Earnouts in M&A Deals: Drafting a Price That Depends on Future Performance

By Hank FasthoffJuly 6, 2026

A seller may value a business at $8 million based on projected growth while a buyer values the same business at $6 million after discounting those projections for execution risk. The parties can place some of the purchase price behind the disputed forecast through an earnout. If the acquired business produces the agreed result after closing, the seller receives additional consideration. If performance falls short, the buyer pays less.

By using an earnout, buyer and seller defer part of the valuation decision to post-closing performance. The purchase agreement must define the performance being purchased, the buyer's authority over the business, the calculation process, and the remedy when post-closing conduct affects the result. If they draft it vaguely, the parties replace one disagreement at signing with a more expensive dispute after the buyer controls the company and the seller has less bargaining power.

Earnout prevalence varies with the sample. The 2025 ABA Private Target M&A Deal Points Study found earnouts in 18% of its 139 reviewed transactions, down from 26% in the prior study. That sample covered publicly disclosed acquisitions of private targets by public buyers with purchase prices from $25 million to $900 million. Smaller private transactions, life sciences deals, and acquisitions handled by shareholder representatives can produce different figures.

Earnout or Deferred Purchase Price

An earnout is contingent purchase consideration. Payment depends on post-closing revenue, earnings, customer retention, regulatory approval, a product launch, or another agreed result. Deferred purchase price is payable after closing without a performance condition, although it may be subject to permitted offsets or the buyer's credit risk.

You should preserve that distinction throughout the purchase agreement, promissory notes, employment documents, and tax provisions. Calling a fixed installment an earnout creates unnecessary uncertainty. Calling a contingent payment deferred purchase price can obscure the conditions that determine whether the buyer owes it.

The formula should identify the maximum payment, each threshold, each measurement period, and the payment date. It should also state whether performance below a threshold produces zero, partial payment, or payment under a sliding scale. If performance above the target can increase the payment, the agreement should provide a cap or an uncapped formula the parties can administer.

Define the Business Being Measured

An earnout tied to the acquired business requires a defined measurement boundary. After closing, the buyer may combine legal entities, consolidate sales teams, transfer employees, discontinue product names, book contracts through an affiliate, bundle products, or sell successor offerings. A metric tied only to revenue booked by the acquired legal entity may stop reflecting the business the seller transferred.

You should define which products, services, customers, contracts, territories, and successor offerings count. The definition should address renewals, expansions, cross-sales, bundled sales, rebates, returns, credits, intercompany transactions, acquisitions, divestitures, and revenue transferred to another buyer entity. If the buyer can replace an acquired product with a functionally similar product, you should state whether sales of the replacement count.

Expense allocations become contested after integration. Shared employees, facilities, systems, insurance, financing, and corporate services may benefit the acquired business while creating allocation questions. You should define permitted allocations and require a consistent method that the buyer can support with records.

Choose a Metric That Matches the Bargain

A revenue formula depends on fewer expense judgments than EBITDA, but it isn't immune from buyer decisions. Pricing, discounts, sales timing, returns, customer allocation, contract terms, and revenue recognition can change the result. A revenue earnout should identify the accounting standard, included revenue streams, exclusions, and treatment of bundled or related party transactions.

A gross profit metric accounts for the cost of producing the measured revenue. Its usefulness depends on the definition of cost of goods sold, including direct labor, freight, warranty expense, inventory reserves, manufacturing overhead, and purchased components. You should specify each included cost and the method used to allocate shared costs.

EBITDA measures earnings before interest, taxes, depreciation, and amortization. EBITDA and adjusted EBITDA are non-GAAP financial measures under the SEC's published guidance, and adjusted EBITDA can vary materially from one agreement to another. The earnout definition should begin with an identified financial statement line item and list every permitted addition and subtraction. Management fees, transaction expenses, owner compensation, stock compensation, restructuring costs, synergies, acquisition costs, unusual items, and recurring expenses require negotiated treatment.

Depreciation and amortization don't reduce EBITDA because the formula adds them back. Inventory accounting, reserves, expense timing, overhead allocations, and the treatment of costs as operating expense or capital expenditure can affect EBITDA or the data used to calculate it. You should test the formula against historical financial statements and a sample post-closing period before signing.

Operational milestones can avoid some accounting disputes, but the triggering event must be objective. Regulatory approval should identify the agency, filing, product, indication, territory, and required form of approval. A product launch should identify commercial availability, minimum inventory, approved channels, and any sales requirement. Customer milestones should address renewals, cancellations, affiliates, and contracts obtained through the buyer's existing relationships.

Use a Formula Instead of a Label

A cliff structure pays the full earnout at the target and zero below it. A $1 million earnout tied to $8 million of revenue pays nothing at $7.99 million unless the agreement provides another result. A sliding scale can pay a stated amount for each dollar or percentage point above a floor, subject to a cap.

The transaction determines which structure fits. A cliff can fit a binary event or a valuation premise that fails below the threshold. A sliding scale can fit performance that creates value incrementally. You should model the payment at several results, including a near miss, the target, an overachievement, a negative adjustment, and a restatement after payment.

Cumulative formulas require additional terms. If the business misses year one and exceeds year two, the agreement should state whether overperformance produces a catch-up payment. You should also address whether one period can reduce an amount earned in another and whether a subsequent restatement permits repayment or only an adjustment to unpaid consideration.

Write an Accounting Hierarchy

References to GAAP, consistent application, or historical practice can conflict. Historical statements may contain practices that don't comply with GAAP, and GAAP can permit more than one treatment. A workable accounting hierarchy states which source controls when they disagree.

You should identify the earnout formula first, followed by a schedule of agreed accounting principles, worked examples, specified historical practices, and GAAP. The order depends on the transaction, but the agreement should state the order. A sample calculation should include the line items most likely to create disagreement rather than a clean example that proves only that the arithmetic works.

You should also select a reference period and identify the historical statements, accounting policies, chart of accounts, and allocation methods that establish the baseline. If the buyer must change a policy to comply with law, GAAP, lender requirements, or its public reporting obligations, the agreement should state whether the earnout calculation uses the new policy, preserves the prior policy for the calculation, or neutralizes the economic effect of the change. That treatment should apply only to the earnout calculation unless the parties agree otherwise.

Allocate Post-Closing Control

The buyer owns the business after closing and ordinarily expects authority to operate it. The seller's payment may depend on decisions about budgets, personnel, pricing, products, customer contracts, integration, and capital allocation. You should negotiate the operating covenants with that conflict in view.

A buyer may agree to use commercially reasonable efforts to achieve specified milestones, avoid actions taken for the purpose of reducing the earnout, maintain identified resources, preserve separate books, refrain from diverting revenue, or consult the seller before specified decisions. Each formulation allocates a different risk. A prohibition based on the buyer's purpose requires proof of intent, while a covenant tied to an objective act can apply regardless of motive.

In Johnson & Johnson v. Fortis Advisors LLC, No. 490, 2024 (Del. Jan. 12, 2026), former Auris stockholders could receive up to $2.35 billion through regulatory and sales milestones. The Delaware Supreme Court reversed the portion of a judgment that used the implied covenant of good faith and fair dealing to substitute a De Novo regulatory process for the 510(k) process stated in the merger agreement. By addressing regulatory developments, the agreement assigned that risk to the sellers. At the same time, the court affirmed findings that J&J breached its written commercially reasonable efforts obligation for other milestones and affirmed a separate fraud determination.

You should specify the required regulatory result, alternative approval processes, effort standard, buyer discretion, and treatment of a process that becomes unavailable. The implied covenant provides a narrow remedy under Delaware law and won't supply a protection foreclosed by the agreement's language and allocation of risk. Those terms belong in the purchase agreement before the regulatory process changes.

Address Integration, Sale, and Discontinuation

An earnout period may outlast the buyer's business plan. The buyer may sell the acquired business, discontinue a product, combine the business with another division, or undergo a change of control before the measurement period ends. You should state whether the buyer may assign the obligation, whether a successor must assume it, and whether specified events accelerate payment.

Acceleration can pay the maximum earnout, a target amount, an amount based on performance through the transaction date, or the present value of a projected payment. A buyer may resist automatic acceleration when a sale leaves the business able to achieve the target. A seller may resist relying on a successor whose strategy, records, and credit differ from the original buyer's.

You should address credit support separately. An earnout payable by an acquisition subsidiary may depend on an entity with few assets after integration. A parent guaranty, escrow, letter of credit, security interest, or covenant restricting distributions and asset transfers can reduce that risk. The payment formula has limited value if the obligor can't pay the amount when due.

Provide Information and Review Rights

You should require periodic reports during the measurement period and a detailed earnout statement after each period. Reports should include the financial statements, calculation workpapers, general ledger detail, sales records, allocation schedules, and other records needed to test the formula. The agreement should provide reasonable access to personnel who prepared the calculation.

Deadlines should run from delivery of a complete statement and supporting records. If the buyer omits required support, the seller's objection period should begin when the missing material arrives. You should also state how long the buyer must preserve records and whether the seller may inspect them through counsel and accountants subject to confidentiality restrictions.

Buyer and seller should decide whether missing a notice deadline makes the calculation final. If it does, the agreement should define the required contents of an objection and whether the seller may revise an objection after receiving additional records. Undisputed amounts should be paid while disputed items proceed through the agreed process.

Separate Accounting and Legal Disputes

An independent accountant can resolve calculations within the accountant's expertise. Claims that the buyer breached an operating covenant, withheld access, diverted revenue, or acted in bad faith can require contract interpretation, testimony, discovery, and legal remedies. Your dispute provision should identify the decision maker for each category.

Fortis Advisors, LLC v. Stillfront Midco AB, No. 162, 2025 (Del. Feb. 13, 2026), shows how drafting and litigation positions can broaden the decision maker's authority. The merger agreement referred the earnout calculation to an accounting firm defined as an arbitrator. After Fortis characterized the process as arbitration in the trial court, the Delaware Supreme Court affirmed referral of calculation, bad faith, and information rights claims to the arbitrator under the agreement and the way Fortis framed the dispute.

By contrast, an expert determination usually assigns a narrower factual question to a specialist. Your agreement should use the intended label, state whether the accountant acts as an expert or arbitrator, define the accountant's authority, identify the governing procedural rules, and reserve identified legal claims for a court or legal arbitrator.

A final, conclusive, and binding standard narrows judicial review. In AM Buyer LLC v. Argosy Investment Partners IV, L.P., No. 467, 2024 (Del. July 23, 2025), the Delaware Supreme Court affirmed enforcement of an independent accountant's earnout determination under a clause using that standard, subject only to fraud or manifest error. An invoice mix-up didn't qualify as manifest error because correcting it wouldn't have changed the maximum earnout payment.

Coordinate Offsets and Other Claims

The purchase agreement should state whether the buyer may offset indemnification claims, working capital amounts, employment obligations, or other asserted liabilities against an earnout. A broad offset right can turn an unrelated estimate into a payment delay. A prohibition on all offsets can force the buyer to pay the earnout while pursuing an established seller liability elsewhere.

You should define whether an offset requires a final judgment, agreed amount, pending claim, or good faith estimate. The agreement should also address notice, reserves, payment of undisputed amounts, interest, and release of excess reserves. You should coordinate those provisions with indemnification caps, escrows, representation and warranty insurance, and any seller note.

Separate Purchase Price From Compensation

When an earnout forms part of the consideration for stock or business assets, each payment takes the character produced by the asset sold and applicable tax rules. An amount paid for services is compensation. Continued employment, individual performance conditions, forfeiture upon termination, compensation formulas, and payments limited to working sellers can support compensation treatment. The label chosen by the parties won't control the federal tax result.

You should document purchase consideration and employment compensation in separate provisions supported by the economics of each arrangement. A seller who must remain employed to receive the payment should obtain tax advice before assuming capital gain treatment. Treasury Regulation Section 1.61-2 treats amounts paid for services as compensation.

Section 453 generally applies the installment method when a qualifying sale includes at least one payment after the sale year. Treasury Regulation Section 15a.453-1 provides separate basis rules for contingent payment sales, including sales with a stated maximum price, a fixed payment period, or neither. Exceptions, depreciation recapture, seller elections, entity structure, and the interest charge under Section 453A can change the result.

Deferred contingent payments may also include interest for federal tax purposes under Section 483 or Section 1274. Treasury Regulation Section 1.483-4 addresses contracts with contingent payments subject to Section 483. Buyer and seller should model character, timing, basis recovery, imputed interest, withholding, and reporting before signing because the same words can produce different tax consequences for each side.

Negotiate the Whole Mechanism

If you're the seller, you should negotiate the metric, measurement boundary, operating covenants, information rights, credit support, acceleration events, offset limits, and dispute forum as parts of one payment right. A high maximum earnout offers little protection when the buyer controls every input and the agreement provides no access to the records.

If you're the buyer, you should preserve authority to integrate and operate the business while defining the restrictions you accept. You should test the formula against the integration plan, reporting systems, acquisition financing, tax structure, and expected resource allocations. Promising separate operation or fixed spending can interfere with the reason for the acquisition.

Both sides should calculate several outcomes from the final language and attach a worked example. They should identify who prepares the reports, who can object, who resolves each kind of dispute, what standard governs review, and when payment becomes final. The parties can resolve a valuation difference through an earnout only when the contract defines the future price before the buyer takes control.