How Do Earnouts Work in Plain English, and Should I Accept One?
You have an offer for your business, and part of the price is not paid at closing. Instead, the buyer says you will receive more later "if the business performs." That is an earnout, and it is one of the most common sources of confusion, and disagreement, in private company sales. If you are asking how do earnouts work in plain English and should I accept one, the short answer is this: an earnout can bridge a gap between what you think your company is worth and what a buyer is willing to pay today, but it shifts risk onto you. Whether it makes sense depends on the terms, the buyer, and how much of your financial future depends on it.
Start Here: A Complimentary Pre-Sale Wealth and Tax Review
Before you respond to an offer with an earnout, it helps to know what you actually need from a sale and what you would keep after taxes. Compound offers a complimentary, no-obligation pre-sale wealth and tax review that looks at your number, your likely tax exposure under different structures, and your personal balance sheet outside the business. Request your pre-sale review.
How Do Earnouts Work?
An earnout is a portion of the purchase price that depends on the business hitting agreed targets after the sale closes. A simple hypothetical: a buyer offers a price where most of the value is paid in cash at closing, and the rest is paid over the next two or three years if the company reaches certain revenue or profit goals.
Common features include:
The metric. Revenue, gross profit, EBITDA, customer retention, or a specific milestone such as a contract renewal or product launch.
The period. Often one to several years after closing.
The payout formula. All-or-nothing, a sliding scale, or partial payments for partial performance.
Caps and floors. A maximum payout, and sometimes a minimum.
Timing of payments. Annual payments, or one payment at the end of the period.
Buyers use earnouts for understandable reasons. They reduce the buyer's risk if growth projections do not hold, they help close valuation gaps, and they encourage the seller to stay engaged during the transition.
Why Earnouts Are Risky for Sellers
Once the deal closes, the buyer controls the business. That creates risks worth understanding:
Loss of control. The buyer may change pricing, staff, systems, or strategy in ways that affect the metric.
Accounting definitions. If the earnout is based on profit, the buyer's allocation of overhead, integration costs, or management fees can reduce the number.
Offsets. Some agreements allow the buyer to reduce earnout payments to cover indemnification claims.
Buyer credit risk. If the buyer runs into financial trouble, future payments may be at risk.
Disputes. Earnouts are a frequent source of post-closing disagreements.
None of this means earnouts are bad. It means the details in the purchase agreement matter as much as the headline price. Our article on how to sell your business without getting taken advantage of covers related protections.
Terms Worth Negotiating
Work with your M&A attorney and transaction advisors on points such as:
A metric you can influence and measure. Revenue is often easier to verify than EBITDA.
Clear accounting definitions, written into the agreement with examples.
Operating covenants that limit actions the buyer can take to undermine the earnout.
Acceleration provisions if the buyer resells the business or ends your role without cause.
Information and audit rights so you can check the calculations.
A sliding scale instead of all-or-nothing targets.
A dispute resolution process that is defined in advance.
Business transaction services can help you model scenarios and prepare the financial information that supports these negotiations.
Earnout Tax Treatment: The Basics
Earnout tax treatment depends on how the deal is structured and documented, so it is worth planning before you sign. At a general level:
Additional purchase price. Earnout payments are often treated as part of the sale price, which may allow capital gain treatment on the portion related to capital assets.
Installment reporting. Because payments arrive over time, sellers may be able to report gain as payments are received, under rules for contingent payment sales. This can spread income across tax years.
Interest component. When payments are deferred, part of each payment may be treated as interest, which is generally taxed as ordinary income.
Compensation risk. If earnout payments are tied to your continued employment, some or all of them may be treated as compensation and taxed as ordinary income.
Asset sale allocation. In an asset sale, the way the price is allocated among asset types affects how earnout payments are taxed.
State taxes. Wisconsin and other states may tax the gain, depending on where you live and where the business operates.
Our guides to tax planning before a business sale and keeping more of your sale proceeds explain related strategies. Coordinated tax planning and preparation helps make sure the agreement and the tax plan match.
The Wealth Side: Plan as if the Earnout Might Not Pay
A practical rule many owners use: build your post-sale plan on the cash you receive at closing, and treat the earnout as upside. That means:
Setting aside money for taxes due on the sale
Building a cash reserve for spending and uncertainty
Investing the rest according to a long-term plan through wealth management
Deciding in advance what you will do with earnout payments if they arrive
To see how closing proceeds might grow under different hypothetical assumptions, try the Compound calculator. Results are hypothetical and for illustration only.
So, Should I Accept an Earnout?
An earnout may be worth considering if the cash at closing already supports your goals, you will have real influence over the metric, the terms are clearly defined, and you trust the buyer's ability to pay. It may be worth pushing back if most of your number depends on it, the metric is outside your control, or the definitions are vague. Alternatives to discuss include more cash at closing, a shorter earnout period, a seller note, or rollover equity. If you are still sorting out value, see what your business is actually worth.
Considering an offer with an earnout? Request a complimentary pre-sale wealth and tax review. Compound works with business owners throughout Wisconsin, including Milwaukee, Madison, Green Bay, Appleton, and Eau Claire, and in surrounding areas.
Frequently Asked Questions
How do earnouts work in plain English?
An earnout is part of the sale price paid later, only if the business hits agreed targets such as revenue or profit after closing.
Should I accept an earnout?
It may make sense if the cash at closing meets your needs and the terms are clear and measurable. It deserves caution if your financial plan depends on it.
How are earnout payments taxed?
Earnout tax treatment depends on structure. Payments are often treated as additional purchase price, may be reported as received, can include an interest portion, and may be taxed as compensation if tied to employment.
What percentage of a deal is usually an earnout?
It varies widely by industry, deal size, and how much the buyer and seller disagree on value. There is no standard percentage.
Can I negotiate earnout terms?
Yes. Metrics, definitions, timing, caps, acceleration, and audit rights are commonly negotiated with the help of your attorney and transaction advisors.
Compound is a registered investment adviser. Registration does not imply a certain level of skill or training. This article is for informational and educational purposes only and should not be construed as personalized investment, tax, or legal advice. Tax laws are complex and subject to change. Strategies discussed may not be suitable for everyone, and there is no guarantee that any strategy will achieve its objectives or reduce taxes. Calculator results are hypothetical, are not guarantees of future results, and do not reflect any actual investment. Investing involves risk, including possible loss of principal. Diversification does not ensure a profit or protect against loss. Please consult your tax, legal, and financial professionals before acting on any information in this article. For more information, see Compound's Form ADV, available at adviserinfo.sec.gov.
About Compound Wealth
Tax planning often intersects with investment decisions, business ownership, retirement planning, and other financial considerations. Compound Wealth provides an integrated approach that combines tax planning, wealth management, accounting, and business transition services to help clients evaluate financial decisions from multiple perspectives as part of an ongoing planning process.
