Earnout Agreements in a Business Sale

How an earnout is structured

The mechanics are simple. A portion of the purchase price is held back and becomes payable if agreed performance targets are met over a defined period after closing. A typical small-business earnout runs 10% to 30% of total consideration over one to three years, measured annually. Beyond three years the causal link between the seller's work and the results becomes too weak to defend on either side.

Three shapes are common. A cliff pays the full amount if the target is hit and nothing if it is missed — simple, but it turns a 1% shortfall into a total loss and creates enormous pressure to game the final quarter. A sliding scale pays proportionally to performance, which is fairer and much less prone to gaming. A tiered structure sets a floor below which nothing is paid and a ceiling above which no more accrues. Sliding scales with a floor and a cap are the most durable in practice.

Choosing the metric

Revenue is the most common trigger in small deals because it is unambiguous and sits at the top of a statement the buyer cannot easily manipulate. Its weakness is that revenue is not value: a seller motivated by a revenue earnout can discount aggressively, take on credit-risky customers, or book work at negative margin, and hit the target while damaging the business you just bought. If you use revenue, pair it with a minimum gross margin condition.

Gross profit is often the best compromise. It captures the discounting problem that pure revenue misses, while staying above the operating expense lines the buyer controls after closing.

EBITDA or net profit is the most economically honest metric and the most litigated one. After closing, the buyer sets salaries, allocates overhead, decides on marketing spend, and may push corporate costs down onto the business. Every one of those choices moves the number the seller is paid on. If you use a profit metric, the agreement must define it with real accounting specificity: which allocations are permitted, what happens to buyer-imposed management fees, how new capital expenditure is treated, and which accounting policies are frozen for the earnout period.

Non-financial milestones are underused and often the cleanest fit. Retention of a named key customer through a given date, renewal of a specific contract, transfer of a license or certification, or the seller successfully training a replacement are all binary, verifiable, and directly aligned with what the buyer was actually worried about.

The clauses that decide whether it gets paid

Most earnout disputes are not about arithmetic. They are about what the buyer did after closing. Both sides need these terms written down.

• Operating covenants. What the buyer commits to during the earnout period — typically maintaining the sales team, not discontinuing the products the target depends on, not reallocating the customer base to another entity, and running the business in the ordinary course.
• Accounting definitions. Frozen accounting policies for the measurement period, an explicit list of permitted overhead allocations, and treatment of any management fee the buyer charges.
• Access and reporting. The seller receives a defined statement on a defined schedule, with the right to inspect the supporting records. Without this, the seller learns their number after it is final.
• Dispute resolution. A named independent accountant, a stated timeline for objection, and an allocation of that accountant's fees. This single paragraph prevents most earnout litigation.
• Acceleration on change of control. If the buyer sells the business mid-earnout, the remaining amount either accelerates or binds the successor. Otherwise a resale quietly extinguishes the seller's claim.
• Set-off rights. The buyer's right to offset indemnity claims against unpaid earnout amounts — frequently the most practical recovery mechanism a buyer has.
• The seller's role. If the seller is expected to influence the result, define their authority and their time commitment. An earnout that depends on a seller with no decision rights is a lottery ticket.

Earnouts and SBA financing

If your acquisition is financed with an SBA 7(a) loan, the structure is constrained. SBA change-of-ownership rules govern how contingent and deferred consideration interacts with the loan, and the total financed amount generally has to be fixed at closing. In practice, buyers using SBA debt more often reach the same economic result through a seller note — sometimes with performance-based offset provisions — than through a classical earnout.

Raise this with your lender before you agree to any contingent structure in the letter of intent. Discovering in underwriting that your agreed structure is not financeable costs weeks and a great deal of goodwill. The related equity-injection rules are covered on our SBA down payment page.

When to use something else instead

An earnout is not always the right instrument for the risk you are trying to price.

• If you are worried about undisclosed liabilities rather than future performance, the answer is an escrow holdback with indemnity, not an earnout.
• If you are worried about the seller walking away at closing, a seller note plus a written transition obligation does more work.
• If you are worried that the historical earnings themselves are wrong, no contingent structure fixes that. Finish diligence, adjust the price, or leave — the diligence checklist is the right tool.
• If the gap is simply that the seller wants a bigger headline number, a longer standby note often satisfies them at lower complexity than an earnout.

A worked example

A services business does $1.6M of revenue with $310,000 of SDE. The seller wants $1.05M, arguing that a contract signed two months ago adds $240,000 of annual revenue. You will pay 3.0x on proven earnings — $930,000 — and are unwilling to pay today for a contract with no renewal history.

The bridge: $930,000 at closing, plus up to $120,000 payable over two years, tied to that named contract remaining in force and generating at least $200,000 of revenue in each twelve-month period, on a sliding scale from 60% to 100% of target, with no payment below 60% and no upside above 100%. The buyer covenants to service the account in the ordinary course; the seller receives a quarterly statement of that customer's billings; disputes go to a named accounting firm with fees split unless the adjustment exceeds 5%.

Both parties get what they argued for. The seller is paid their number if they were right about the contract. You pay for it only if it turns out to be real. That is the entire purpose of the instrument, and our negotiation guide covers how to introduce it without signalling that you are simply trying to lower the price.

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