An earn-out means part of the purchase price in a business sale is held back at closing and paid later only if the business hits agreed performance targets afterward. The buyer pays a guaranteed base amount on the closing date and promises additional sums during a defined measurement period if revenue, profit, or specific milestones come in at or above the levels written into the agreement. Roughly a quarter of private-company acquisitions use this structure, most often to bridge a gap between what the seller thinks the business is worth and what the buyer is willing to pay upfront.
How the Two Payments Work
The purchase agreement splits the total deal value into two pieces. The fixed portion transfers on the closing date and is not conditional on anything that happens next. The contingent portion is a promise: if the business performs well enough during the measurement window, the buyer owes more; if it doesn’t, the buyer owes nothing beyond the base price.
That structure shifts risk in a specific direction. Once the deal closes, the buyer controls the business, which means the seller is exposed not only to the risk that the business will underperform on its own, but also to the subtler risk that the buyer will run the business in ways that suppress the very metrics tied to payment. Most of the negotiation around an earn-out is really negotiation around that second risk.
What Triggers the Extra Payment
The targets that unlock a contingent payment usually fall into one of two buckets: financial results or operational milestones.
Financial Metrics
Revenue is by far the most common benchmark. Recent deal data shows about 60 percent of earn-outs outside the life sciences sector are tied to revenue. It’s popular because it’s straightforward to measure and hard to manipulate through accounting choices. A buyer cannot easily make revenue disappear by reclassifying expenses or accelerating depreciation.
Profit-based metrics like EBITDA or net income show up in a smaller share of deals, around 20 percent outside life sciences. They protect against a business that grows revenue at the expense of margins, but they open a different problem: the definition of EBITDA varies from deal to deal. The agreement has to spell out what’s in and what’s out. Common exclusions, called add-backs, cover one-time transaction costs, restructuring the buyer initiates after closing, and integration expenses tied to folding the acquired business into the buyer’s operations. Without those adjustments, a buyer can load the business with integration expense or corporate overhead allocations that depress EBITDA and shrink the earn-out. Every add-back should be defined in the disclosure schedules so there is no argument later.
Operational Milestones
Non-financial targets can supplement or replace the financial ones. These include finishing development of a product, securing regulatory approval, retaining a set percentage of key employees, or signing a specified number of new enterprise clients. Milestones work well for early-stage businesses where the financials are still too thin to be meaningful. Each milestone gets a specific dollar value or a percentage of the total contingent payment attached to it, so both sides know what each achievement is worth.
How Long the Earn-Out Period Lasts
Most measurement periods run one to three years from the closing date. The median outside life sciences is 24 months. That window is long enough for the buyer to integrate the business and for the metrics to be meaningfully tested, but short enough that the final purchase price does not stay uncertain forever.
The agreement should say whether the period is cumulative or broken into annual intervals. In a cumulative structure, only total performance across the whole window matters. In an annual structure, each year stands alone with its own calculation. Some agreements add catch-up provisions that let a strong second year offset a weak first, which matters for seasonal or cyclical businesses. Once the period ends and the final number is set, the buyer’s obligation to track performance and make contingent payments is done. Miss the targets, and the buyer owes nothing more than the base price.
Protections While the Buyer Runs the Business
Because the buyer holds the keys during the measurement period, sellers negotiate for contractual guardrails on how the business is operated.
Operating Covenants
Typical 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
- Keep separate books and records and give the seller access to them
- Maintain a minimum working capital level so the business has resources to perform
- Avoid loading the business with new debt above a defined 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 to operate the business consistently with past practice or as a stand-alone entity. A larger share, roughly 58 percent, contain more general language such as commercially reasonable efforts obligations or prohibitions on bad faith conduct.
The Implied Covenant of Good Faith
Even when the contract is silent, courts in most jurisdictions recognize an implied covenant of good faith and fair dealing that prevents either side from deliberately undermining the other’s ability to receive the benefits of the deal. Sellers have used it to argue that a buyer sabotaged targets by diverting customers to other divisions, cutting the sales budget, or delaying lucrative contracts until after the window closed.
The doctrine has limits. Courts generally will not use it to add obligations the parties could have written in but didn’t. A recent Delaware Supreme Court decision reinforced that the implied covenant does not rescue sellers from foreseeable risks they failed to address in the agreement. The practical lesson: negotiate the explicit covenants rather than counting on a court to fill the gap.
Acceleration Events
Acceleration clauses trigger immediate payment of some or all of the remaining earn-out on defined events. The most common is a change of control: if the buyer sells the acquired business to a third party before the period ends, the seller shouldn’t lose the earn-out because a new owner has stepped in. Nearly 25 percent of non-life-sciences earn-out deals include change-of-control acceleration. Other triggers include termination of key employees without cause and material breaches of the operating covenants. Buyers typically insist that acceleration doesn’t apply when an employee is terminated for cause or resigns. Some agreements also give the buyer a buy-out option, sometimes at a discount, to pay off the remaining earn-out and be free of the post-closing restrictions.
Calculating and Paying the Final Amount
After the measurement period ends, the buyer prepares a detailed calculation and delivers it to the seller in a formal notice. The seller then has a contractual review window, commonly 30 days, to check the numbers, ask questions, and either accept the calculation or file a notice of disagreement.
If the two sides can’t reconcile, most agreements send the dispute to an independent accounting firm. What that accountant is allowed to decide depends entirely on the drafting. A narrow clause might limit the accountant to verifying that the calculation followed the specified accounting methods. A broader clause might let the accountant evaluate whether the buyer operated the business in good faith during the period. A narrow clause pushes any wider dispute into court, so this is worth getting right during negotiation. The accountant’s determination is generally binding, and courts give it significant deference. The agreement should also specify how the accountant’s costs get split, whether the loser pays or the costs are allocated based on how close each side landed to the final answer.
Payment can come as a cash wire, buyer stock, or installment notes. Installments show up when the buyer expects to fund the payment out of the acquired business’s own cash flow.
Making Sure the Money Is There
An earn-out is only worth what the buyer can pay when the time comes. If the buyer runs into financial trouble or gets acquired itself during the period, the contingent payment can become uncollectible. Sellers can push for security: a portion of funds placed in escrow at closing, a parent-company guaranty when the buyer is a subsidiary, a lien on the acquired business’s assets, or a bank letter of credit the seller can draw on if payment is missed. Buyers resist these because they cut into the financial flexibility earn-outs are partly meant to preserve, but where the contingent portion is a big share of the total price, some form of security is often the difference between getting paid and holding an uncollectible contract right.
How Sellers Are Taxed on Earn-Out Payments
The tax picture depends on how the payments are structured and whether the seller stays on with 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 generally come out as capital gain. 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 ordinary income and subject to employment taxes. A clause that forfeits the earn-out on termination of employment strengthens that recharacterization argument considerably. The cleaner approach is to keep employment compensation separate: tie the earn-out to business results that don’t depend on the seller’s personal involvement, and document any post-closing services in a separate employment agreement with its own terms and withholding.
Installment Method Reporting
Because the total price isn’t known at closing, an earn-out is treated as a contingent payment sale. Under IRC Section 453, gain is reported using the installment method, so the seller recognizes income as payments actually arrive rather than all at once in the year of the sale.1Office of the Law Revision Counsel. 26 USC 453 – Installment Method That can meaningfully reduce the tax bill in the closing year by spreading the gain across multiple years. The Treasury regulations set out how the seller’s cost basis gets allocated across contingent payments, with different rules depending on whether the agreement has a stated maximum price, a fixed term, or 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 a year after closing, IRC Section 483 can recharacterize part of each payment as interest, even if the agreement says nothing about interest.3Office of the Law Revision Counsel. 26 USC 483 – Interest on Certain Deferred Payments This kicks in when the agreement fails to provide interest at a rate at least equal to the applicable federal rate. The result: the seller reports part of each payment as interest income (ordinary rates) rather than capital gain, which raises the total tax bill. Addressing this with stated interest in the agreement heads it off.
Section 409A
If the IRS treats an earn-out as a nonqualified deferred compensation plan, the payments have to fit within the timing and distribution rules of IRC Section 409A.4Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans Falling out of compliance is expensive: all the deferred amounts become 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. A common safe harbor is the short-term deferral exception, which generally covers payments made by the 15th day of the third month after the year in which the right to payment is no longer subject to a substantial risk of forfeiture. Structured to fall inside that window, the earn-out avoids 409A entirely.
Why the Buyer’s Accounting Matters to You
Buyers have to recognize the contingent obligation at fair value on the closing date under ASC 805, and when the earn-out will be settled in cash, they usually have to remeasure it every reporting period, running the changes through income. A business that’s beating targets increases the liability and creates a book loss; a business that’s missing them shrinks the liability and creates a book gain. Those swings can affect the buyer’s debt covenants and, at the margin, its appetite for the deal structure it’s offering. That’s part of why some buyers push for longer earn-out periods: more time to fund payments from the acquired business’s own cash flow.