for how a seller allocates cost basis across contingent payments depending on whether the agreement caps the total price, fixes a payment term, or does neither.2eCFR. 26 CFR 15a.453-1 – Installment Method Reporting for Sales of Real Property and Casual Sales of Personal Property
Imputed Interest
When earn-out payments are due more than one year after closing, IRC Section 483 may recharacterize part of each payment as interest rather than purchase price, even if the agreement does not mention interest.3Office of the Law Revision Counsel. 26 USC 483 – Interest on Certain Deferred Payments This happens when the agreement fails to provide for interest at a rate at least equal to the applicable federal rate. The practical effect: part of each payment ends up reported as ordinary interest income rather than capital gain, which can raise the overall tax bill. Addressing stated interest in the agreement avoids the surprise.
Section 409A Risk
If an earn-out is structured in a way the IRS treats as a nonqualified deferred compensation plan, payments must comply with IRC Section 409A.4Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans Failure triggers harsh consequences: all deferred compensation becomes immediately taxable, plus a 20 percent penalty tax and interest. The risk is highest when payments are tied to the seller’s personal services rather than business results. The short-term deferral exception, which generally exempts payments made by the 15th day of the third month following the year the right to payment vests, is a common way to stay clear of 409A entirely.
Why Buyers Care About the Accounting
From the buyer’s side, the contingent obligation is not just a future cash concern. Under ASC 805, the buyer must record the earn-out at estimated fair value on the closing date. Cash-settled earn-outs are typically classified as liabilities and remeasured to fair value every reporting period, with changes running through the income statement. If the business is beating targets, the liability grows and the buyer books a loss; if it is underperforming, the liability shrinks and the buyer books a gain. Those swings can create earnings volatility unrelated to core operations and can affect financial ratios that lenders monitor under loan covenants. Buyers with significant earn-out liabilities should make sure their lending agreements address how these adjustments are treated for covenant calculations.