# How does an earn-out work?
An earn-out makes part of a business sale price depend on results after closing. The metric, the formula and the accounting definitions decide what is paid.
---
An earn-out works by making part of the price of a business depend on how that business performs after the sale: the buyer pays a fixed amount at closing, then pays more, up to an agreed maximum, if the business reaches agreed results over an agreed period. The seller is paid the extra only if the results arrive, and the clause that defines "results" decides how much of it is ever paid.
An earn-out is a contract term, so its rules come from the purchase agreement and from the law that governs it. Contract law, accounting standards and tax treatment differ from one country and state to the next; what follows is general information, not legal or tax advice.
Most of the clause is design. Two earn-outs with the same headline maximum can pay very different amounts on identical results. The worked example below runs three formulas over the same three years, with a $12,000,000 payment at closing and an earn-out of up to $6,000,000.
$2,000,000paid by an annual all-or-nothing formula on the example's three years of results
$4,250,000paid by an annual sliding scale on the same results
$6,000,000paid by a formula with a catch-up on the same results
Illustrative worked example detailed below: three annual tranches of $2,000,000 measured on EBITDA.
## Why do buyers and sellers agree to an earn-out?
Buyers and sellers agree to an earn-out to bridge a valuation gap: the seller prices the business on what it is about to become, the buyer prices it on what it has already done. The buyer pays its own valuation at closing and pays the difference only if the seller's forecast comes true.
In the worked example, the seller values the company at $18,000,000 on the strength of a growth plan, and the buyer will not go above $12,000,000 on historical earnings. The gap is $6,000,000. With an earn-out, the buyer pays $12,000,000 at closing and promises up to $6,000,000 more over three years if the plan is delivered.
The earn-out does three other jobs.
- **It shifts risk.** The buyer does not pay for growth that never happens. The seller carries the risk of the forecast, including the part it no longer controls.
- **It finances part of the price.** Money paid in year three does not have to be found at closing. For the seller, a later dollar is worth less and depends on the buyer still being able to pay.
- **It keeps the seller engaged.** A founder who stays on has a reason to deliver the handover and the plan.
An earn-out fits best when the uncertainty is specific and measurable: a product about to launch, a large contract about to be renewed, a regulatory approval pending, a young company with little history. It fits badly when the buyer will merge the business into its own operations at once, because separate numbers then stop existing.
## Which metric should an earn-out be measured on?
An earn-out is measured on revenue, gross profit, EBITDA or another profit figure, or on non-financial milestones, and the choice sets who controls the result: the higher up the income statement the metric sits, the less the buyer's cost decisions can move it.
| Metric | Who it tends to favour | What it leaves open to dispute |
| --- | --- | --- |
| Revenue | The seller: costs decided by the buyer do not touch it | Discounts, bundling with the buyer's products, timing of recognition, sales booked through another group company |
| Gross profit | A middle ground: rewards sales that carry a margin | What counts as a direct cost, transfer prices on goods bought within the group |
| EBITDA or net profit | The buyer: it pays only for growth that produces earnings | Group overhead charges, new hires, integration costs, one-off items, accounting policy changes |
| Milestones | Either, depending on wording | Whether the event happened, by the date, in the required form |
Revenue is the hardest metric for the buyer to depress by spending, and the easiest for a seller who still runs the business to inflate by selling at any price, which is why buyers who accept revenue often add a margin floor.
EBITDA, which is earnings before interest, tax, depreciation and amortisation, measures what the buyer is buying. It also has the most moving parts: every cost line is a potential argument, and after closing the buyer decides most of them.
Milestones suit businesses whose value hangs on an event: a regulatory approval, a product shipped, a named customer signed. They are binary, so the wording has to say exactly what counts.
## How long is the measurement period, and what do thresholds, caps and floors do?
The measurement period is the time over which results count toward the earn-out, usually divided into annual tranches, and the threshold, cap and floor set the lowest result that pays anything, the most that can ever be paid and the least the seller is guaranteed.
**The period.** A short period, one or two years, limits how long the seller waits and how long the buyer must keep the business measurable. A long period gives a growth plan time to work, and more time for the business to be reorganised. A period that starts mid-year should say how the part-year is measured.
**The threshold.** A threshold is the result below which nothing is paid. Set at the target, it makes the formula a cliff; set below, it opens a band in which a partial amount is paid.
**The cap.** A cap is the maximum the buyer can owe, in total and often per year. Buyers want one so that the price is bounded and can be financed; a seller confident of beating the plan may ask for a share of the excess above target instead.
**The floor.** A floor is a guaranteed minimum paid whatever the results. It is deferred consideration under another label: part of the contingent price has become fixed.
**Annual or cumulative measurement.** Annual tranches pay sooner and test each year on its own. A single cumulative test at the end smooths out timing, since a contract signed in January instead of December no longer costs a tranche, but the seller waits the whole period to be paid.
## Cliff or sliding scale: which pays the seller more?
A sliding scale pays the seller more than a cliff whenever results land close to the target without reaching it, because a cliff pays nothing for a near miss while a sliding scale pays in proportion; the two pay the same only when the target is met in full or missed by a wide margin. A catch-up changes the comparison again by letting a strong later year recover an earlier shortfall.
The three formulas compared here work as follows, each with a maximum of $2,000,000 a year and $6,000,000 in total.
- **Cliff.** Each year pays $2,000,000 if that year's EBITDA reaches the year's target, and nothing if it does not.
- **Sliding scale.** Each year pays nothing at or below 80% of the year's target, the full $2,000,000 at or above the target, and a straight-line share in between. Written out, the payment is $2,000,000 multiplied by the actual EBITDA less 80% of the target, divided by 20% of the target, limited to between zero and $2,000,000.
- **Cliff with catch-up.** Each year works like the cliff, but at each year-end the cumulative EBITDA since closing is compared with the cumulative target. If the cumulative figure reaches the cumulative target, every tranche up to that year is treated as earned, and any tranche missed earlier is paid.
A cliff is simple to draft and to audit. It also concentrates the dispute on a single number: when $2,000,000 turns on whether EBITDA was just above or just below a line, every accounting judgment near that line is worth arguing about. A sliding scale lowers the stakes, because a small change in the measured figure produces a small change in the payment.
A catch-up, sometimes called a carry-forward, protects the seller against timing. A carry-back does the reverse, crediting an excess in one year to a later weak year. Buyers sometimes ask for a clawback of amounts paid for an early strong year if the cumulative figure later falls short; early payments are then provisional.
## What do three payout formulas pay on the same results?
On the same three years of results, the three formulas pay $2,000,000, $4,250,000 and $6,000,000, so the total price received for the same company ranges from $14,000,000 to $18,000,000. The figures are illustrative assumptions, not market data.
The plan and the results are these.
| Year | EBITDA target | Actual EBITDA | Actual as a share of target |
| --- | --- | --- | --- |
| Year 1 | $2,400,000 | $2,100,000 | 87.5% |
| Year 2 | $2,800,000 | $2,660,000 | 95.0% |
| Year 3 | $3,200,000 | $3,700,000 | 115.6% |
| **Three years** | **$8,400,000** | **$8,460,000** | **100.7%** |
The business missed two years narrowly, beat the third, and finished $60,000 ahead of the cumulative plan. Each formula reads those results differently.
| Year | Cliff | Sliding scale | Cliff with catch-up |
| --- | --- | --- | --- |
| Year 1 | $0 | $750,000 | $0 |
| Year 2 | $0 | $1,500,000 | $0 |
| Year 3 | $2,000,000 | $2,000,000 | $6,000,000 |
| **Earn-out paid** | **$2,000,000** | **$4,250,000** | **$6,000,000** |
| **Total price with $12,000,000 at closing** | **$14,000,000** | **$16,250,000** | **$18,000,000** |
Under the sliding scale, the first year's lower threshold is 80% of $2,400,000, which is $1,920,000. Actual EBITDA of $2,100,000 is $180,000 above it, in a band $480,000 wide, so 37.5% of the tranche is paid: $750,000. The second year's threshold is $2,240,000; EBITDA of $2,660,000 is $420,000 into a band of $560,000, or 75%, which pays $1,500,000. The third year is above target and pays the full tranche.
Under the catch-up, cumulative EBITDA after two years is $4,760,000 against a cumulative target of $5,200,000, so nothing has been earned yet. After three years it is $8,460,000 against $8,400,000, so all three tranches are earned at once.
The seller who delivered slightly more than the three-year plan is paid one third of the earn-out under the cliff and all of it under the catch-up. A seller who compares offers by their headline maximum is comparing the wrong number: the formula is part of the price.
## Which accounting definitions decide the result?
The accounting definitions that decide an earn-out are the ones that say how the metric is computed: which accounting standards and policies apply, which costs the buyer may charge to the business, which items are excluded, and how transactions with the rest of the buyer's group are priced.
A workable definition usually settles the following points.
- **The policies.** The metric is computed under named accounting standards, applied consistently with the policies the target used in a stated set of pre-closing accounts. Otherwise a change of revenue recognition or provisioning policy can move the figure without any change in the business.
- **Group charges.** Management fees, shared-service allocations and head-office overheads are either excluded or limited to a stated amount.
- **Deal and integration costs.** Transaction fees, restructuring, systems migration and adjustments that arise only because the business was bought, such as asset revaluations at closing, are excluded.
- **Intra-group dealings.** Sales to and purchases from the buyer's other companies are measured at arm's-length prices.
- **One-off items.** Extraordinary gains and losses, insurance recoveries and litigation costs are assigned in advance.
To see what one definition is worth, suppose the buyer charges the business a $280,000 share of group overhead in year two, and the agreement does not exclude it. Year-two EBITDA falls from $2,660,000 to $2,380,000, and the three-year total from $8,460,000 to $8,180,000.
Earn-out paid with and without one $280,000 overhead chargeTotal over three years, same business results, illustrative example
With the charge in year 2Without the charge
Worked example. The charge lowers year-2 EBITDA to 85% of its target and cumulative EBITDA to $8,180,000 against a target of $8,400,000.
The cliff is unchanged because year two was already a miss. The sliding scale loses $1,000,000: year two now sits $140,000 into its $560,000 band, 25%, and pays $500,000. The catch-up loses $4,000,000, because the cumulative figure drops below the cumulative target and the two missed tranches are never recovered. Under the catch-up, a charge of $280,000 moves the price by more than fourteen times its own size, which is why the definitions deserve as much negotiation as the maximum.
## What operating covenants protect the seller after closing?
Operating covenants are the buyer's promises about how it will run the business during the measurement period, and they are the seller's main protection once control has passed. After closing the buyer sets prices, budgets, headcount and strategy, and unless the agreement says otherwise it may run the business in its own interest.
Covenants sellers ask for include keeping the business as a separate unit with its own books, funding it to an agreed budget, keeping named people and a minimum sales headcount, not diverting customers to other group companies, and not changing the accounting policies. Buyers usually offer a narrower commitment: not to act with the purpose of reducing the earn-out.
How much the law adds on its own depends on the jurisdiction. In Delaware, a state whose law governs many United States acquisition agreements, the Supreme Court addressed the point in a 2015 decision on a revenue-based earn-out. The buyer had paid $40 million at closing and promised up to another $40 million if revenue reached a set level, which it did not. The agreement barred the buyer from taking action to divert or defer revenue with the intent of reducing or limiting the earn-out payment. The court read that wording as requiring intent, not mere knowledge of the effect, and held that the implied covenant of good faith and fair dealing did not inhibit the buyer's conduct unless the buyer acted with the intent to deprive the seller of an earn-out payment. It noted that the seller had sought affirmative post-closing obligations during negotiation and had not obtained them.
Other jurisdictions treat good faith differently, so the governing law of the agreement is itself a term to negotiate. Whatever the law, a protection the seller needs is best written as an express covenant, with a stated consequence if it is breached. Proving what a buyer intended is far harder than proving that a budget was not funded.
## What triggers acceleration of an earn-out?
Acceleration makes some or all of the unpaid earn-out payable at once when a stated event occurs, typically a sale of the business or of the buyer, a breach of the operating covenants, the buyer's insolvency, or the dismissal of the seller without cause.
The seller asks for the full unpaid maximum: in the example, if the business were sold to a third party after year one under the sliding-scale formula, $750,000 would have been paid and $5,250,000 would fall due. The buyer usually offers less: the amount implied by performance to date, a discounted value, or transfer of the obligation to the new owner with no payment.
Where the seller stays on as an employee, the agreement should say what happens to the earn-out if the employment ends. Sellers generally ask that forfeiture apply only on resignation without good reason or dismissal for cause, with both terms defined.
## Can the buyer set off indemnity claims against the earn-out?
The buyer can set off indemnity claims against earn-out payments only to the extent the agreement, or the governing law, allows it, and most buyers ask for an express right to do so. A set-off right turns the earn-out into security for the seller's warranties.
Suppose that in year three the buyer claims $600,000 for a breach of a tax warranty. With an unrestricted set-off right, the $2,000,000 tranche due for that year arrives as $1,400,000, on the buyer's own assessment of its claim. The seller then has to pursue the $600,000; the buyer no longer has to prove its loss first.
Sellers negotiate three limits: set-off only for claims that are agreed or finally determined, with disputed amounts paid into escrow and not kept by the buyer; the indemnity caps and time limits continuing to apply; and any amount wrongly withheld repaid with interest.
## How are earn-out disputes resolved?
Earn-out disputes about the calculation are usually resolved by an independent accountant acting as an expert, under a timetable written into the agreement, while disputes about breach of covenant or the meaning of the contract go to the courts or to arbitration.
The agreement should say which questions go where; the calculation route usually has five stages.
From year-end to paymentThe typical determination procedure for each measurement period
Earn-out statementThe buyer delivers a statement of the metric and the resulting payment within a fixed number of days after the period's accounts are finalised.
Access and reviewThe seller and its accountants get access to the books and working papers for a fixed review period.
Objection noticeThe seller accepts the statement or serves a notice listing each disputed item and its own figure. Items not objected to become final.
NegotiationThe parties try to agree the disputed items within a set period. Any amount not in dispute is paid in the meantime.
Expert determinationUnresolved items go to an independent accounting firm, whose decision on those items is final and binding save for manifest error, with its fees split as the agreement provides.
The expert's mandate should be limited to the disputed items and to accounting questions, and the clause should name the firm, or the method for appointing one, because two parties in dispute rarely agree on a name.
## What credit risk does the seller take on the buyer?
The seller takes unsecured credit risk on the buyer for every earn-out dollar: an amount that has been earned is still only a claim against whichever entity signed the agreement, payable if that entity can pay.
The exposure is greatest when the buyer is a newly formed acquisition vehicle with no assets except the business, and when the lenders' documents rank the earn-out behind the acquisition loans.
The protections available are the usual credit tools: a guarantee from a parent company with real assets; money placed with an escrow agent, which holds funds under instructions from both sides and releases them on the agreed conditions; a bank letter of credit; security over the shares or assets sold; and a limit on dividends and further borrowing while the earn-out is outstanding. A seller who obtains none of them should value the earn-out below its face amount.
When a tranche falls due, the buyer pays the determined amount within the days the agreement allows, to the seller or, where there are several sellers, to each in the proportions the agreement sets, often through a paying agent or a sellers' representative. Where one payment has to be divided among several parties, a payment router is one way to carry out the division: Shaka, for example, routes a single payment so that each party's share is agreed, and can be signed by each recipient, before the payer pays, and every party is paid at the same moment. It routes and never holds funds, so it does not replace the escrow or guarantee that secures an earn-out.
## How is an earn-out taxed and accounted for, in general terms?
An earn-out is generally taxed as additional sale price when it is paid for the business and as employment income when it is really pay for the seller's continued work, and the line between the two is drawn by the facts of the agreement. The outcome depends on the country and on the seller's own position.
**Price or pay.** Payments made to every selling shareholder in proportion to their shares, employed or not, look like price. Payments that only the working sellers receive, or that are forfeited on leaving, look like remuneration, which many tax systems treat differently from sale proceeds.
**Timing.** Tax systems differ on whether a contingent right is taxed when the sale closes, on an estimated value, or when each payment arrives. In the United States, the Internal Revenue Service's Publication 537 for 2025 defines an installment sale as a sale of property where at least one payment is received after the tax year of the sale, and a contingent payment sale as one in which the total selling price cannot be determined by the end of the tax year of sale, for which different rules apply to figure the contract price and the gross profit percentage. The same publication notes that where a contract provides for little or no interest, part of each deferred payment may have to be treated as unstated interest.
**The buyer's accounts.** For a buyer reporting under IFRS, the standard on business combinations, IFRS 3, requires contingent consideration to be measured at fair value at the acquisition date, and later changes in the fair value of contingent consideration classified as a liability go to profit or loss instead of adjusting goodwill. A buyer therefore records an expense when the acquired business outperforms and the expected payment rises.
## What should an earn-out term sheet settle before signing?
An earn-out term sheet should settle the metric and its definition, the period, the formula, the buyer's covenants, the acceleration events, set-off, the dispute procedure and the security for payment before the purchase agreement is signed. Each item left open will be decided later by the party in control of the business.
- **Metric and definition:** the metric, or the exact milestone event and deadline; accounting standards, reference accounts and exclusions.
- **Period:** start date, length, annual or cumulative measurement.
- **Formula:** target, threshold, cliff or sliding scale, cap and floor, with one worked calculation in a schedule.
- **Catch-up, carry-back and clawback:** which apply, and in which direction.
- **Operating covenants:** each promise, and the consequence of a breach.
- **Acceleration and employment:** each trigger, the amount payable on it, and whether leaving affects the earn-out.
- **Set-off:** permitted or not, for which claims, with disputed amounts paid into escrow.
- **Information and disputes:** access to the books throughout the period, the timetable, the expert's mandate and appointment, and the forum for legal questions.
- **Security and payment:** guarantee, escrow or letter of credit, ranking against the buyer's lenders, due date, late interest and the proportions among the sellers.
- **Governing law:** chosen with its treatment of good faith in mind.
Running the formula on two or three invented sets of results, as in the tables above, and attaching the output to the agreement exposes ambiguities while both sides still want the deal to close.