An earnout is part of the purchase price that the buyer pays later, and only if the business hits agreed targets after closing. It usually appears when the buyer and the seller cannot agree on value. The seller believes next year will be strong; the buyer will only pay for what the numbers already prove. The earnout lets both sides sign by moving part of the price into the future.
I'm Sergei Mochtchenkov, a CFA Charterholder. I build and review acquisition models and diligence for buyers, sellers and lenders. This guide covers how earnouts are structured, how to value one, how to put it into a deal model, and where earnouts tend to cause disputes.
What an earnout is and why deals use one
In accounting terms an earnout is contingent consideration. The FASB glossary, as quoted in PwC's Viewpoint guide, defines it as usually "an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree" if "specified future events occur or conditions are met." The same guide notes that contingent consideration "is often used when the buyer and seller cannot agree on the consideration for the acquired business."
Typical situations include:
- A business with a short track record of growth, where trailing earnings understate what the seller expects.
- A pending event, such as a large contract renewal, a product launch or a regulatory approval.
- Customer concentration, where one account could leave after the owner exits.
- An owner who will stay on to run the business and can influence the result.
An earnout is not the only way to bridge a valuation gap. A seller note, rollover equity or a holdback can do similar work with fewer disputes. More on that below.
The building blocks of an earnout
Every earnout clause answers the same six questions.
1. Which metric? Revenue, gross profit, EBITDA, units shipped or a milestone such as a signed contract. Revenue is the hardest for the buyer to manipulate after closing, so sellers often prefer it. EBITDA aligns better with value, but it is affected by the buyer's cost allocations, integration spending and accounting choices. Gross profit is a common compromise.
2. Over what period? One to three years is common. Longer periods give the seller more chance to earn the payment but expose them to more decisions they do not control.
3. What threshold and payment curve? A cliff pays everything once a target is hit and nothing below it. A linear or tiered schedule pays a share of the earnout as performance rises between a floor and a ceiling. Cliffs are simpler but create sharp incentives near the line; sliding scales reduce the fight over a single number.
4. Is there a cap? Most earnouts set a maximum. Some also include a catch-up, where a shortfall in year one can be earned back in year two.
5. How is the metric calculated? Define the accounting policies in the agreement: which GAAP basis, consistency with the historical financial statements, treatment of acquisitions the buyer makes later, corporate overhead allocations and one-off integration costs. The diligence work behind the deal is the natural starting point. If the price was set on adjusted EBITDA, the same EBITDA add-backs logic should govern the earnout calculation.
6. What protects each side? Sellers ask for operating covenants (for example, keeping the business as a separate unit, maintaining a sales team, or acceleration of the earnout if the buyer sells the business). Buyers ask for discretion to run the business, set-off rights against indemnity claims, and a clear dispute process with an independent accountant.
How to value an earnout
The headline earnout amount is the maximum, not the value. To compare offers, or to decide whether an earnout is worth accepting instead of a lower fixed price, estimate its present value.
A simple, hypothetical example shows the method. A buyer offers 9.0 million at closing plus an earnout of up to 3.0 million, payable two years after closing if gross profit reaches agreed targets. The parties estimate three outcomes:
- Targets missed: 40% probability, earnout paid 0
- Partial achievement: 35% probability, earnout paid 1.5 million
- Targets met: 25% probability, earnout paid 3.0 million
The probability-weighted payment is 0.35 × 1.5 + 0.25 × 3.0 = 1.275 million. Discounted for two years at 15%, a rate that reflects both the business risk and the buyer's credit risk, it is worth about 0.96 million today. The offer is therefore worth roughly 9.96 million in present value terms, not 12.0 million.
The probabilities and the discount rate are judgments, and the result is sensitive to both. Test them the same way you would test any key assumption, with a scenario and sensitivity analysis. For complex earnouts with several thresholds or years, valuation specialists often use option pricing or Monte Carlo simulation instead of three discrete scenarios. The Wiley practitioner guide on fair value measurement of contingent consideration describes all three methods.
Two adjustments are easy to miss. First, the seller is an unsecured creditor of the buyer for the earnout, so the buyer's ability to pay matters. Second, the earnout depends on a business the seller no longer controls, so the probabilities should reflect how the buyer plans to run it.
How to model an earnout in a deal model
In an acquisition model, an earnout touches three areas.
- Sources and uses. At closing, only the fixed price is funded. Show the earnout as a contingent obligation, not as a use of cash on day one.
- Cash flow and debt. In the payment years, the earnout is a cash outflow. If it is funded from operating cash flow, it competes with debt service. Lenders will usually want it subordinated, and the payment timing should appear in the LBO model debt schedule and covenant tests.
- Returns. Run the buyer's returns with the earnout paid in full, partly paid and not paid. Note a feature of most earnouts: the buyer pays more only in the cases where the business performs well, so the earnout reduces the downside risk of the purchase price.
Keep the working capital mechanics separate. A working capital peg adjusts the price for the balance sheet delivered at closing. It is a true-up, not a performance payment, and mixing the two creates double counting.
Accounting and tax basics
Under US GAAP (ASC 805), the buyer records contingent consideration at fair value on the acquisition date as part of the purchase price. PwC's guide explains that earnouts settled in cash are classified as liabilities, and liability-classified contingent consideration is remeasured at fair value each reporting period, with changes recognized in earnings. That can make an earnout a source of volatility in the buyer's reported results.
The same guide flags a classification point that matters in negotiation: under ASC 805-10-55-25(a), an earnout in which payments are automatically forfeited if the seller's employment ends is treated as compensation for post-combination services, not purchase price. That changes the buyer's accounting and can change the seller's tax treatment, so tying an earnout to continued employment should be a deliberate decision, made with advisors.
For the seller, a sale whose total price cannot be determined by the end of the tax year is a "contingent payment sale" under Treasury Regulation 15a.453-1(c), which is generally reported on the installment method unless the seller elects otherwise. The regulation sets rules for allocating basis depending on whether there is a stated maximum price or a fixed payment period. Tax treatment depends on the facts, so involve a tax advisor before the structure is final.
When an earnout does not fit
Some deals cannot use one. For SBA 7(a) change-of-ownership loans, the current operating procedure, SBA SOP 50 10 8.1, does not permit seller earnouts; the price needs to be fixed at closing. Buyers using SBA financing typically bridge a valuation gap with a seller note instead, and should confirm the current rules with their lender.
In other deals an earnout is permitted but still a poor fit:
- The buyer will integrate the business quickly, making its results hard to measure separately.
- The metric depends on decisions only the buyer will make, such as pricing or sales headcount.
- The seller will leave at closing and cannot influence the outcome.
In those cases, a lower fixed price with a seller note, rollover equity in the combined business, or an escrow tied to specific diligence findings is often cleaner. If the gap comes from disagreement about valuation rather than uncertainty about the future, revisit the valuation itself before adding contingent terms.
If you are negotiating an earnout and want the structure tested in a model, you can book a call.
FAQ
What is a typical earnout period?
One to three years is common. Longer periods increase the chance that changes the buyer makes, rather than the seller's business plan, decide the outcome.
Is an earnout good for the seller?
It can help a seller reach a higher headline price, but the earnout is uncertain and paid later. Compare offers on present value, with realistic probabilities and the buyer's credit risk.
Which metric is best for an earnout?
There is no single best metric. Revenue is harder to manipulate after closing; EBITDA is closer to value but more exposed to the buyer's cost decisions. Gross profit is a common middle ground.
How are earnout disputes usually resolved?
Most agreements set out a statement-and-objection process and refer unresolved accounting disputes to an independent accountant. Precise definitions in the agreement prevent most disputes.