Earnouts in a small business sale: how to bridge a price gap without starting a fight

What is an earnout?

An earnout is deferred, contingent purchase price: extra payments after close that are owed only if the business hits targets written into the purchase agreement. A simple shape looks like this:

• A fixed amount paid at closing.
• One or more measurement periods after close, often one to three years.
• A defined metric for each period, such as revenue, gross profit, retained accounts, or a milestone.
• A formula or tiers that say exactly what gets paid if the metric is hit, partly hit, or missed.

The important word is contingent. Unlike a seller note, which the buyer owes no matter what, an earnout can pay zero.

When does an earnout make sense?

Earnouts work best when the disagreement is about a specific, measurable uncertainty. Good fits:

• Recent growth the buyer cannot verify yet, where the seller wants credit for a new run rate.
• Concentration risk, where a large account might not stay after the owner leaves — see customer concentration in SMB diligence.
• A pending contract or renewal that is real but not signed at close.
• Owner-dependent revenue, where the seller stays through a transition and wants to be paid for the relationships they hand over.

They work poorly when the real disagreement is about trust, when the seller will have no influence after close, or when nobody can agree on how the numbers will be counted.

How do you write the metric so it can be measured?

Most earnout disputes are not about whether the business did well. They are about what the numbers mean. Settle that before signing. Practical sequence:

1. 1
   Pick a metric close to the top line

   Revenue or gross profit is harder to move with accounting choices than net income or EBITDA, which the new owner's overhead, salaries, and financing can push down.

2. 2
   Define it in words and with an example

   Which revenue counts, how returns and credits are treated, and whether price increases or new product lines the buyer adds are included.

3. 3
   Name the accounting basis

   Use the same methods as the historical financials the price was based on, applied consistently.

4. 4
   Set the period and payment date

   For example, the first twelve full months after close, paid within a set number of days after that period's financials are final.

5. 5
   Choose tiers over a cliff

   A single all-or-nothing target invites fights at 98 percent. Graduated payments are easier to live with.

6. 6
   Write in reporting and audit rights

   The seller gets periodic statements and the right to review the books behind the earnout number.

7. 7
   Add a dispute path

   An independent accountant decides calculation disputes on a deadline, instead of going straight to litigation.

What operating covenants should an earnout include?

After close the buyer runs the business, and the seller's earnout depends on decisions they no longer control. That tension is normal and needs to be written down. Common points to negotiate:

• Whether the buyer must keep the business operating substantially as before during the earnout period.
• Whether the buyer can merge it with another company, change pricing, or move key accounts in ways that affect the metric.
• What happens to the earnout if the buyer sells the business before the period ends.
• Whether the earnout accelerates if the buyer breaches these terms or terminates the seller without cause.

Buyers want flexibility to run what they bought. Sellers want protection against the metric being steered down. A reasonable middle is a short list of specific prohibited actions rather than a vague promise of good faith.

How is an earnout different from a seller note, holdback, or escrow?

These tools get mixed up, but they solve different problems. In plain terms:

• Earnout — price that is contingent on future performance. Bridges a valuation gap.
• Seller note — price that is owed regardless of performance, paid over time. Bridges a financing gap. See seller financing explained.
• Holdback — price that is owed but held after close as security against warranty or liability claims.
• Escrow — a neutral party holding funds until conditions are met. See what escrow does in a business sale.

Many deals combine them: most of the price at close with a lender, a seller note for part, a holdback in escrow, and a smaller slice in an earnout tied to one large account.

What financing and tax checks come first?

Confirm the structure works for your lender and your tax position before it goes into the LOI. Check these early:

• SBA loans — SBA 7(a) rules have generally not allowed earnouts in change-of-ownership deals, so the price has to be fixed at close. Confirm with your lender under the current SOP. See SBA 7(a) loans explained.
• Other lenders and seller notes — lenders may restrict when earnout payments can be made relative to debt service. Get that in writing.
• Tax treatment — how an earnout is structured, and whether payments are tied to the seller's continued employment, can change how both sides are taxed. Bring in a CPA and an M&A attorney before signing.

Lock the structure in the letter of intent and keep the formula, reporting schedule, and payment history in one verified deal room. Use Biz Checkout for verified SMB buy and sell with NDA-gated financials and escrow deal rooms, and pull entity records anytime on BizFacts.

This guide is general information, not legal, tax, or financing advice. Have your attorney, CPA, and lender review any earnout terms.