When a buyer and seller cannot agree on what a business is worth, an earnout is the classic way to split the difference: pay part of the price now, and the rest only if the business actually performs. The trouble is that earnout structures vary widely, the tax treatment is easy to get wrong, and for the most common kind of small-business buyer, the SBA-financed searcher, a true earnout is usually off the table entirely. This guide gives you the honest, current picture: the main structures compared, how each is taxed, why SBA 7(a) deals change the math, and how to draft one that does not end in a fight.
A quick grounding before the menu of options: earnouts are less common in small deals than the internet implies. Per the latest SRS Acquiom and ABA deal studies, earnouts appeared in roughly 18 to 22 percent of private-target deals in 2024, and in the smallest transactions fewer than about 5 percent use one, because they are expensive to negotiate and police. This is general information, not legal or tax advice.
Key takeaways
- An earnout ties part of the price to post-close performance (revenue, EBITDA, or a milestone), usually over one to three years, to bridge a valuation gap.
- Earnouts underpay. Across all deals they pay only about 21 cents on the dollar of their maximum, so a seller should treat the earnout as upside, not guaranteed price.
- Revenue is the safest metric for a seller; EBITDA is the most disputed, because the buyer controls the cost lines that feed it.
- SBA 7(a) deals usually cannot use a true earnout. SOP 50 10 8 (effective June 1, 2025) requires a fixed, determinable price. The workarounds are standby or forgivable seller notes.
- The number-one dispute driver is buyer control after closing. Recent data shows only about 5% of deals require the buyer to run the business to maximize the earnout.
- Tax characterization matters. Earnouts tied to continued employment can be taxed as ordinary compensation instead of capital gain.
What is an earnout in a business acquisition?
An earnout is a deal structure where part of the purchase price is paid only if the business hits agreed performance targets after closing. It bridges a valuation gap by tying the contested amount to future results, usually revenue, EBITDA, or a specific milestone, over a one-to-three-year period. The buyer reduces the risk of overpaying for promised growth; the seller keeps a shot at full value if the promises come true.
Earnouts make the most sense when the disagreement is specifically about the future: the seller projects strong growth the buyer has not seen yet, a big chunk of revenue rides on one or two accounts, or the business depends on the seller staying through a transition. If the gap is about historical performance or clean financials, an earnout just postpones the argument.
How common are earnouts in small business deals?
Less common than you would think, and they pay less than sellers hope. Here is the current data, which corrects the decade-old figures floating around most articles.
| Metric | Current figure | Source (year) |
|---|---|---|
| Share of private deals with an earnout | ~18 to 22% | SRS Acquiom / ABA studies (2024 to 2025) |
| Share of the smallest deals using one | Under 5% | Morgan and Westfield (2025) |
| Median earnout size | ~31% of closing payments | SRS Acquiom (2024) |
| Median earnout duration | ~24 months | SRS Acquiom (2025) |
| Average payout vs. maximum | ~21 cents per dollar | SRS Acquiom (2024) |
| Deals requiring buyer to maximize earnout | ~5% | ABA Deal Points Study (2025) |
The takeaway for a seller: an earnout is a bet on the buyer's good faith and the business's results, and most of the time it pays out a fraction of the headline number. Size your expectations to roughly 20 to 50 cents of the maximum, not the full figure.
The main earnout structures, compared
There are five genuine earnout structures plus one cousin (rollover equity) that gets lumped in but is really retained ownership. Here is how they stack up for a small-business deal.
| Structure | How it works | Best for | SMB fit | Main risk |
|---|---|---|---|---|
| Revenue-based | Pay if post-close revenue hits thresholds or tiers | Growth disagreements; service or agency deals | Strong | Ignores profitability; can reward low-quality sales |
| EBITDA / profit-based | Pay if post-close EBITDA or net profit hits targets | Standalone businesses with clean books | Partial | Buyer cost allocations can suppress the number |
| Milestone (non-financial) | Pay on a discrete event: keep a key client, transfer a license | Customer concentration; key-person risk | Strong | Cliff effect; buyer can cause the miss |
| Gross-margin / KPI | Tie to gross margin, units, or a sector KPI | When revenue misleads but EBITDA is too gameable | Partial | Needs tight definitions; less standard |
| Reverse earnout / holdback | Pay full price up front, claw back if targets are missed | Sellers with leverage who insist on getting paid | Partial | Buyer fronts more cash; harder for SBA buyers |
| Rollover equity | Seller keeps a minority stake for a future exit | Lower-middle-market PE platform deals | Middle-market | Illiquid; triggers SBA guaranty issues |
Revenue vs. EBITDA: which metric to tie the earnout to
This is the single most consequential choice in the whole agreement, because it decides how much the buyer can quietly influence your payout.
| Metric | Buyer can manipulate it? | Simplicity | Reflects true value | Best when |
|---|---|---|---|---|
| Revenue | Hard (sits above the buyer's cost lines) | High | Low to medium | Seller stays in sales; clean top line |
| Gross margin / KPI | Moderate | Medium | Medium | Unit economics matter more than top line |
| EBITDA / profit | Easy (cost allocations, fees, hires) | Low | High | Standalone books; sophisticated seller |
For most sellers, especially a first-time seller without a forensic accountant on retainer, revenue is the safer metric. It sits above the lines a buyer controls, so the buyer cannot suppress it by loading in management fees, new hires, or shared overhead. EBITDA reflects what the buyer actually values, which is why it is the common compromise, but it is also the leading source of earnout litigation. If you do agree to EBITDA, the accounting definition is the contract: spell out permitted add-backs, GAAP versus cash, and exactly how shared costs are (or are not) allocated.
How earnouts are taxed
Earnout tax treatment is technical, and getting it wrong is expensive. The short version, with a real caveat that you should run your specific deal past a tax advisor.
For the seller, contingent earnout payments are generally reported under the installment method (IRC 453) as a contingent-payment sale. Deferred amounts paid well after closing carry imputed interest under the applicable federal rate, and that interest portion is taxed as ordinary income, not capital gain. The biggest trap: an earnout conditioned on the seller's continued employment can be recharacterized by the IRS as ordinary compensation (subject to payroll or self-employment tax) rather than capital gain. To preserve capital-gain treatment, structure the earnout as purchase price payable regardless of employment, and pay separately for any post-close work at a market rate.
One correction worth flagging, because the source material for this topic and many competing articles get it wrong: the claim that "capital losses can only be carried back three years" does not apply to individuals. Under IRC 1212, individual sellers generally cannot carry capital losses back at all; they carry forward indefinitely. Only C-corporations may carry a net capital loss back three years and forward five. So a reverse-earnout clawback that creates a later capital loss is mainly a timing problem for a corporate seller, not a typical individual seller.
For the buyer, an earnout that is additional purchase price gets capitalized into asset basis (usually goodwill, amortized over the remaining 15-year Section 197 period). An earnout properly characterized as compensation is currently deductible, which is exactly why buyers often prefer the compensation framing and sellers prefer purchase-price treatment. Negotiate and document the characterization deliberately.
Earnouts and SBA 7(a) loans: why they're usually off the table
Here is the part almost no general earnout guide covers, and it is the part that matters most to the typical searcher. If you are financing the acquisition with an SBA 7(a) loan, a true contingent earnout is effectively prohibited.
SBA SOP 50 10 8, effective June 1, 2025, requires a fixed, determinable purchase price documented at closing. Contingent consideration that floats with future performance does not fit. Lenders treat anything economically like deferred contingent price as seller financing, which has to live on a seller note. So the practical, SBA-compatible substitutes for an earnout are:
| Tool | How it works | SBA 7(a) status |
|---|---|---|
| True contingent earnout | Price floats with future performance | Effectively prohibited |
| Standby seller note | Fixed note, no payments during standby | Allowed; full standby for the loan life to count toward equity injection |
| Forgivable seller note | Forgiven if trailing (historical) benchmarks are missed | Allowed; tie forgiveness to past results, not projections |
| Holdback / escrow | Part of the fixed price held and released or returned | Allowed; clean fixed-price mechanics |
Note also that a seller who rolls equity is treated as retaining ownership, which triggers a two-year personal guaranty under the new SOP and usually rules out rollover in small SBA deals. If you are buying with a 7(a) loan and need to bridge a valuation gap, a fixed price plus a standby or forgivable seller note is the road, and you should get the structure pre-blessed by your lender before you sign. For how the seller note interacts with your required cash, see our guide to SBA 7(a) equity injection sources.
How to structure an earnout that won't blow up
Most earnout disputes trace back to the same root cause: after closing, the buyer controls the business, and the agreement did not constrain how they run it. Recent ABA data shows only about 5% of deals require the buyer to operate so as to maximize the earnout. Close that gap with the following.
- Pick a simple, objective metric within the seller's influence. Revenue beats EBITDA for manipulation resistance.
- Define the accounting precisely. What counts as revenue or EBITDA, permitted add-backs, GAAP versus cash, and how shared costs are allocated. The definition is the deal.
- Constrain buyer conduct. Require the buyer to operate consistent with past practice and use commercially reasonable efforts to hit the targets. No moving customers or revenue to a sister entity, no loading the unit with unrelated costs.
- Keep the period short. One to two years is cleaner than three-plus; longer means more integration changes that muddy the metric.
- Use tiers, not a cliff. A linear or tiered formula so a near-miss still pays something, avoiding the "missed by 2 percent, got zero" fight.
- Add an acceleration clause. If the business is sold, the buyer takes a change of control, or the seller is terminated without cause, the remaining earnout comes due.
- Build in cheap dispute resolution. Give the seller the calculation with detail, an objection window, audit rights, and binding resolution by an independent accountant instead of litigation.
Earnout examples
Revenue-based earnout (hypothetical $2M HVAC business). The seller wants $2.0M; the buyer offers $1.6M because half of revenue comes from two commercial accounts. They agree on $1.6M at close plus up to $400K over 24 months: $200K if trailing-12-month revenue stays at or above the current $1.5M at month 12, and another $200K if it reaches $1.65M (10 percent growth) by month 24, with the two anchor accounts named and revenue audited annually. The top-line metric is hard to game and keeps the seller motivated to retain the anchor accounts. (If this were SBA-financed, the contingent piece would be replaced with a fixed price plus a standby note.)
Milestone earnout (hypothetical $1.5M marketing agency). One client is 40 percent of revenue. The buyer pays $1.2M at close and holds $300K as a milestone: paid in full if that client is on an active contract 12 months post-close, pro-rated to $150K if retained at least 6 months, with a covenant that the buyer will use reasonable efforts to keep the account and not reassign it to a sister agency. It targets the exact risk, the whale leaving, instead of a fuzzy profit number.
A cautionary tale (real). When Sanofi acquired Genzyme in 2011, it used contingent value rights, an earnout-style instrument, worth up to roughly $3.8 billion tied to FDA approval and sales milestones for the MS drug Lemtrada. Shareholders alleged Sanofi deliberately slowed the drug to dodge the payouts, and Sanofi settled for $315 million in 2019. Even sophisticated parties end up in court when the buyer controls the levers that drive the metric. The SMB lesson: write strong reasonable-efforts covenants and acceleration triggers, because the buyer's post-close conduct is the central risk.
Where Clef fits
An earnout is a tool for one specific problem: a gap between what a seller wants and what the numbers support. The better you understand a business before you make an offer, the less often you need a contingent structure to paper over uncertainty, and the more precisely you can price the deal in the first place.
Clef is where that understanding starts. It aggregates more than 120,000 business-for-sale listings into one searchable feed, with an AI assistant to interrogate the financials and a pipeline to track every deal from first look to LOI. It will not draft your earnout, and for an SBA deal you will be reaching for a standby note instead. But a clearer read on the business, its revenue concentration, and its real profitability is what lets you structure the rest of the deal with confidence. Start by finding businesses for sale, and bring a sharper valuation to the table.
Frequently asked questions
How long does a typical earnout last?
Most SMB earnouts run one to three years, with the broader market median around 24 months. Periods rarely exceed four years because longer terms create more integration changes that muddy the metric and spark disputes.
What percentage of the purchase price is usually an earnout?
It varies widely. In the broader M&A market the median earnout is around 31% of closing payments, while many SMB guides cite a 10 to 50 percent range. Just remember earnouts historically pay only about 21 cents on the dollar of their maximum, so treat the earnout as upside, not guaranteed price.
Can you use an earnout with an SBA 7(a) loan?
Generally no. Under SBA SOP 50 10 8 (effective June 1, 2025), a 7(a)-financed acquisition needs a fixed, determinable purchase price at closing, which rules out contingent earnouts. Lenders instead use a standby seller note or a forgivable note tied to historical benchmarks. Confirm the structure with your lender before signing.
How are earnout payments taxed for the seller?
Earnouts are usually reported under the installment method (IRC 453) as a contingent-payment sale, with deferred amounts carrying imputed interest taxed as ordinary income. Watch out: an earnout tied to your continued employment can be recharacterized as ordinary compensation instead of capital gain. Talk to a tax advisor before signing.
Revenue or EBITDA: which is better for an earnout?
Revenue is simpler and much harder for the buyer to manipulate because it sits above the cost lines the buyer controls, so it is usually safer for the seller. EBITDA better reflects real value and is the common compromise, but it is the leading source of earnout disputes because cost allocations and management fees can suppress it.