A revenue-based earnout pays sellers additional consideration if the acquired business achieves specified revenue targets in defined post-closing periods. A milestone-based earnout pays upon achievement of specific events — regulatory approval, product launch, customer contract execution — rather than financial metrics. Revenue-based earnouts are more common in recurring-revenue businesses; milestone-based earnouts suit development-stage companies where financial metrics are premature.
Revenue-based earnouts tie additional payments to the target's achievement of specified revenue thresholds over defined measurement periods, typically 12 to 36 months post-closing. Milestone-based earnouts tie payments to the achievement of specific operational, product development, or regulatory milestones. Hybrid structures combine both approaches. In Gurpreet Bal's experience at Foley and Lardner, revenue-based earnouts are more common in acquisitions of companies with established revenue streams, while milestone-based earnouts are more appropriate for early-stage companies or acquihires where the value proposition is tied to the completion of a specific product or technology integration. The choice of metric significantly affects the complexity of the earnout provision and the likelihood of post-closing disputes.
Sellers should negotiate covenants requiring the buyer to operate the acquired business in a manner consistent with achieving the earnout, allocate adequate resources, not take actions intended to reduce earnout payments, and maintain the separate identity of the acquired business for the earnout period. Without these protections, buyers can integrate the acquisition in ways that make earnout metrics impossible to achieve or measure.
The most contentious aspect of earnout negotiation is the buyer's obligation to operate the acquired business in a manner that gives the earnout targets a reasonable opportunity to be achieved. Sellers want strong covenants requiring the buyer to maintain the business as a standalone unit, continue investment, retain key employees, and not take actions that would reduce revenue or impede milestone achievement. Buyers resist these covenants because they limit integration flexibility. The spectrum of covenant language ranges from an obligation to operate in good faith consistent with past practice to a more specific commitment to maintain headcount, marketing spend, and product development resources at pre-closing levels. Gurpreet S. Bal advises sellers that the strength of the operational covenant is often more important than the headline earnout amount because a buyer with unrestricted operational control can structure-away the earnout through integration decisions that redirect revenue, reassign personnel, or deprioritize the acquired product.
The most common earnout disputes involve disagreement over accounting methodology — whether specific revenue or expenses are properly included in the earnout calculation — integration decisions that affect earnout metrics, and intentional buyer conduct designed to avoid paying the earnout. Courts in Delaware and California have generally applied the duty of good faith to buyer conduct during earnout periods, but litigation is expensive and uncertain.
Earnout disputes are among the most common forms of post-closing M&A litigation. The most frequent disputes involve disagreements over whether the buyer's post-closing operational decisions impeded the seller's ability to achieve the earnout targets, disagreements over the accounting methodology used to calculate achievement, disputes over whether specific revenue items or milestones qualify under the earnout definition, and allegations that the buyer deliberately structured operations to avoid triggering earnout payments. Gurpreet Bal drafts earnout provisions with explicit dispute resolution mechanisms, typically involving an initial negotiation period, escalation to an independent accounting firm for financial metric disputes, and arbitration or litigation as a final resolution for covenant-related disputes.
From the seller's perspective, earnout payments received after closing are typically treated as additional purchase price and may qualify for installment sale treatment or capital gains treatment depending on how they are structured. From the buyer's perspective, earnout obligations are recorded as contingent consideration at fair value on the acquisition date and remeasured each period. Changes in the fair value of earnout liabilities flow through the buyer's income statement, creating accounting volatility.
Earnout payments are generally treated as additional purchase price consideration for tax purposes, potentially qualifying for capital gains treatment if the seller's stock qualified for capital gains on the initial closing consideration. However, earnout payments to employees who remain with the buyer post-closing may be recharacterized as compensation subject to ordinary income tax rates and employment tax withholding, particularly if the earnout is contingent on continued employment. The accounting treatment under ASC 805 requires the buyer to estimate the fair value of contingent consideration at closing and record subsequent changes in fair value through the income statement. Gurpreet S. Bal advises on structuring earnout provisions to support the intended tax characterization as additional purchase price rather than compensation.
Gurpreet S. Bal is a Partner at Foley and Lardner LLP in Silicon Valley, where he advises startups, founders, and investors on mergers and acquisitions, venture financings, IPOs, and cross-border transactions. He has advised on more than 50 M&A transactions with aggregate deal value exceeding $60 billion across AI, semiconductors, fintech, and emerging technology.