Exit Strategy · Volume 11

Earnout Clauses When Selling Your Business: What They Are and Why They're Dangerous

By Mark Stetler & Mason Stetler · June 2026 · 10 min read

Earnouts are one of the most contested provisions in small business M&A. They appear in deals as a bridge mechanism — a way to close a gap between what a seller thinks the business is worth and what a buyer is willing to pay today. In theory, they align incentives. In practice, they generate more post-closing disputes than almost any other acquisition term.

If you're selling a business and the buyer proposes an earnout, understanding exactly what you're agreeing to is critical before you sign.

A client sold a specialty manufacturing business to a regional private equity group. The deal included a $1.2 million earnout payable over two years if the company hit specific EBITDA targets post-closing. He was optimistic — the business had been trending upward. After closing, the buyer began adding corporate overhead allocations to the business's P&L (costs for shared services, management fees, corporate IT) that hadn't existed before. EBITDA targets, calculated after these new expenses, were missed both years. He received nothing from the earnout. We pursued an arbitration claim focused on whether the new expense allocations violated an implied covenant of good faith, and settled for a fraction of the earnout. The language in the earnout provision would have supported him if we'd negotiated it differently at signing.

What an Earnout Is

An earnout is a provision in a purchase agreement under which the buyer agrees to pay the seller additional consideration after closing, contingent on the business achieving defined performance metrics during a defined earnout period.

The typical structure: "Seller will receive $X for each year the company achieves $Y in [revenue/EBITDA/gross profit] during the two years following closing, payable within 30 days after the earnout period ends."

Earnouts arise most commonly when:

The seller's price expectations exceed what the buyer is willing to pay based on current performance
The business has significant upside potential (a new product, new contract, or growth trajectory) that hasn't yet materialized in financials
The buyer has uncertainty about whether current performance is sustainable
The acquisition structure requires seller participation to bridge a valuation gap

Why Earnouts Create Risk for Sellers

The fundamental problem: the buyer controls the business after closing, which means the buyer controls many of the variables that determine whether the earnout is earned.

Expense allocation. As in the example above, buyers can introduce new expenses that reduce profitability metrics without technically breaching any agreement. Corporate overhead allocations, management fees, shared services, and intercompany transactions can all reduce EBITDA targets that were set based on the company's standalone economics.

Revenue recognition timing. If the earnout is based on revenue and the buyer has discretion over when to recognize revenue or when to bill customers, the timing of earnout period revenues can be managed.

Capital investment decisions. A buyer who decides to invest heavily in the business during the earnout period — adding staff, marketing, infrastructure — can legitimately reduce short-term profitability while building long-term value, at the expense of earnout payments.

Customer and channel decisions. Buyers can redirect customers, modify pricing, or alter the business model in ways that affect earnout metrics, often with business rationale that makes legal challenge difficult.

Accounting methodology changes. Switching depreciation methods, accrual timing, or cost allocation approaches can affect earnings metrics without changing cash economics.

The Provisions That Matter in Earnout Negotiation

Definition of the metric. The earnout should define EBITDA, revenue, or whatever metric is used with specificity — the exact calculation, what's included and excluded, which accounting standards apply, and whether the metric is calculated on the same basis as pre-closing financials. Vague definitions produce disputes.

Expense allocation cap or exclusion. Negotiate specifically that new expenses not present in the business pre-closing (corporate overhead, management fees, intercompany charges) will not be allocated against the earnout calculation.

Non-interference covenant. The buyer agrees not to take actions designed to reduce or eliminate the earnout. This is an implied covenant in most jurisdictions but is worth making explicit.

Continuity of operations. During the earnout period, the buyer agrees to operate the business in substantially the same manner as pre-closing, or at least to maintain the conditions necessary for the earnout to be achievable.

Seller authority and input. In some deals, the seller continues to manage the business during the earnout period. Define authority — who controls pricing, headcount, customer decisions, capex — and whether the seller has veto rights over decisions that would materially affect earnout achievement.

Dispute resolution. If the parties disagree on the earnout calculation, what process applies? An independent accountant review provision is common and preferable to full litigation.

Acceleration on certain events. If the business is sold again, or if the buyer causes the earnout to be unachievable through specific actions (discontinuing a product line, dismissing key personnel), the earnout should be deemed earned in full.

When Earnouts Make Sense for Sellers

Earnouts aren't inherently bad — there are situations where they make sense:

If your business has genuine upside that's difficult to prove at closing and you believe you can demonstrate it during an earnout period
If the buyer and seller are so far apart on valuation that closing requires bridging, and you'd rather have upside potential than walk away
If you're staying on to run the business after closing and have meaningful control over earnout-relevant decisions

The key word is control. Earnouts work better for sellers when the seller retains meaningful operational authority during the earnout period. They're riskiest when the seller steps away and the buyer has full control over every variable that determines earnout achievement.

The Tax Dimension

Earnout payments are generally taxed as additional purchase price (capital gains) when received, provided the underlying sale was structured as a capital asset sale. But timing of recognition and character can be more complex, particularly if the earnout is tied to the seller's continued employment or services rather than purely contingent on business performance.

If the earnout is structured to compensate the seller for staying on as an employee or consultant, the IRS may recharacterize it as ordinary compensation rather than capital gain. This characterization dispute is common in deals where the earnout correlates with the seller's continued involvement. Get a tax advisor's input on the earnout structure before signing.

The Negotiating Reality

Sophisticated buyers who regularly include earnouts have experience with the structures that minimize payout. First-time sellers face an information asymmetry. Having M&A counsel involved — not just general business counsel, but someone with specific acquisition transaction experience — during earnout negotiation is the investment that most often produces better outcomes in this context.

The earnout is not a footnote to the main deal. It can represent 20 to 40% or more of the total purchase price. It deserves proportional attention.

This article is educational and does not constitute legal or tax advice. M&A transactions are complex and fact-specific. Engage qualified M&A counsel for guidance on specific transactions.

This article draws from Volume 11: Selling Your Business of The Million Dollar Highway series — covering valuation, deal structure, reps and warranties, earnouts, and what happens in the years after a sale.

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