Earnouts when buying a small business: how they work and when you can't use one
Short answer
An earnout is part of the purchase price paid later, only if the business hits agreed targets such as revenue or gross profit. It bridges a gap when the seller believes in future growth and the buyer doesn't want to pay for it upfront.
If you're financing with an SBA 7(a) loan, you can't use one: SOP 50 10 8.1 prohibits seller earnouts in change-of-ownership loans. Buyer rebates based on performance are allowed, and seller notes are the usual substitute.
Earnouts sound like the perfect compromise. The seller says the business will grow 20% next year; you say prove it; you agree to pay extra if it does. In practice, they're one of the most argued-over terms in small business deals, and if you're using SBA money, they're off the table entirely.
How an earnout works
Part of the price is contingent. For example: $900,000 at closing, plus up to $150,000 paid over two years if gross profit exceeds a target. The agreement defines the metric, the measurement periods, the targets, how payments are calculated (all-or-nothing or sliding), when they're paid, and how disputes are resolved.
Illustrative example, not a real deal
The earnout pays $75,000 a year for two years if gross profit is at least $700,000, scaling down to zero at $600,000. Year one gross profit is $660,000: 60% of the way from $600,000 to $700,000, so the seller earns 60% × $75,000 = $45,000.
Why they cause fights
- You control the results. Hire a manager, raise prices, open a second location: each changes the metric the seller is paid on.
- Accounting choices matter. Net profit after "corporate overhead" you add is easy to argue about. Revenue is harder to argue about but can be bought with discounts.
- Integration blurs it. If you merge the business into another one you own, measuring its standalone results gets murky.
If you do use one outside SBA financing: pick revenue or gross profit, define every term with examples, require the business to keep separate books for the earnout period, set a sliding scale rather than a cliff, and agree what happens if you sell or merge the business.
The SBA rule
Under SOP 50 10 8.1 (effective October 1, 2026), Appendix 15 says seller earnouts are prohibited in 7(a) change-of-ownership transactions. Buyer rebates based on performance are allowed because they benefit the borrower, and if you receive one, it must be applied to pay down the principal of the 7(a) loan that financed the purchase.
What to use instead in an SBA deal
| Tool | How it bridges a gap | Watch out for |
|---|---|---|
| Lower price | Pay for verified earnings, not projections | Seller may walk |
| Seller note on full standby | Seller is paid later and only after the SBA loan; counts toward equity (within limits) | Sellers dislike waiting up to 10 years |
| Seller note with payments | Seller shares risk through deferred payments | Counts as debt; must fit within the valuation cap and coverage test |
| Buyer rebate | Full price at closing, seller refunds part if targets missed | Rebate proceeds must pay down the 7(a) loan |
The best bridge is usually evidence. If the seller's optimism is based on a big new contract or a recent price increase, verify it. If it's real, it shows up in recent months and you can price it. If it isn't, you've avoided paying for it. Start with verifying SDE and read seller financing for note terms.
Worked example: a buyer rebate instead of an earnout
Illustrative example, not a recommended structure; confirm with your lender
A seller insists a new contract will add $120,000 of gross profit next year and wants a price of $1,200,000. You'd pay $1,050,000 on the current numbers. In a non-SBA deal, you might pay $1,050,000 at closing plus an earnout of up to $150,000 if the contract delivers. In an SBA 7(a) deal, seller earnouts aren't allowed. One alternative the SOP permits is a buyer rebate: you pay $1,200,000 at closing, and if the contract doesn't produce the agreed gross profit, the seller refunds part of the price, with the rebate used to pay down the SBA loan. The difference matters: with a rebate, the seller holds the risk of having to pay back; with an earnout, you hold the risk of having paid too little and owing more. A rebate also means you finance the full price up front, so the earnings have to support that debt from day one. Ask your lender how they document rebates before you agree to one.
Not every post-closing payment is an earnout
A working capital true-up, where the price adjusts after closing based on the actual working capital delivered versus the agreed target, is a normal feature of many purchase agreements. SBA's September 2026 technical update clarified that these adjustments are not treated as seller rebates and may be treated as cash to the borrower. Inventory counts at closing and prorations of rent and utilities are similar mechanical adjustments. None of these are earnouts, but write them precisely so they don't become disputes. See working capital peg.
If you use an earnout outside SBA financing: a drafting checklist
- The metric (revenue or gross profit), defined line by line with an example calculation.
- The accounting rules: same methods as the historical financials, no new overhead allocations.
- The period and measurement dates.
- A sliding scale rather than an all-or-nothing target.
- Operating covenants: what the buyer can and can't change during the earnout.
- Reporting: what the seller receives and when.
- Disputes: an independent accountant to resolve calculation disagreements.
- What happens if the business is sold or merged during the earnout.
Your duties to the seller while the earnout runs
A seller who accepts an earnout will ask for protections over how you run the business, because your decisions affect what they are paid. Expect requests like these, and decide in advance what you can live with:
- Keeping separate books for the acquired business, so the earnout measure can be calculated.
- Monthly or quarterly reports to the seller on the earnout measure.
- Limits on moving customers, staff or products to another business you own.
- Limits on charging new overhead or management fees to the acquired business.
- Acceleration of the earnout if you sell the business or breach these terms.
Each one constrains how you operate. A buyer planning to integrate the business quickly should prefer a measure the integration won't distort, such as gross revenue from named customers, or avoid an earnout altogether.
Earnouts and taxes
An earnout changes when and how the seller is taxed, and how you account for the purchase price. Payments may be treated as part of the price, as interest in part, or in some cases as compensation if they are tied to the seller continuing to work in the business. Ask both accountants how the earnout will be treated before you agree it, because the seller may want to restructure once they see the tax result. This is general information, not tax advice.
Keep every earnout report and the data behind it until the period ends and the last payment is settled. Disputes usually turn on the records.
Frequently asked questions
Are earnouts allowed with SBA loans?
No. Under SOP 50 10 8.1 Appendix 15, seller earnouts are prohibited in 7(a) change-of-ownership transactions. Buyer rebates based on business performance are allowed, and any rebate received must be used to pay down the 7(a) loan.
What's a buyer rebate?
The reverse of an earnout: the full price is paid at closing, and the seller pays some back if the business underperforms agreed targets. Because the buyer benefits, the SBA allows it, with proceeds applied to the loan principal.
What metric should an earnout use?
Revenue or gross profit is usually easier to measure and harder to manipulate than net profit, which the buyer controls through spending decisions. Whatever the metric, define it precisely with examples.
Why do earnouts lead to disputes?
After closing the buyer runs the business, and every spending, pricing or staffing decision affects whether the seller gets paid. Sellers often feel the buyer steered results below the target.
Can I use an earnout if I'm not using an SBA loan?
Yes, earnouts are common in deals financed with cash, conventional loans or investor money. Define the metric, the period, the accounting rules, the payment schedule, who controls operating decisions, and how disputes are resolved. Revenue or gross profit metrics cause fewer disputes than net profit.
How are earnouts taxed?
It depends on the structure, and both buyer and seller should get tax advice. In asset purchases, contingent payments can change the price allocation reported on IRS Form 8594 when they're paid. Your CPA will explain the treatment for your deal.
Sources
- SBA SOP 50 10 8.1, Appendix 15: seller earnouts prohibited; buyer rebates allowed
- 13 CFR 120.223 (referenced in SOP regarding rebate payments), eCFR Part 120
- SBA Information Notice 5000-882227 (working capital true-ups are not seller rebates)
- IRS: About Form 8594 (contingent consideration and later allocation changes)
Related guides
General information, not legal, tax, financial or investment advice. Rules and lender practices change; check the linked sources and talk to your attorney, CPA and lender about your deal. Examples with named numbers are illustrations, not real businesses. OKtoBuy's Deal Check does not value businesses or give price opinions.