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An earnout is a provision in a business sale agreement that ties part of the purchase price to the business’s performance after closing. Instead of paying the full price at the closing table, the buyer pays a portion upfront and agrees to pay the remainder later if the business hits the agreed-upon revenue, profit, or other targets. Earnouts most often arise when a buyer and seller cannot agree on the business’s current value. A Ventura County business law attorney at Schneiders & Associates can help you decide whether an earnout makes sense for your deal and, if it does, how to draft one that holds up.
Why Do Buyers and Sellers Use Earnouts?
Earnouts exist to bridge a gap in expectations. A seller may believe recent growth justifies a higher price. A buyer may want to see that growth continue before paying for it. An earnout lets both sides move forward without either one giving up entirely on their number. The seller has the opportunity to earn a higher price if the business performs as promised. The buyer avoids paying full price up front for results that have not yet happened.
Earnouts also arise when a seller plans to stay involved in the business after closing, since a buyer may be more comfortable sharing future upside with someone who still has a hand in generating it.
What Should an Earnout Provision Include?
A well-drafted earnout answers a few questions clearly, before the deal closes rather than after a dispute starts.
- What metric determines payment. Revenue, EBITDA, and customer retention are common choices, and each behaves differently depending on how the buyer runs the business after closing.
- How long the earnout period runs. Most earnouts span one to three years, measured quarterly or annually.
- How the metric will be calculated and by whom. Vague accounting language is one of the most common sources of later disputes.
- What control the seller retains, if any, over decisions that affect the metric during the earnout period.
- What happens if the buyer sells the business, changes its operations significantly, or is acquired before the earnout period ends.
Buyers and sellers often negotiate operating covenants alongside these terms, such as a requirement that the buyer run the business in the ordinary course or in good faith during the earnout period. These covenants matter because California law already implies a covenant of good faith and fair dealing in every contract, but that implied duty has limits. It does not require a party to take a specific action the contract does not otherwise call for, so a seller who wants real protection typically needs it spelled out in the agreement itself, not left to the implied covenant to supply later.
It also helps to decide upfront how a disagreement over the numbers will be resolved, whether that is a named independent accountant, a mediation step before litigation, or an arbitration clause. Agreeing on a process while both sides are still on good terms is far easier than negotiating one after a dispute has already started.
How Are Earnout Payments Taxed?
Earnout payments are generally treated as contingent payment sales under the federal installment sale rules, which affects when and how the seller reports gain. Depending on whether the agreement sets a maximum selling price, a fixed payment period, or neither, the applicable Treasury regulations assign a different method for allocating basis and gross profit across the payments as they are received. Whether a given earnout payment is taxed as capital gain or as ordinary compensation income can also depend on whether the seller remains an employee of the business during the earnout period, which is a structuring decision worth making deliberately rather than by default.
Where Earnout Disputes Usually Start
Most earnout disputes trace back to the same handful of issues. The metric was defined loosely enough that the buyer and seller can reasonably disagree on the number. The buyer made a legitimate business decision, such as cutting a product line or changing pricing, that happened to reduce the earnout payout. The seller lost the day-to-day visibility needed to confirm the buyer’s calculations. Or the earnout period ran long enough that a market change made the original targets unrealistic, through no fault of either side.
None of these are unusual business events. They become disputes when the agreement did not anticipate them.
A related issue worth flagging separately is a change of control during the earnout period. If the buyer sells the business, merges it into another company, or brings on new investors before the earnout period ends, the original targets can become difficult or impossible to measure against a business that no longer operates the way it did at closing. An acceleration clause, which pays out some or all of the remaining earnout if a triggering event like this occurs, is one of the more common ways sellers protect themselves against this scenario.
Protecting Your Interests Before You Sign
Whether you are buying or selling, the earnout provision deserves the same level of scrutiny as the purchase price itself, because in practice it often determines how much of that price actually gets paid. Sellers should push for objective, auditable metrics and reporting rights that let them verify the numbers as the earnout period runs, not just at the end. Buyers should be clear about what operational flexibility they need to preserve, and get that flexibility written into the agreement rather than assumed.
Contact Schneiders & Associates to talk with a Ventura County business law attorney before you sign a letter of intent that includes an earnout, whether you are buying or selling.