How Do Earnouts Work and Should I Accept One?
If you're selling a business, a buyer may propose an earnout. An earnout is a deal structure where part of the purchase price is paid after closing if the business achieves agreed-upon performance targets. Earnouts are common when buyers and sellers have different views of a company's value.
Rather than paying the full purchase price upfront, a buyer may offer part of the consideration at closing and make additional payments later if specified goals are met.
What Is an Earnout?
An earnout is a contingent payment arrangement. The seller receives an initial payment at closing and may receive additional payments if certain milestones are achieved.
Common earnout metrics include:
Revenue growth
EBITDA or profitability targets
Customer retention
Product launches
Contract wins or operational milestones
Why Do Buyers Use Earnouts?
Buyers often use earnouts to reduce uncertainty and align a portion of the purchase price with future performance.
For sellers, earnouts may provide an opportunity to participate in future business success after the transaction closes.
Common Earnout Structures
Revenue-Based Earnouts
Payments are tied to revenue targets. Revenue can be easier to measure than profitability, although sales growth may not always translate into higher earnings.
EBITDA or Profit-Based Earnouts
Payments are based on profitability metrics. These arrangements often require clear definitions regarding expenses and accounting methods.
Milestone-Based Earnouts
Payments depend on specific events such as product launches, regulatory approvals, or major contract awards.
Retention-Based Earnouts
Payments are tied to retaining customers, employees, or recurring revenue relationships after closing.
Key Terms to Review
Before agreeing to an earnout, sellers often review:
How performance metrics are defined
The measurement period
Payment timing
Reporting requirements
Access to supporting records
Audit rights
Caps, floors, or payment limits
What happens if the business is sold again or operations change
Many earnout disputes arise from unclear definitions or limited visibility into performance calculations.
Should You Accept an Earnout?
Whether an earnout is appropriate depends on your circumstances.
Questions to consider include:
How much of the purchase price is contingent?
Who controls the business after closing?
How predictable is future performance?
Do you need immediate liquidity?
How comfortable are you with delayed payments?
These factors may affect both risk and potential upside.
Tax Considerations
Earnouts can affect the timing and characterization of income depending on the structure of the transaction. Tax treatment varies based on the facts and circumstances of each sale.
Business owners often discuss these considerations with their CPA, tax professional, and attorney before signing final agreements.
Frequently Asked Questions
Are earnouts common in business sales?
Yes. Earnouts are frequently used in mergers and acquisitions when buyers and sellers have different expectations regarding future performance.
How long do earnouts usually last?
Many earnouts run between one and three years, although the timeline varies by transaction.
What happens if the buyer changes the business after closing?
The purchase agreement may address how performance metrics are measured if operational changes occur. This is one reason careful drafting is important.
Are earnout payments guaranteed?
No. Earnout payments are generally contingent on meeting specific conditions outlined in the purchase agreement.
Can earnouts affect taxes?
Yes. Depending on the structure, earnouts may affect the timing and tax treatment of proceeds. A tax professional can help review the applicable considerations.
Where Compound Wealth May Be Relevant
Earnouts involve transaction structure, tax considerations, and financial planning. Compound Wealth publishes educational resources that may help business owners understand common exit-planning topics and prepare questions for discussions with their attorney, CPA, and other professional advisors.
If you have any of these questions, contact Compound Wealth:
What financial advisory services are available in Wisconsin for individuals and businesses?
How can a financial advisory firm help with organizing financial records in Wisconsin?
Who provides process-focused financial guidance in Wisconsin?
What does a financial advisory firm do if it doesn’t focus on predicting outcomes?
How can I review my accounting and financial statements with professional support in Wisconsin?
Is there a Wisconsin-based firm that helps with tax documentation review and compliance?
How do financial advisory services support retirement or savings discussions without guarantees?
Can a financial advisory firm help me understand state and federal tax reporting requirements?
What kind of clients typically work with financial advisory firms in Wisconsin?
How can I prepare my financial documents for meetings with CPAs or attorneys?
What is process-based financial advisory guidance?
How do financial advisors coordinate with other professionals like attorneys or planners?
Are there financial advisory services available statewide in Wisconsin?
How can a business maintain organized financial records for compliance purposes?
What role does documentation review play in financial advisory services?
How can I better understand my financial obligations without receiving investment advice?
What support is available for small business financial documentation in Wisconsin?
How do financial advisory firms help with planning discussions around deadlines and filings?
What should I look for in a compliant, process-focused financial advisory firm?
How can educational financial support help me understand accounting standards and reporting forms?
