What is an earn-out? Definition, formula and example
This post is for buyers and sellers who are apart on price and have been told "an earn-out could close the gap." By the end you will know what an earn-out is, how the payout rule is written, what a three-year example looks like in dollars, and why these clauses cause more disputes than any other part of a deal.
The definition in plain words
An earn-out is deferred price with a condition attached. The buyer pays a fixed amount at closing. If the business then performs as the seller promised, the buyer pays more; if it does not, the buyer pays less or nothing. Investopedia's earn-out explainer describes it as a contractual provision that ties future payments to the business meeting stated goals.
It is most common when the seller's asking price rests on growth that has not happened yet: a new contract, a second location, a product that launched last quarter. The buyer says "I will pay for it when I see it."
The formula: the payout rule
An earn-out needs four parts written down: the measure, the threshold, the rate, and the cap.
Earn-out payment = rate × (measure − threshold), each period, up to the cap
The measure is usually revenue or gross profit, because they are hard to argue about. EBITDA is used too, but the buyer controls costs after closing, which opens the door to disputes. The threshold is the level the business must beat. The rate is the share of the excess the seller receives. The cap is the most the seller can ever get.
Illustrative example: a $3,000,000 agency
A buyer pays $3,000,000 at closing for an agency with $2,000,000 of revenue. The seller wanted $3,300,000. They agree an earn-out of 20% of revenue above $2,000,000 in each of the next three years, capped at $300,000 in total.
| Year | Revenue | Excess over $2,000,000 | 20% of excess | Paid (after cap) | Running total |
|---|---|---|---|---|---|
| 1 | $2,400,000 | $400,000 | $80,000 | $80,000 | $80,000 |
| 2 | $2,900,000 | $900,000 | $180,000 | $180,000 | $260,000 |
| 3 | $3,100,000 | $1,100,000 | $220,000 | $40,000 | $300,000 |
In year three the formula gives $220,000, but only $40,000 remains under the $300,000 cap, so that is what is paid. The seller receives the full $3,300,000 they asked for, and the buyer paid the last $300,000 only after the growth showed up. If revenue had stayed at $2,000,000, the earn-out would have paid nothing.
Where it shows up in a deal
The earn-out is agreed in the letter of intent and written in detail in the purchase agreement. It sits alongside the cash at close and any seller note. Sellers should read our guide on how to sell a business before agreeing to one: an earn-out moves risk from the buyer to the seller, so it should buy a higher total price.
Buyers should note that lenders treat earn-outs with care. In an SBA 7(a) deal the lender will want to see how the earn-out is paid and whether it affects the loan's coverage; the SBA's 7(a) loan page has the program rules, and the lender applies them. Our guide on how to buy a business covers where structure like this fits after due diligence.
Common mistakes
- Measuring on EBITDA without rules on costs. The buyer adds a manager's salary, EBITDA falls, the earn-out pays nothing, and the seller sues. Use revenue or gross profit, or write down what costs are allowed.
- No cap. A business that doubles can produce an earn-out larger than the price. Buyers should always cap it.
- No floor on effort. Sellers should ask for a clause that the buyer will run the business in the ordinary course and not starve it of staff or marketing.
- Too long a period. One to three years is normal. After that the business is the buyer's work, not the seller's.
- No dispute process. Name the accountant who settles the numbers if the two sides disagree.
- Vague definitions. "Revenue" should say which revenue: recognised when, from which customers, including or excluding a new line the buyer brings in.
Questions people ask
Is an earn-out part of the purchase price?
Yes. It is deferred and conditional price. For tax and accounting it is usually treated as purchase price paid later, though the exact treatment depends on how it is written, so ask an accountant.
How long does an earn-out usually last?
One to three years. Shorter periods are easier to measure and less likely to end in a dispute; longer ones reward growth the buyer, not the seller, has created.
What is a typical earn-out size?
Commonly 10% to 30% of the total price in small and mid-sized deals, with the rest paid at closing or by a seller note. A larger share means the seller is carrying more of the risk.
Can an earn-out be based on profit instead of revenue?
Yes, and many are. Profit-based earn-outs need clear rules on which costs count, because the buyer controls spending after closing. Revenue or gross profit is simpler and causes fewer arguments.
Sources
- investopedia.com — https://www.investopedia.com/terms/e/earnout.asp
- sba.gov — https://www.sba.gov/funding-programs/loans/7a-loans
Pober, M. (2026). What is an earn-out? Definition, formula and example. Acquisitions.com. https://acquisitions.com/blog/what-is-an-earn-out/
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