Guides
Structuring an earnout when selling a business: stage order, the 12 to 24 month window, Section 1060
Earnout structure when selling a business: the stage order, the 12 to 24 month window, metric controls, and the Section 1060 tax character of each payment.
What to take away
- An earnout pays only after a measurement period closes, so the calendar decides more than the headline percentage.
- Earnout windows in small US acquisitions commonly run 12 to 24 months. Treat that as an illustrative range.
- Section 1060 governs how both sides allocate purchase price, and IRS Form 8594 is the form that reports it.
- A contingent payment is allocated when it becomes fixed, and a supplemental Form 8594 follows in the year it is settled.
- A seller note and an earnout carry different risks, and one clause rarely holds both well.
The short version
An earnout splits the consideration into a payment at closing and one or more payments later. The later payments depend on what the business does after the seller hands over the keys. The buyer takes certainty for the near term and insurance against what follows. The seller takes a second chance at full value.
A seller note is debt, and repayment does not depend on performance. The IRS installment sale rules in Publication 537 follow the note's terms, which is why a note and a contingent earnout are reported separately on the seller's return. Mixing the two in one clause invites a fight at closing.
Stage by stage
| Stage | Typical duration | What must be closed first |
|---|---|---|
| Define the gap the earnout bridges | 3 to 5 days | Normalized financials both sides accept |
| Choose the metric and measurement base | 1 to 2 weeks | Letter of intent naming the metric |
| Draft the earnout clause | 2 to 3 weeks | Financing commitment that permits contingent payments |
| Agree controls and reporting rights | 1 to 2 weeks | Draft clause with both sets of counsel |
| Run the measurement period | 12 to 24 months | Funded closing and transferred books |
| Settle each measurement date | 30 to 60 days after period end | Statements in the agreed format |
The IRS explains how a buyer allocates purchase price across asset classes in its fact sheet on purchase price allocations, and Section 1060 puts that framework into the code. Both sides report the allocation on IRS Form 8594, Asset Acquisition Statement, filed with the return for the year of the sale; when a contingent amount is later settled, each side files a supplemental Form 8594 for that year. The allocation follows the residual method through seven asset classes: Class I cash, Class II securities and actively traded property, Class III accounts receivable, Class IV inventory, Class V all other assets such as equipment, land and vehicles, Class VI Section 197 intangibles other than goodwill, and Class VII goodwill and going concern value.
Earnout Stage Sequence
- Define gap3 to 5 days
- Choose metric1 to 2 weeks
- Draft clause2 to 3 weeks
- Agree controls1 to 2 weeks
- Measurement period12 to 24 months
- Settle dates30 to 60 days after
A contingent payment is allocated when it becomes fixed. Reg. §15A.453-1 is the regulation that picks up a sale the parties cannot price at closing, and it sets three routes: the open transaction, a stated maximum selling price, and a fixed period. Deferred payments carry interest as well; Sections 483 and 1274 impute it when the agreement does not state a market rate. A seller who reports gain as the payments arrive uses the installment method under Section 453. Where an earnout depends on the seller staying on and working, part of it can be treated as compensation rather than sale proceeds.
What has to exist before what
Pre-Closing Earnout Prerequisites
- Financing commitment confirms contingent consideration
- Metric recomputed on last eight quarters
- Accounting standard chosen for measurement
- Monthly statements in fixed format
- Dispute mechanism with 30-day window
- Financing commitment. The buyer's lender has to confirm in writing that contingent consideration fits inside the credit agreement. Nothing else moves until that letter arrives, because a buyer who cannot fund the deferred payment cannot agree to it. Terms worth checking are set out in this guide to acquisition financing.
- Metric definition. Recompute the metric on the seller's last eight quarters before drafting. If the seller cannot reproduce the number from their own books, the buyer's will not match either.
- Accounting standard. Decide whether measurement follows the company's normal presentation or a schedule built for the earnout.
- Reporting rights. Ask for monthly statements in a fixed format for the whole measurement period.
- Dispute mechanism. Name an accountant and set a 30-day objection window.
Where it stalls
The failure that stays hidden for months is an earnout tied to a metric the seller no longer controls. The seller stays on, keeps the relationships, and watches the measure fall anyway. The cause is nearly always timing: the clause was drafted before the buyer's integration plan was disclosed.
How Earnouts Stall
- Clause drafted before integration plan disclosed
- Buyer applies corporate overhead allocations
- Gross margin falls after closing
- Seller no longer controls the metric
- No breach, but definition points elsewhere
Overhead loading is the usual mechanism. Gross margin, as the buyer calculates it, arrives after corporate allocations that did not exist before closing. Nothing in the agreement was breached. The definition simply pointed somewhere new.
Test any metric against the seller's own chart of accounts before signing. The requirements for valuation methods page explains what each family needs before its output counts as evidence, which is a fair standard for a number that will be disputed later.
Example: a 14-month earnout on a services company
The example below shows the shape of the clause, not a finished set of numbers; the purchase price, the split between closing cash and the contingent payment, the revenue floor and any cap are negotiated when the clause is drafted. A commercial services company with a concentrated account list sells with an earnout measured on two things: renewal of the top accounts and a floor on service revenue. The window runs 14 months, split into two measurement periods. The seller stays nine months under a transition agreement and keeps a named list of accounts.
14-Month Earnout Example
- Month 0Closing and transfer
- Months 1-9Seller stays under transition agreement
- Month 14End of measurement window
- 30 days afterObjection window closes
The clause names an accountant to settle disputes and sets a 30-day objection window. The renewal metric is one the seller can still influence after closing, which is the point. The revenue floor stops the buyer from running the service line down.
What to do while waiting
- File the management accounts in the format the agreement names, and send them the same day each month.
- Keep one copy of every renewal, price change and account note, held by both sides.
- Diarize each measurement date so the calculation and any objection leave inside the window.
Record keeping shapes the settlement. Preparation work done before the sale is what makes that possible, and the seller preparation comparison brief covers what each kind of engagement hands over.
Common questions
How long should an earnout run?
Twelve to 24 months covers a full seasonal cycle in most small businesses. Shorter periods reward timing over effort. Longer ones push the seller's risk past the point where they can influence the number.
Can a deal carry both a seller note and an earnout?
Yes, and buyers often prefer it. The note is fixed and the earnout is contingent. Decide the split before drafting, because it decides who carries credit risk and who carries operating risk.
What if the buyer sells the business during the earnout period?
The clause has to say whether the obligation travels with the buyer or accelerates on a change of control. Silence sends the seller after a stranger. The businesses for sale requirements checklist covers the disclosures that usually sit beside it.
