Only 21 cents on every earnout dollar promised actually gets paid, according to theSRS Acquiom 2025 Deal Terms Study. That means 79% of earnout dollars promised in M&A deals never reach the seller's bank account.
If you're considering a deal with an earnout component, you need to understand exactly how these structures work. The difference between a well-structured earnout and a poorly written one can be millions of dollars.
Key Takeaways
- Earnout metrics must be clearly definedto prevent buyer manipulation
- Baseline protection clausesensure you maintain operational control during the earnout period
- Acceleration triggersprotect your payout if the buyer sells or restructures
- Tax treatment varies dramaticallybased on how the earnout is structured
- Dispute resolution mechanismsdetermine how conflicts get resolved
Why Most Earnouts Fail
Earnouts are used in 24% of deals today, well above the historic average of 20%. The median earnout potential represents 34% of the closing payment. But here's the problem:28% of earnout deals are contested, and most sellers lose.
The fundamental issue is misaligned incentives. Once the buyer owns your business, they control the levers that determine your earnout payout. Without proper protections, they can manipulate results to minimize what they owe you.
Hypothetical example: a software company sells for $10 million upfront plus a $5 million earnout based on revenue growth. The buyer then shifts resources away from the acquired business, reduces marketing spend, and reassigns key customers to other divisions. Revenue drops, and the earnout pays zero.
The Five Critical Earnout Clauses
1. Metric Definition and Calculation
Your earnout metric must be bulletproof. Vague language like "revenue growth" or "EBITDA improvement" creates loopholes.
What to include:
- Exact calculation methodology
- Which revenue streams count
- How expenses are allocated
- Treatment of one-time items
- Accounting standards to be used The buyer should not have discretion in how metrics are calculated. Everything must be defined upfront with mathematical precision.
2. Baseline Protection and Operating Covenants
This clause prevents the buyer from sabotaging your earnout through operational changes.
Essential protections:
- Maintain current management team
- Preserve marketing and sales budgets
- Restrict customer reassignments
- Limit cost allocations from parent company
- Maintain competitive compensation levels Without these covenants, the buyer can systematically undermine your business performance during the earnout period.
3. Acceleration Triggers
Currently,75% of deals expressly exclude accelerationif the buyer sells the acquired business during the earnout period. This is a major red flag.
Your acceleration clause should trigger full earnout payment if:
- The buyer sells your business or division
- The buyer undergoes a change of control
- Key management is terminated without cause
- The buyer materially breaches operating covenants Hypothetical example: a buyer acquires your manufacturing business for $8 million plus a $4 million earnout. Eighteen months later, they sell your division to a competitor for $20 million. Without acceleration, you get nothing from that $20 million sale.
4. Tax Structure and Treatment
How your earnout is structured determines your tax bill. According to theIRS Publication 544, earnout payments can be treated as either purchase price or compensation.
Purchase price treatment:Taxed at capital gains rates (15% or 20%) plus potential 3.8% net investment income tax
Compensation treatment:Taxed at ordinary income rates up to 37% plus payroll taxes
The difference on a $2 million earnout payment could be over $400,000 in taxes. Structure the earnout as additional purchase price, not employment compensation.
5. Dispute Resolution and Audit Rights
When earnout disputes arise, you need clear resolution mechanisms.
Include these provisions:
- Independent accounting firm to resolve calculation disputes
- Your right to audit earnout calculations
- Specific timelines for dispute resolution
- Binding arbitration rather than litigation
- Fee-shifting if buyer's calculations are materially wrong The median earnout period is capped at 24 months. You need efficient dispute resolution that doesn't eat up your entire earnout window.
The Austin Advantage
Texas law generally favors clear contract language and efficient dispute resolution. Austin's business-friendly legal environment can work in your favor when structuring earnout protections.
However, don't assume standard earnout language will protect you. Each deal requires custom structuring based on your specific business model and risk factors.
Beyond the Earnout Structure
Even with perfect earnout clauses, you're still taking significant risk. The buyer controls your business during the earnout period. Market conditions can change. Key employees might leave.
Consider these alternatives:
- Seller financing:More predictable than earnouts
- Escrow arrangements:Protects against specific risks
- Representations and warranties insurance:Transfers risk to insurers
- Higher upfront payment:Bird in the hand approach Hypothetical example: instead of a $10 million upfront plus $5 million earnout structure, negotiate for $13 million upfront with seller financing for the remaining $2 million. You eliminate earnout risk while still capturing some upside.
Frequently Asked Questions
What percentage of earnouts actually pay out?According to the SRS Acquiom 2025 Deal Terms Study, only 21 cents on every earnout dollar promised actually gets paid to sellers.How long do earnout periods typically last?The median earnout period is 24 months, with no deals exceeding four years according to recent M&A studies.Can earnout payments be taxed as capital gains?Yes, if structured as additional purchase price rather than compensation. This can save significant taxes compared to ordinary income treatment.What happens if the buyer sells my business during the earnout period?In 75% of deals, there is no acceleration clause, meaning you get nothing from the sale. This is why acceleration triggers are critical.Should I accept a deal with a large earnout component?Earnouts represent significant risk. Consider whether you can negotiate higher upfront payment or alternative structures like seller financing instead.
Work with Pinnacle Wealth Advisory
If you're facing an earnout decision, the structure details matter enormously. A well-negotiated earnout can preserve millions in value, while a poorly structured one leaves you empty-handed.
If this applies to your situation, it might be worth a conversation:https://pnwadvisory.com/exit-planning/?utm_source=blog&utm_medium=organic&utm_campaign=earnout-structure-guide-5-clauses-final-check
This blog post is for informational purposes only and does not constitute legal, tax, or financial advice. Past performance does not guarantee future results. Consult with qualified professionals for guidance tailored to your specific situation. Doug may provide services and conduct business as Pinnacle Wealth Advisory with advisory services offered through SB Advisory, LLC.
