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What are Earnouts and Why Are They Used?

Buying, Selling

An earnout is a business purchase arrangement where a portion of the seller's payment is contingent on the performance of the business after it is sold. In other words, if after closing the company achieves certain defined performance targets, the seller will be compensated for these achievements for a set period of time- usually in the form of a percentage of sales and/or earnings. 

A Practical Example 

The owner of a software company (seller) and a private equity firm (buyer) are introduced. The software company has had, by far, their best year on record and has recently developed a new product that is expected to generate high sales as soon as it hits the market. The seller wants to sell the company for $10 million.

The buyer is interested in the business and their exciting new product but realizes there is uncertainty with all new products and even if it is successful, will likely not meaningfully contribute to sales for some time. Further, the buyer is skeptical about the seller’s lofty sales forecasts and based on their own analysis, the buyer doesn't want to pay more than $7 million for the company. However, since the buyer does see potential in the company, the two parties agree to work out an earnout clause.

In order to make this happen, the buyer and the seller mutually agree to an objectively verifiable measurement of performance- in this case, sales revenue. Commencing one year after closing, if the previous 12 months' sales exceed $15M, the buyer will pay an extra $4 million to the seller in addition to the original purchase price of $7 million paid at closing (totaling $11M). However, if the company generates less than the benchmark $15M that was agreed upon, then the seller receives no additional funds above the price paid at closing ($7M).

Why Are They Used

As you can see, earnouts can be used to bridge the gap between differing expectations from the buyers and sellers (especially when dealing with future performance). If a business owner is seeking to sell their business for a price that exceeds (within reason) what a buyer is willing to pay, an earnout provision can be utilized.

Not agreeing on a price at closing can lead to postponement of negotiations and eventually, deal fatigue. If, however, the parties take more of a collaborative approach and want to grow the post-close company, an earnout clause can open up a variety of opportunities that are profitable for both sides.


No one earnout is the same, and are therefore worked out by the buyer and seller at their own discretion. However, this is where some complications can arise. Inexperienced or rash negotiating on either side may set targets or conditions that can cause considerable inconvenience to the other side. 

There are countless stories of buyers being accused of deliberately incurring higher costs in order to suppress profits and avoid an earnout being paid. Others have been said to have postponed major marketing campaigns that are expected to drive sales until beyond the earnout period, making the earnout unachievable. Another tactic is that business that should flow through the company is temporarily shifted to a subsidiary or another company owned by the buyer and therefore not reflected on the company’s financials. 

The point here is that earnouts can work, but only when both sides are transparent with their intentions and actions and when the language of the clause is not in any way open to interpretation. The purchase agreement should not only specify the amount of the earnout, but also the accounting assumptions that will be made to calculate it.

Advantages and Disadvantages



  • A longer period of time to pay for the purchase of the business rather than all upfront.
  • Flexibility in that if earnings are not as high as expected, the buyer does not have to pay as much.
  • Allows buyers to directly tie sellers to future performance of the business.


  • It can be a difficult clause to negotiate and requires a careful projection as to the future performance of the business.
  • Requires detailed monitoring of the business' performance post-closing.
  • Disputes may arise as to how the earnout should be calculated.



  • In situations where the seller might believe there is a great opportunity for future growth potential with a new buyer, the seller can reap the benefits of post-close growth & success. 
  • The ability to spread out taxes over a period of time can help to reduce the tax burden of the sale.
  • The seller may be able to receive a higher offer from the buyer this way compared to an all at once payment at closing. 


  • When the seller does not remain involved in the business post-closing, their earnout becomes subject to the conduct of the buyer.
  • In situations where the performance target isn’t met, the seller would not receive any payments on account of the earnout.
  • Disputes may arise as to how the earnout should be calculated.

Disclaimer: This article is a very brief description of how earnouts work. It's not intended to be tax or legal advice. If you are buying or selling a business and you are considering an earnout, be sure to get advice from an accountant and an attorney. An earnout is a complex agreement and all the elements must be carefully considered.