Earnouts in M&A: Bridging the Valuation Gap Without Walking Into a Lawsuit

The seller wants $50 million. The buyer will pay $35 million. Neither is bluffing—they genuinely disagree about how fast the business will grow over the next three years. So the lawyers draft a clause that says the seller gets the extra $15 million if the business hits certain numbers after closing. Handshake, signatures, champagne.

Three years later, the parties are in a Delaware courtroom arguing over whether the buyer ran the business in good faith.

Welcome to the earnout—the most useful and most litigated tool in middle-market M&A. Roughly one in three private-target deals in 2024 included one, and Delaware courts have ruled for sellers in six of the seven most recent major earnout decisions. Earnouts work, but only when both sides understand exactly what they are signing up for.

This guide breaks down what an earnout is, why parties use them, how the IRS taxes the payments, and the drafting and operational mistakes that turn deals into disputes.

What Is an Earnout, Really?

An earnout is contingent purchase price. Some portion of what the seller earns from selling the business is paid not at closing but later, tied to the post-closing performance of the acquired business over a defined "earnout period"—commonly one to three years, occasionally four.

The mechanics are simple in theory:

• Closing payment: A guaranteed amount paid at closing (cash, stock, or both).
• Earnout payment: An additional amount, capped or uncapped, that the seller receives if the business hits certain milestones during the earnout period.
• Milestones: Quantitative (revenue, EBITDA, gross profit, units shipped) or qualitative (regulatory approval, customer renewal, product launch).

A typical structure might look like this: $35 million at closing, plus up to $15 million payable over three years based on the acquired business achieving stated revenue thresholds. Some deals stack metrics, set tiered payouts, or include catch-up provisions that let strong year-three performance backfill a weak year one.

Why Use One?

Three reasons drive most earnouts:

1. Valuation gap. The seller's projections are optimistic; the buyer is cautious. An earnout lets the seller "prove it" with money on the table—if growth materializes, the seller is paid; if it doesn't, the buyer is protected.
2. Information asymmetry. The seller knows the business intimately. The buyer is buying a story. An earnout shifts some of that information risk back to the seller.
3. Retention. When the seller is also a key operator, an earnout keeps that operator engaged through the integration period—provided the structure is designed correctly (more on that danger below).

In uncertain economic windows—post-pandemic, post-rate-hike, mid-AI-disruption—earnouts surge. They are the deal-doer's pressure valve when neither side trusts the other side's forecasts.

The State of Earnouts in 2024 and 2025

Data from the most recent SRS Acquiom studies of private-target deals tells a clear story:

• About one third of 2024 private-target M&A deals contained an earnout—up sharply from prior years and a return to historical norms after a quiet 2022.
• 68% of those deals used more than one earnout metric, layering revenue, gross profit, and EBITDA targets together.
• 62% used revenue as a primary metric and only 22% used EBITDA or earnings, a notable shift toward simpler, less manipulable measures.
• The median earnout potential as a percentage of the closing payment jumped from 32% in 2023 to roughly 43% in 2024—buyers are pushing more of the price into the contingent bucket.
• Earnouts pay out about 21 cents on the dollar of the maximum possible amount when measured across all deals. Excluding deals that paid zero, the average successful earnout pays roughly 50 cents on the dollar.

In other words: earnouts are getting bigger, more complex, and—on average—pay less than half of what sellers think they will earn.

Section 453 and the Tax Mechanics

Earnouts are not just a commercial structure. They are a tax structure, and the IRS treats them as a "contingent payment sale" under Section 453 of the Internal Revenue Code. Get the tax treatment wrong and you can convert capital gain into ordinary income, accelerate tax into the closing year, or land an unexpected interest charge on the seller.

The Default Rule: Installment Method

For most asset and stock sales with deferred contingent payments, Section 453 lets the seller recognize gain proportionally as payments are received rather than all at once at closing. This deferral is valuable: it spreads tax liability across the actual cash receipts.

The IRS sets out three regimes depending on what is known at closing:

1. Stated maximum amount. When the purchase agreement caps the earnout (e.g., "no more than $15 million additional"), the regulations assume the maximum will be paid for purposes of computing the gross profit percentage. The seller recognizes gain on each payment based on that ratio, with adjustments if the maximum is not ultimately received.
2. Fixed period, no max. If the earnout has a fixed duration (e.g., five years) but no cap, the seller's basis is allocated ratably across the earnout period and recognized as payments come in.
3. Neither known. If there is no cap and no fixed period, the seller recovers basis ratably over 15 years—a punishing default that almost no one wants.

The lesson: always negotiate a stated maximum and a defined earnout period. Open-ended earnouts cause tax pain even when they pay out.

Opting Out

A seller can elect out of installment treatment and recognize all gain at closing, valuing the contingent right as part of the amount realized. This makes sense rarely—usually when the seller has expiring net operating losses or believes future capital-gain rates will rise. Once elected, the choice is generally irrevocable.

Section 453A Interest Charge

There is a hidden cost in installment sales. Under Section 453A, if the sale price exceeds $150,000 and the seller's outstanding installment obligations at year-end exceed $5 million, the IRS imposes an interest charge on the deferred tax. This effectively claws back part of the deferral benefit on large deals. Sellers should model the 453A drag before celebrating their installment-method savings.

Imputed Interest

Because the contingent payments are deferred, the imputed interest rules of Sections 483 and 1274 will recharacterize a portion of each earnout payment as interest income—taxed at ordinary rates—unless the agreement provides for adequate stated interest. Negotiating an explicit interest rate on deferred payments can preserve more capital-gain treatment, though buyers usually resist paying stated interest on contingent amounts.

The Compensation Trap

This is where most earnouts go sideways for tax purposes.

When the seller is also the founder-CEO who is staying with the acquired business, the IRS may look at the earnout and ask: is this contingent purchase price, or is this disguised compensation for the seller's continued services? The two have very different tax results:

• Purchase price: Capital gain to the seller, generally not deductible to the buyer (must be added to asset basis or goodwill).
• Compensation: Ordinary income to the seller, FICA/Medicare withholding, and a current deduction to the buyer.

Buyers prefer compensation treatment. Sellers prefer purchase-price treatment. The two preferences pull the planning in opposite directions.

The IRS and courts look at several factors:

• Forfeiture on termination. If the earnout disappears when the seller's employment ends, that strongly suggests compensation.
• Proportionality. Does the earnout track the seller's equity ownership? If yes, it looks like purchase price.
• Separate compensation. Is the seller already drawing a market-rate salary or consulting fee? A separate, properly-documented employment stream supports treating the earnout as purchase price.
• Document language. Does the agreement explicitly call the earnout "additional purchase price" and not "compensation"?

Best practice: pay key sellers a documented, market-rate salary for their post-closing services; keep the earnout payable to the equity holders pro rata; and put it in writing that earnout payments are not contingent on continued employment.

The Litigation Traps

Six of the last seven major Delaware earnout decisions sided with the seller. That is not because Delaware loves sellers—it is because buyers keep making the same drafting mistakes. Here are the recurring traps.

Trap 1: Vague EBITDA

EBITDA is the most litigated word in M&A. Earnings before interest, taxes, depreciation, and amortization sounds simple, but every adjustment is debatable: bonuses to retained employees, allocated corporate overhead, transaction costs, integration expenses, one-time items.

Buyers can quietly "load" the acquired business with allocated parent overhead—rent, IT, shared services, executive time—that reduces post-closing EBITDA below the earnout threshold. Sellers see the same earnings line that looked healthy at closing now mysteriously below target.

Fix it in the draft. Spell out EBITDA as a defined term with specific add-backs, exclusions, and accounting policies. Lock the calculation to "consistently applied with the target's historical practice" or attach a sample schedule that walks through a hypothetical year.

This is also why revenue has overtaken EBITDA as the preferred earnout metric. Revenue is harder to manipulate. You either booked the sale or you didn't.

Trap 2: The Operating Covenant Vacuum

If the contract says nothing about how the buyer must operate the acquired business during the earnout period, the buyer has wide latitude—and may use it. Cutting sales headcount, deprioritizing the acquired product, raising prices to harm competitive position, redirecting customers to a sister business: all of these can torpedo an earnout.

Sellers should negotiate explicit operating covenants: maintain stated headcount, fund the marketing budget at a defined level, preserve product roadmaps, do not divert customers to other lines of business. The strongest provisions add a "best efforts" or "commercially reasonable efforts" duty to achieve the earnout milestones.

Beware of the implied covenant of good faith and fair dealing. Delaware will read it into the contract, but it is a weak shield. Explicit covenants beat implied ones every time.

Trap 3: Misaligned Management Incentives

When the seller's earnout is paid only for hitting a year-one milestone, the seller may sprint—cutting R&D, pulling sales forward, mortgaging year three to win year one. Conversely, multi-year earnouts can incentivize the seller to hide problems until the meter runs out.

Tiered earnouts, catch-up provisions, and cumulative metrics across the period reduce these distortions. So does linking buyer-side performance bonuses to long-term value creation rather than earnout avoidance.

Trap 4: Change of Control Mid-Earnout

What happens if the buyer is acquired during the earnout period? Or sells off the business unit that holds the acquired operation? Standard answers include: accelerated payment of a defined amount, continued operation as a separate segment, or a market-value buyout. Skipping this clause is asking for litigation.

Trap 5: No Information Rights

Sellers need access to the post-closing financials to verify the milestone math. The agreement should grant periodic reporting, audit rights (with a defined arbitration process for disputes), and a window to challenge the buyer's calculation. Without information rights, the seller is operating blind and the buyer can stonewall.

Sample Structure That Avoids the Trap

A reasonably seller-friendly earnout typically includes:

• A stated maximum capped earnout amount, payable over a defined two-to-three-year period.
• Revenue as the primary metric (cleaner than EBITDA), with a defined accounting policy.
• Quarterly reporting to the seller with annual reconciliation.
• An operating covenant requiring the buyer to run the business consistent with past practice and to use commercially reasonable efforts to achieve the milestones.
• Explicit language that the earnout is "additional consideration for the equity" and is not conditioned on any seller's continued employment.
• Acceleration of remaining earnout payments on change of control of the buyer.
• A dispute-resolution clause with a tight timeline and a named independent accountant.
• Imputed interest carve-outs or a stated interest rate consistent with the applicable federal rate.

That is a long list, but every line corresponds to a Delaware case or a tax dispute someone has lost.

What This Means for Your Books

Earnouts create accounting and bookkeeping complexity for both sides.

Buyers must recognize contingent consideration at fair value on the closing balance sheet under ASC 805 and remeasure it through earnings each reporting period. That earnings volatility surprises buyers who have never lived through it. The acquired business will have allocated goodwill that needs annual impairment testing. And every operating decision affecting the earnout creates a paper trail that could surface in litigation—keep records of why you cut a department, how you allocated overhead, and what your operating covenants required.

Sellers need to track their installment method calculations, file Form 6252 each year an earnout payment is received, and reconcile what they received against the stated maximum. They also need to monitor whether Section 453A interest charges apply on outstanding balances. And they need clean records to defend the capital-gain characterization if the IRS argues the payments were really compensation.

For both sides, the bookkeeping is harder when records are scattered across spreadsheets, accounting software, and signed agreements. Keeping a clean, version-controlled accounting trail—where every adjusting entry is traceable to a contract clause—saves enormous time when the dispute or audit arrives.

Practical Negotiation Checklist

When you sit down across the table, work through this list:

• Cap and term. What is the maximum? Over what period? Anything open-ended is bad tax and bad business.
• Metric. Revenue, EBITDA, or qualitative? If EBITDA, exactly how is it defined?
• Tax characterization. Is the agreement clear that payments are additional purchase price, not compensation?
• Operating covenants. How must the buyer run the business during the period?
• Reporting and audit. When does the seller see the numbers? What are the audit rights?
• Acceleration triggers. Change of control, termination of the seller's role, business sale—what triggers immediate payment?
• Interest. Stated interest or imputed? Who bears the imputation risk?
• Dispute resolution. Tight timelines and named arbitrators avoid the worst Delaware outcomes.

Keep Your Financial Records Audit-Ready

Whether you are a seller waiting to collect or a buyer needing to remeasure contingent consideration each quarter, an earnout creates years of accounting entries that need to tie back cleanly to the underlying agreement. Beancount.io offers plain-text accounting that is transparent, version-controlled, and AI-ready—every adjusting entry leaves a clear audit trail, and you own the data. Get started for free and see why founders, finance professionals, and M&A practitioners are switching to plain-text accounting.