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Earnout in M&A: Structuring the Contingent Payment, Accounting Under ASC 805, Disputes

By The Ledgerism Editorial Team · The Ledgerism Brief Editorial Team produces original, methodology-disclosed accounting and tax research—data trackers, databases, and reference guides built to be the most-cited source in the field. Every figure is verified against primary sources including FASB, the IRS, the PCAOB, NASBA, the AICPA, and state boards of accountancy.

An earnout in M&A is a contingent payment that bridges the gap between what a seller thinks the business is worth and what a buyer is willing to pay today. Part of the price is deferred and tied to the company hitting agreed targets after closing, usually revenue, EBITDA, or specific milestones. It can rescue a stalled negotiation, and it is one of the most dispute-prone structures in any deal.

What is an earnout?

An earnout is a provision in a purchase agreement under which a portion of the purchase price is paid after closing, contingent on the acquired business achieving specified results. Instead of paying the full price up front, the buyer pays a base amount at closing and promises additional consideration, the earnout, if the business performs over a defined measurement period, commonly one to three years.

Earnouts arise when buyer and seller cannot agree on value. The seller projects strong future growth and prices the business accordingly; the buyer is skeptical and will not pay for performance that has not happened. An earnout lets the seller prove the case. If the projections come true, the seller collects the additional payment; if they do not, the buyer is protected from overpaying. The structure shifts risk onto the seller and aligns the seller with the post-close success of the business.

The trade-off is complexity. Because the earnout depends on a number measured after the buyer takes control, the parties must agree precisely on how that number is calculated, who controls the business in the meantime, and what happens if the buyer’s decisions affect the result. Those questions are where earnouts go wrong. A thorough quality of earnings report during diligence helps both sides agree on a clean, normalized metric to build the earnout around.

It is worth being precise about what an earnout is not. It is not a financing tool in the ordinary sense, although it does reduce the cash a buyer needs at closing. It is not the same as a holdback or escrow, which secure indemnification claims rather than reward performance. And it is not a guarantee of future payment; the seller earns the contingent amount only if the agreed results occur. An earnout sits squarely on the pricing side of the deal, allocating the risk and reward of future performance between the parties rather than securing the seller’s past representations.

Why the earnout matters in M&A

Earnouts matter because they keep deals alive that would otherwise collapse on price. When the bid-ask gap is driven by uncertainty about future performance rather than by stubbornness, an earnout converts the disagreement into a measurable bet. The buyer pays for performance only if it materializes; the seller gets full value only if the projections were real. For founders staying on to run the business, the earnout doubles as a retention and incentive tool.

They also matter because they are accounting-heavy and litigation-heavy. The ASC 805 requirement to remeasure liability-classified earnouts to fair value each period introduces earnings volatility that catches buyers off guard: a business that outperforms can drive up the earnout liability and produce a charge to earnings, an outcome that feels counterintuitive. On the dispute side, the ABA Deal Points Studies and practitioner experience consistently identify earnouts as a leading source of post-closing litigation, because the measurement happens after control has changed hands.

SRS Acquiom and ABA data show earnouts are far from rare. They appear in a significant minority of private-target deals overall and in a larger share of certain segments, including life sciences and some private-equity transactions, where future milestones or rapid growth make contingent pricing attractive. Where valuation gaps are common, as in many private-equity roll-ups, earnouts show up frequently.

There is a behavioral reason earnouts persist despite their dispute record. Both sides tend to be optimistic about their own position. The seller believes the projections are conservative and that the earnout is essentially free money it will certainly collect. The buyer believes the targets are a stretch and that the earnout protects it from overpaying for performance that may never arrive. Each side signs because each side expects to win the bet, which is precisely why earnouts close deals: the structure lets two parties with incompatible valuations both feel they got the better end. The reckoning comes later, when the numbers land somewhere in the middle and the careful drafting either holds or fails.

How the earnout works (mechanics)

An earnout has a handful of moving parts that must all be defined in the agreement.

The metric. The performance measure: revenue, gross profit, EBITDA, units sold, regulatory approval, customer retention, or a specific milestone. EBITDA is common because it approximates profitability, but it requires a precise definition of every adjustment.

The target and the payout curve. The threshold the metric must reach and how payment scales. Some earnouts are all-or-nothing (hit the target, get the full amount); others are linear or tiered (partial payment for partial achievement, with accelerators above target).

The measurement period. The window over which performance is measured, often annual periods across one to three years. Multi-year earnouts may allow catch-up between periods so a strong year can make up for a weak one.

Operating covenants. Because the buyer controls the business during the earnout, the agreement usually constrains the buyer: a covenant to run the business consistent with past practice, not to divert revenue, not to load the unit with acquisition costs, and sometimes to use commercially reasonable efforts to achieve the targets.

The calculation and dispute process. The buyer computes the metric after each period and delivers a statement; the seller can review and object; disputes route to an independent accountant. The same expert-determination structure used for working capital true-ups is common here.

A well-drafted earnout also addresses the events that can short-circuit the measurement. What happens if the buyer sells the business, or the whole company, during the earnout period? Acceleration clauses can deem the targets met, or pay a formula amount, on a change of control, so the seller is not deprived of the earnout by a transaction it cannot control. What happens if the selling owner who is running the business is terminated without cause? The agreement may accelerate or protect the earnout in that case. And what happens if the buyer wants to make an acquisition or a large investment that temporarily depresses the metric? The parties may agree to add back the effect of buyer-directed initiatives so the seller is not penalized for the buyer’s strategic choices. Each of these scenarios, left unaddressed, becomes a dispute waiting to happen.

Earnout metric structures compared

Worked example

A buyer acquires a services business for $20 million at closing plus an earnout of up to $5 million tied to EBITDA over the two years after closing. The agreement sets a Year 1 plus Year 2 cumulative EBITDA target of $6 million, with the earnout paying linearly: the full $5 million if cumulative EBITDA reaches $6 million, nothing below $4 million, and a pro-rata amount in between.

Year 1: the business produces EBITDA of $2.6 million, on track.

Year 2: the business produces EBITDA of $2.9 million. Cumulative two-year EBITDA is $5.5 million.

Earnout calculation: the payout scales linearly between $4 million (zero) and $6 million (full $5 million). Cumulative EBITDA of $5.5 million is 75 percent of the way through that $2 million band ($5.5M minus $4M, divided by $2M). The seller earns 75 percent of $5 million, or $3.75 million.

Accounting wrinkle: at the acquisition date the buyer estimated the fair value of the earnout liability at $3.0 million and recorded it as part of the consideration. As performance came in ahead of that estimate, the buyer remeasured the liability upward to its expected settlement value. The increase from $3.0 million to $3.75 million, $750,000, was recognized as a charge in the buyer’s earnings over the remeasurement periods. The business performed well, yet the earnout remeasurement produced an expense, which surprises buyers seeing it for the first time.

Why the linear band matters: note how the structure shapes the outcome. Because the payout scales between a $4 million floor and a $6 million ceiling, the seller captures partial credit for partial achievement rather than losing everything by missing the top target. Had the earnout been all-or-nothing at $6 million, the seller would have collected zero on cumulative EBITDA of $5.5 million, a punishing result for a near miss. The choice between a cliff and a sliding scale is one of the most consequential decisions in earnout design, and it is why sellers fight for linear or tiered payout curves while buyers often prefer harder thresholds.

What a dispute would look like: suppose the buyer, during Year 2, allocated $400,000 of newly imposed corporate management fees to the acquired unit, reducing its reported EBITDA from $3.3 million to $2.9 million. Cumulative EBITDA would have been $5.9 million rather than $5.5 million, and the seller’s payout would have been roughly 95 percent of $5 million, about $4.75 million, a full $1 million higher. Whether those management fees are a legitimate cost of the business or an improper pushdown is exactly the kind of question that lands in front of an independent accountant. The dollars in dispute, $1 million here, show why the EBITDA definition is worth pages of careful drafting.

The accounting treatment under ASC 805

An earnout is contingent consideration under ASC 805, Business Combinations. At the acquisition date, the buyer recognizes the earnout at its fair value as part of the total consideration transferred for the business. That initial fair value typically comes from a probability-weighted or option-pricing model that estimates the likelihood and amount of future payments, discounted to present value.

The critical step is classification. The buyer must determine whether the contingent consideration is a liability or equity, applying the relevant guidance, including ASC 480 and ASC 815. An obligation to pay cash or a variable number of shares is generally a liability; an obligation to issue a fixed number of the buyer’s shares may be classified within equity.

Classification drives subsequent accounting. A liability-classified earnout is remeasured to fair value at each reporting date, with changes recognized in earnings. That is why an outperforming target can generate an expense: as the probability of a large payout rises, the liability grows, and the increase hits the income statement. An equity-classified earnout is not remeasured; it stays in equity and is settled by issuing the shares.

Two boundaries matter. First, measurement-period adjustments (within up to one year of the acquisition date) that reflect new information about facts existing at the acquisition date adjust goodwill rather than earnings; later changes flow through earnings. Second, arrangements that are really compensation for post-closing services, for example a payment forfeited if a selling employee leaves, are accounted for as compensation expense, not as part of the purchase consideration. The EBITDA definition itself ties back to the same normalization discipline behind EBITDA adjustments and the broader ASC 805 business combination framework.

Common disputes and pitfalls

• EBITDA definition fights. The single biggest source of earnout disputes. Buyers push corporate overhead, integration costs, and management fees into the earnout unit’s expenses, lowering EBITDA and the payout. The cure is an exhaustive, agreed EBITDA definition with named exclusions.
• Buyer operating decisions. The buyer controls the business and can make choices, reducing sales staff, shifting customers to affiliates, changing pricing, that depress the metric. Operating covenants and an efforts standard are the seller’s defense (a recurring theme in earnout litigation such as the Delaware line of cases on implied covenants).
• The implied covenant of good faith. Courts, especially in Delaware, have wrestled with whether a buyer must affirmatively try to maximize the earnout. The default is often only that the buyer not act in bad faith, so sellers who want more must negotiate explicit efforts covenants.
• Integration that destroys the metric. Merging the target into the buyer’s operations can make standalone EBITDA or revenue impossible to measure. The agreement should require the business to be run separately enough to compute the metric, or define a clear allocation method.
• Catch-up and acceleration ambiguity. Whether a strong later year can recover a weak earlier year, and whether a sale or change of control during the earnout accelerates payment, must be spelled out.
• Compensation versus consideration. Earnouts conditioned on continued employment can be recharacterized as compensation expense for accounting and as ordinary income for tax, changing both the buyer’s earnings and the seller’s tax outcome.
• Fair value remeasurement surprises. Buyers underestimate the earnings volatility from remeasuring a liability-classified earnout each period, particularly when the business outperforms.

Frequently asked questions

What is an earnout in an M&A deal?

It is a contingent portion of the purchase price paid after closing only if the acquired business meets agreed performance targets, such as a revenue or EBITDA threshold, over a defined measurement period.

How common are earnouts?

They appear in a significant minority of private-target deals and a larger share of certain segments, including life sciences and many private-equity transactions, where valuation gaps or future milestones make contingent pricing useful, per ABA Deal Points and SRS Acquiom data.

How are earnouts accounted for under ASC 805?

An earnout is contingent consideration measured at fair value on the acquisition date and classified as a liability or equity. Liability-classified earnouts are remeasured to fair value each reporting period, with changes recognized in earnings; equity-classified earnouts are not remeasured.

Why can an earnout create an accounting expense when the business does well?

Because a liability-classified earnout is remeasured each period. When performance improves and a larger payout becomes likely, the liability grows, and that increase is charged to earnings, even though the operating performance is positive.

Which metric is best for an earnout, revenue or EBITDA?

Revenue is simpler and harder to manipulate but ignores profitability; EBITDA reflects profit but invites disputes over expense allocations. The right choice depends on how cleanly the target can be measured as a standalone unit after closing.

What are the most common earnout disputes?

Disagreements over how the metric is defined, especially EBITDA, and over buyer operating decisions after closing that reduce the metric. Both are addressed through precise definitions and operating covenants.

Can an earnout be treated as compensation?

Yes. If the earnout is conditioned on a selling employee’s continued service, it can be recharacterized as compensation expense for accounting and ordinary income for tax, rather than as purchase consideration.

How long do earnout periods usually last?

Most run one to three years. Longer periods give the business more time to hit targets but extend the parties’ entanglement and the buyer’s remeasurement obligation.