Earnouts: When Buyer and Seller Disagree on Value and Agree to Let the Business Decide

By Hank FasthoffJuly 6, 2026

A seller who built a business over 20 years believes it's worth $8 million based on projected growth. A buyer looking at the same financials, discounting the projections for risk, believes it's worth $6 million. Both numbers can be right, because the two sides are pricing different futures. An earnout bridges that $2 million valuation difference by making a portion of the purchase price contingent on the business's post-closing performance. If the business hits the seller's projections, the seller gets the full $8 million. If it doesn't, the buyer pays closer to $6 million.

Earnouts appear in roughly 21 percent of private company M&A transactions, up from 14 percent in 2019. Median contingent consideration runs 18 to 25 percent of total deal value. They're most common in technology, healthcare, and professional services transactions where future performance is uncertain, growth projections are aggressive, or the buyer and seller can't agree on a fixed price.

Earnouts bridge valuation disagreements, but they introduce their own risks. Approximately 23 percent of earnouts trigger post-closing disputes, and the most frequent source of those disputes is the methodology used to calculate the performance metric. An earnout that's poorly structured or ambiguously drafted converts a valuation disagreement into a multi-year litigation, which is the opposite of what it was supposed to accomplish.

How Earnouts Work

An earnout is a contractual right to receive additional purchase consideration if the acquired business achieves specified performance targets during a defined measurement period after closing. It's contingent consideration, earned only if the targets are met, unlike deferred purchase price, which is owed regardless of performance.

At closing, the buyer pays the base purchase price. After closing, the business operates for a measurement period (typically one to three years), during which performance is measured against the agreed targets. At the end of each measurement period (or at the end of the entire earnout period), the buyer prepares an earnout statement calculating whether the targets were met and delivers it to the seller. If the targets are met, the buyer pays the earnout amount. If they're not, the seller receives nothing (in a binary structure) or a proportional amount (in a tiered structure).

Choosing the Performance Metric

Selecting the right metric is the most consequential decision in any earnout. Revenue, EBITDA, gross profit, and discrete milestones are the most common choices, and each has trade-offs.

Revenue is the simplest metric and the hardest for the buyer to manipulate. Revenue is recognized when earned under applicable accounting standards, and a buyer who wants to suppress revenue has limited tools. It's the metric sellers should prefer in most situations. Its limitation is that revenue doesn't account for profitability. A business that grows revenue by 30 percent while losing money on every sale will hit a revenue target but may destroy value.

EBITDA (earnings before interest, taxes, depreciation, and amortization) reflects profitability and is the metric most closely tied to how businesses are valued. But EBITDA is vulnerable to manipulation through accounting decisions the buyer controls after closing. Allocating corporate overhead to the acquired business, accelerating expenses, changing depreciation methods, reclassifying capital expenditures as operating expenses, writing down inventory, and increasing reserves all reduce EBITDA without affecting the business's underlying performance. Forty-one percent of earnout disputes involve EBITDA calculation methodology, making it the most litigated metric in earnout practice.

Gross profit falls between revenue and EBITDA. It's harder to manipulate than EBITDA (because it's affected by fewer accounting judgments) but more informative than revenue (because it captures the cost of delivering the revenue). Gross profit works well for businesses where the seller's concern is that the buyer will grow revenue by discounting prices.

Discrete milestones (regulatory approvals, product launches, customer acquisition targets, contract renewals) are common in technology and healthcare transactions where the earnout is tied to specific events rather than financial performance. Milestones are binary (the event either happened or it didn't), which eliminates accounting disputes but creates all-or-nothing risk.

Binary Versus Tiered Structures

In a binary (cliff) structure, the seller receives the full earnout if the target is met and nothing if it isn't. A $1 million earnout conditioned on $8 million in revenue either pays $1 million or $0. If the business generates $7.95 million, the seller receives nothing.

In a tiered (sliding-scale) structure, the seller receives a proportional payment based on how close the business comes to the target. If the earnout pays $1 for every $1 of revenue above $6 million, up to a cap of $2 million at $8 million, the seller receives some payment as long as revenue exceeds $6 million. A tiered structure rewards partial performance and produces fewer disputes because the seller receives something even if the full target isn't reached.

Tiered structures pay sellers more on average because they eliminate the cliff risk of missing a target by a small amount. Sellers should push for tiered structures whenever possible. Buyers should accept them because a tiered structure reduces the seller's incentive to litigate over marginal performance differences.

Operating Covenants

After closing, the buyer controls the business. The seller no longer manages day-to-day operations, doesn't make spending decisions, doesn't hire or fire employees, and doesn't set pricing. Every earnout carries the same tension, because the seller's contingent payment depends on the buyer's management decisions, and the buyer has no financial incentive to maximize the earnout. The buyer already owns the business; the earnout is money flowing out.

Operating covenants address this tension by requiring the buyer to operate the acquired business in specified ways during the earnout period. Common operating covenants include maintaining the business as a separate reporting unit (so financial performance can be measured without being commingled with the buyer's existing operations), operating the business in the ordinary course consistent with past practices, maintaining a specified level of sales and marketing investment, retaining key employees and not reassigning them to other business units, not diverting customers, contracts, or revenue from the acquired business to other parts of the buyer's organization, and using consistent accounting policies (the same policies the seller used before closing, locked in for the measurement period).

Without operating covenants, the buyer can integrate the acquired business into its existing operations (making performance measurement impossible), reallocate resources away from the acquired business (reducing its performance), or change accounting policies in ways that suppress the measured metric. Express covenants are dramatically more effective than relying on the implied covenant of good faith and fair dealing.

In J&J v. Fortis (Delaware Supreme Court, January 2026), the court partially reversed a $1 billion-plus earnout award, holding that the implied covenant of good faith and fair dealing can't supply protections the parties didn't negotiate into the agreement. If the purchase agreement doesn't contain express operating covenants, the buyer's obligation to operate the business in a way that provides the earnout a reasonable chance of being achieved is limited. Contract drafting, not judicial implication, is where earnout protection comes from.

Accounting Policy Lock-In

If the earnout is measured by EBITDA, gross profit, or any financial metric that depends on accounting judgments, the purchase agreement should lock in the accounting policies used to calculate the metric. "Consistent with the Company's historical accounting practices as in effect during the 12 months preceding closing" prevents the buyer from changing depreciation methods, reserve assumptions, expense classification, or revenue recognition policies after closing in ways that suppress the earnout metric.

Without an accounting lock-in, a buyer who switches from FIFO to LIFO inventory accounting, accelerates depreciation on assets, or establishes new reserves against receivables can reduce EBITDA by hundreds of thousands of dollars without any change in the business's underlying performance. The seller has no recourse unless the purchase agreement prohibits the change.

Seller's Information and Audit Rights

During the earnout period, the seller has a financial interest in the business's performance but no access to the business's books. Without contractual information rights, the seller receives the buyer's earnout statement at the end of the measurement period and has no way to verify whether the calculation is accurate.

Contractual information rights should give the seller periodic financial reports during the measurement period (monthly or quarterly), access to the books and records used to prepare the earnout statement, the right to have an independent accountant audit the earnout calculation, and a defined objection and dispute resolution process (similar to the post-closing working capital true-up process, with a review period, objection window, negotiation period, and binding determination by an independent accountant).

Dispute Resolution

Earnout disputes that go to court are expensive and unpredictable. The purchase agreement should provide a fast-track dispute resolution process that keeps earnout disagreements out of the courtroom.

Most earnout provisions use a process parallel to the working capital dispute mechanism. The buyer delivers the earnout statement. The seller has a review period (typically 30 to 45 days) to accept or object. If the seller objects, the parties negotiate for a defined period. If they can't resolve the dispute, an independent accounting firm makes a binding determination limited to the disputed items, using the calculation methodology specified in the purchase agreement.

An independent accountant's role should be limited to applying the agreed methodology to the numbers, not exercising independent judgment about how the business should have been operated. The accountant determines whether the earnout metric was calculated correctly, not whether the buyer made good business decisions.

Tax Considerations

Earnout payments can be taxed as purchase price (capital gain) or as compensation (ordinary income). If the seller remains employed by the business after closing and the earnout is structured in a way that resembles an employment bonus (tied to the seller's personal performance rather than the business's performance, payable only while the seller remains employed), the IRS may recharacterize the earnout as compensation, which converts favorable capital gains treatment into ordinary income rates.

To preserve capital gains treatment, structure the earnout as contingent purchase consideration payable to the seller in its capacity as a former equity holder (not as an employee), tie the metric to the business's performance rather than the seller's individual performance, make the earnout payable regardless of whether the seller remains employed after closing, and avoid conditioning payment on continued employment or personal service requirements.

Under IRC § 453, installment-method treatment may allow the seller to defer gain recognition on earnout payments until they're received, spreading the tax liability over the measurement period rather than recognizing all gain in the year of closing. Consult with a tax advisor to determine whether installment treatment is available and beneficial.

Practical Recommendations

Prefer revenue over EBITDA as the earnout metric. Revenue is harder to manipulate, easier to measure, and produces fewer disputes. If the buyer insists on EBITDA, lock in accounting policies, define every adjustment, and demand audit rights.

Use a tiered (sliding-scale) structure rather than a binary (cliff) structure. Tiered structures reward partial performance, reduce disputes over marginal performance differences, and produce fairer outcomes for both parties.

Include express operating covenants that require the buyer to operate the acquired business in the ordinary course, maintain it as a separate reporting unit, and refrain from diverting resources, customers, or revenue during the measurement period. Don't rely on the implied covenant of good faith.

Give the seller audit rights and periodic financial reporting during the measurement period. A seller who can't verify the buyer's earnout calculation until the end of the measurement period is negotiating in the dark.

Include a fast-track accounting dispute resolution process. Earnout disputes should be resolved by an independent accountant applying the agreed methodology, not by a court applying general contract interpretation principles.

Structure the earnout to preserve capital gains treatment. Tie the metric to business performance, not personal performance. Make payment unconditional on continued employment. Evaluate installment-method treatment under IRC § 453.

Keep the measurement period as short as possible. Longer periods introduce more variables, more opportunities for the buyer to change how the business operates, and more potential for disputes. One to two years is standard. Three years should be the maximum unless the business cycle demands it.