Earnout Clauses When Buying or Selling a Small Business: How They Work and Where They Go Wrong

What is an earnout in a business purchase?

An earnout is contingent purchase price. Instead of paying the whole price at closing, the buyer pays a fixed amount up front and promises additional payments if the business reaches agreed targets over a set period, often one to three years after closing. If the targets are missed, the payment shrinks or disappears.

A typical small-business example: a buyer offers $1.2 million for a marketing agency whose owner thinks it is worth $1.5 million. They settle on $1.2 million at closing plus up to $300,000 over two years, paid at $150,000 per year if annual revenue from existing clients stays above $900,000.

Earnouts are distinct from a seller note, where the buyer owes a fixed debt regardless of performance, and from an escrow, where part of the agreed price is held back to cover claims. The headline price in a deal with an earnout is a maximum, not a promise.

Why do buyers and sellers agree to earnouts?

For the buyer, an earnout shifts risk. If a large customer leaves after the owner exits, or last year's growth was a one-off, the buyer pays less. For the seller, it is a way to be paid for growth the buyer will not credit up front.

The trade-off is concentration of risk on the seller. The seller is now an unsecured creditor whose payment depends on the buyer's management, accounting and good faith. For that reason, many advisers tell sellers to treat earnout dollars as uncertain and to negotiate the price as if the earnout might pay nothing.

If the buyer is financing the deal with an SBA 7(a) loan, check early. SBA lenders generally treat an earnout paid to the seller as inconsistent with the program's requirement for a complete change of ownership, and lender guidance commonly says it must be removed from the agreement. Confirm with your lender under the SOP in force for your loan, since the change-of-ownership rules were reorganized for loans numbered on or after October 1, 2026.

Which metric should an earnout use?

The metric decides how easy the earnout is to manipulate, intentionally or not. The further down the income statement the metric sits, the more it depends on costs the buyer controls.

Who controls the business during the earnout?

This is the heart of most earnout fights. A buyer may close a location, move staff, change pricing, fold the business into a larger company or simply stop investing in the product line the earnout depends on. Courts generally enforce what the contract says, and are reluctant to add duties the parties did not write down.

The Delaware Supreme Court's January 2026 decision in Johnson & Johnson v. Fortis Advisors, a dispute over earnout milestones in a large medical device acquisition, illustrates the point. The court reversed a lower-court finding that the buyer had breached the implied covenant of good faith on the regulatory milestones, holding that the earnout terms already allocated the risk of regulatory change to the sellers, while it upheld a separate finding against the buyer on fraud. The practical lesson for a small business seller: if you want the buyer to run the business a certain way, say so in the agreement.

Risky wording: "Buyer shall have sole discretion over the operation of the Business following Closing and shall have no obligation to achieve the Earnout Targets."

Fairer wording: "During the Earnout Period, Buyer shall operate the Business in the ordinary course consistent with past practice, maintain it as a separately tracked unit, and shall not take any action with the primary purpose of reducing or avoiding an Earnout Payment."

• Ask for an express operating covenant, not just "commercially reasonable efforts" with no definition.
• List specific prohibited actions: closing the location, diverting customers to another business, cutting the sales team below a set level.
• Require separate books for the business during the earnout period.

How is an earnout calculated and disputed?

Most disputes are accounting disputes. The agreement should say exactly how the metric is calculated: which accounting principles apply, whether they match the seller's historical practice, how corporate overhead, management fees and integration costs are treated, and whether one-time items count.

Then it should set a process. A good earnout clause requires the buyer to deliver a calculation statement within a fixed time after each period (often 60 to 90 days), gives the seller access to the books and staff needed to check it, allows a written objection within 30 to 45 days, and sends unresolved items to an independent accountant whose decision is binding on the calculation. Without that, the seller's only option is a lawsuit.

Also check the payment date and whether late payments carry interest. A payment due "following Buyer's review" has no deadline at all.

What happens if the buyer sells the business, fires the seller or withholds payment?

Many sellers stay on as employees or consultants during the earnout, often under a separate consulting agreement. Two risks follow. First, if the earnout is conditioned on the seller remaining employed, the buyer can end the payment by ending the job. Second, payments tied to continued employment may be treated as compensation rather than purchase price, which can change the tax result for both sides.

Ask for acceleration: if the buyer sells the business, merges it, terminates the seller without cause, or materially breaches the operating covenants, the full remaining earnout (or a negotiated portion) becomes payable immediately. Buyers commonly resist full acceleration, so a middle ground is acceleration at the target level or a pro-rated amount.

Usually, if the agreement says so, and buyers routinely ask for this right of setoff. It gives the buyer a source of recovery for breaches of the seller's representations without chasing the seller. For a seller, an unlimited setoff right means the buyer can withhold earnout money by asserting a claim, whether or not it is valid.

A fair compromise: setoff only for claims that are finally resolved, or that the parties agree on, with disputed amounts paid into escrow rather than kept by the buyer. The setoff should also be subject to the same caps, baskets and deadlines as the rest of the indemnification provisions.

How are earnout payments taxed?

Earnout payments made to the seller as part of the price are generally treated as additional purchase price, not wages. In an asset sale they also have to be allocated across the asset classes on Form 8594 when they are paid, which can change the tax result for both sides years after closing.

Sellers can often use the installment method to pay tax on earnout amounts as they are received rather than all at closing, but there are special rules for contingent payments, and part of each deferred payment may be treated as interest if the agreement does not charge interest. The bigger risk is characterization: if a payment is conditioned on the seller staying employed, it can look like compensation, taxed as ordinary income to the seller and deducted differently by the buyer. Ask both tax advisers to review the earnout wording before signing, not after the first payment.

A worked example: how a vague earnout goes wrong

Maria sells her two-location bakery for $600,000 at closing plus up to $200,000 based on "EBITDA of the Business" over two years. After closing the buyer, which owns other cafes, moves its central kitchen costs, a regional manager's salary and a new point-of-sale system into the bakery's books. Sales grow 12%, but reported EBITDA falls below the target and Maria receives nothing.

Nothing in the agreement defined how shared costs would be allocated, and there was no independent accountant process, so Maria's only option is litigation that may cost more than the earnout is worth. A revenue target, or EBITDA defined to exclude buyer overhead and integration costs, with a right to review the books, would likely have avoided the dispute.

Earnout negotiation checklist

Before you sign, check the earnout against this list. The Business Purchase analyzer splits the headline price into cash at closing, escrow, seller note and earnout, so you can see in an automated review how much of the price is actually contingent and on what.

• Is the metric objective (revenue, named customers, a milestone) rather than net profit?
• Are the accounting rules defined and consistent with the seller's past books?
• Is there a clear operating covenant and a list of prohibited actions?
• Are calculation statements, access rights and an independent accountant process included?
• Is there a payment deadline and interest on late payments?
• Does a sale of the business or termination of the seller accelerate the earnout?
• Is setoff limited to resolved claims?
• Is the earnout capped, and is there a catch-up if a strong year follows a weak one?
• If an SBA loan is involved, has the lender approved the structure?
• Have both sides' tax advisers reviewed how the payments will be taxed?