Key insights
- Proper structuring and tax treatment of earnouts is crucial, especially in service industries where human capital drives results.
- Revenue earnouts are straightforward and encourage growth but may lead to low-margin client acceptance and increased costs that reduce profitability.
- Gross margin earnouts promote cost discipline but can discourage strategic investments, while adjusted EBITDA aligns with profitability but is complex and can be manipulated.
- Effective earnout management requires robust post-merger integration and financial oversight. Work with your advisors for help with validation, accounting support, and operational integration.
Achieve the financial and strategic goals of your transaction.
In the world of mergers and acquisitions (M&A), contingent earnouts have become a common mechanism to bridge valuation gaps between buyers and sellers.
These arrangements allow a portion of the purchase price to be paid post-closing, contingent on the acquired business achieving specified performance targets.
While earnouts can align incentives and reduce upfront risk, their structure and tax treatment require careful consideration — especially in service-based industries. Consider how proper earnout structure can help you reach the financial and strategic goals of your transaction.
Structuring earnouts: Purchase price vs. compensation
A critical distinction in earnout design is whether the contingent payments are treated as part of the purchase price or as compensation for services. This distinction has significant tax implications:
Purchase price treatment
If the earnout is not tied to the seller’s continued employment, it’s generally treated as additional purchase consideration. This allows the seller to recognize capital gains, which are typically taxed at favorable rates (15% or 20%, plus potential 3.8% net investment income tax).
Compensation treatment
If the earnout is contingent on the seller remaining employed post-acquisition, the IRS may recharacterize it as compensation. This would subject the payment to ordinary income tax rates and employment taxes, and the buyer may be required to withhold payroll taxes.
To avoid recharacterization, it’s essential the earnout agreement clearly separates employment terms from the contingent payment provisions and avoids language conditioning payment on continued service.
Common metrics in service industry earnouts
In service-based industries — such as consulting, engineering, marketing, and professional services — performance is often driven by human capital. This makes the selection of earnout metrics particularly nuanced. The most common metrics include:
Revenue-based earnouts
Pros:
- Simple to measure and verify
- Less susceptible to accounting manipulation
- Encourages top-line growth and client acquisition
Cons:
- Revenue growth in service industries often comes with proportional increases in payroll and subcontractor costs, which can significantly reduce profitability
- Sellers may be incentivized to accept low-margin or even loss-leading clients to boost revenue, potentially undermining long-term value
Gross margin-based earnouts
Pros:
- Provides a more balanced view of performance by accounting for direct costs
- Encourages cost discipline and operational efficiency
- Better reflects the quality of revenue, not just quantity
Cons:
- Gross margin can be negatively impacted by necessary investments in staff or delivery infrastructure, which may be essential for long-term growth
- Sellers may be incentivized to reject new clients with lower margins, even if they are strategically valuable
- Allocation of direct costs can be subjective and lead to disputes
Adjusted EBITDA-based earnouts
Pros:
- Widely used as a proxy for cash flow and profitability
- Aligns with valuation models and investor expectations
- Allows for normalization of one-time or non-operational expenses
Cons:
- Complex to calculate and often requires agreement on what constitutes “adjustments”
- Susceptible to manipulation through discretionary spending or accounting treatments
- May discourage necessary investments in growth or integration during the earnout period
Using a combination of metrics
Some acquirers use a combination of two or more metrics — such as revenue and EBITDA or gross margin and EBITDA — to balance competing incentives and provide a more holistic view of performance.
Pros:
- Reduces the risk of gaming a single metric
- Encourages balanced decision-making that supports both growth and profitability
- Provides flexibility to account for different phases of post-acquisition integration
Cons:
- Increases complexity in tracking and validating performance
- May lead to confusion or disputes if the metrics are not clearly defined or if they conflict (e.g., growing revenue may hurt EBITDA in the short term)
- Requires more robust financial systems and oversight to administer effectively
How CLA can help with post-merger integration and earnout validation
Successfully managing an earnout doesn’t end at deal close. It requires robust post-merger integration and ongoing financial oversight. CLA offers a full suite of services to support this process:
Earnout validation: We confirm performance metrics are calculated accurately and in accordance with the purchase agreement, reducing the risk of disputes.
Financial reporting support: Our teams assist with ASC 805 purchase accounting, including the fair value measurement of contingent consideration.
Operational integration: CLA works with clients to align systems, processes, and teams post-acquisition, positioning the acquired business to meet its earnout targets.
Whether you’re structuring a deal, navigating tax implications, or managing post-close obligations, CLA brings deep experience and practical guidance to help you get there.