Financial Reporting
Earnouts Under ASC 805: What "Up To $20 Million" Is Actually Worth on Day One
An earnout isn't worth its maximum. How ASC 805 values contingent consideration on day one, when it's really compensation, and why it moves every quarter.
By 409.AI Team - 2026-08-19
# Earnouts Under ASC 805: What "Up To $20 Million" Is Actually Worth on Day One
Your purchase agreement says $40 million at close and up to $20 million more if the business hits its numbers. You tell your team the company sold for $60 million. Your buyer's auditor books the deal at $51.2 million. Nobody is lying. Only one of those figures ends up in the financial statements, though, and the space between them is where most earnout arguments start.
Contingent consideration, the accounting name for an earnout, has to be measured at fair value on the acquisition date and folded into the purchase price. That's a valuation exercise, not a negotiation, and it decides a lot: how much goodwill lands on the buyer's balance sheet, how much of your payout runs through compensation expense instead of purchase price, and how violently the buyer's earnings swing for the next two years.
Earnouts sit in roughly a quarter of private deals
SRS Acquiom's [2026 M&A Deal Terms Study](https://www.srsacquiom.com/our-insights/deal-terms-study/), built from more than 2,300 private-target acquisitions that closed between 2020 and 2025, found earnouts in 24% of 2025 deals, up from 22% in 2024 and above the roughly 20% long-run average. Median earnout potential came in at 34% of the closing payment, and most structures ran one to two years.
That's a market where buyers and sellers still disagree about price and paper over the gap with a promise. For a founder, the promise is worth studying before you sign it, because the accounting treatment is decided at signing, not when the check clears.
First question: is it purchase price, or is it payroll?
Before anyone models a payoff curve, someone has to decide whether the earnout is consideration for the business or compensation for showing up to work. ASC 805-10-55-24 and 55-25 set out the test, and the first indicator is close to determinative: if the payment is automatically forfeited when employment ends, it is compensation for post-combination services, not part of the purchase price.
Two structures, same dollars, very different outcomes.
Structure A. The buyer pays $6 million to the founder-CEO if she is still employed at the end of year two and the business clears $30 million in revenue. Forfeited on departure. That's compensation expense, recognized by the buyer over the two-year service period, and it never touches purchase price or goodwill.
Structure B. The buyer pays $6 million pro rata to all selling shareholders if the business clears $30 million in revenue, whether or not anyone stays. That's contingent consideration, measured at fair value on day one and added to what the buyer paid for the company.
The other indicators in that guidance matter when the answer is less obvious: whether the payment rate to selling shareholders who stay is out of line with those who leave, whether the earnout formula looks like a profit-sharing plan, and how the arrangement was described during negotiations. Buyers generally prefer the compensation characterization for the tax deduction. Sellers generally do not, since compensation is ordinary income subject to employment taxes while sale proceeds are generally capital gain. Get your own tax counsel on that before the term sheet hardens, because the label follows the substance of the agreement, not the box you check afterward.
Day one value is not the ceiling, and it is not the base case either
ASC 805-30-25-5 requires the acquirer to recognize contingent consideration at acquisition-date fair value as part of consideration transferred. Under ASC 820 it is a Level 3 measurement, the same category funds wrestle with when they mark illiquid positions. If you want the wider picture on Level 3 inputs and how much judgment they carry, we walked through it in [ASC 820 and the Level 3 Problem](https://409.ai/articles/asc-820-level-3-fair-value-fund-portfolio-valuation).
Work through the numbers on a tiered structure. The earnout pays nothing below $30 million of year-two revenue, $10 million at $30 million, and $20 million at $40 million, with straight-line interpolation in between and a hard cap. Management's forecast is $34 million.
The tempting shortcut is to interpolate the forecast: $34 million sits 40% of the way up the band, so call it $14 million. That answer is wrong in a specific way. It ignores the shape of the distribution around the forecast. Revenue could land at $27 million, in which case the earnout pays zero, and that downside is not offset by the upside, because the cap chops off everything above $40 million. Run the full distribution and the probability-weighted payment might be $12.6 million, which then has to be discounted back from the payment date. Call the fair value $11.2 million.
So the accounting purchase price is $51.2 million, not $60 million and not $54 million. That $51.2 million is what gets allocated across identified intangibles and goodwill in the [purchase price allocation](https://409.ai/articles/asc-805-purchase-price-allocation-startup-acquisition), which means an earnout that is mismeasured on day one distorts every number that follows it.
Two accepted methods, and using the wrong one shows
Practice has settled on two techniques, described in the AICPA's practice aid on valuing contingent consideration and in the Appraisal Foundation's VFR Valuation Advisory on the same subject.
The scenario-based method builds discrete outcomes, weights them by probability, and discounts the result. It fits event-driven triggers whose risk is idiosyncratic: regulatory approval, a court ruling, landing one named contract. Those outcomes are not correlated with the market, so a probability-weighted expectation discounted for time value and credit risk gets you there.
The option pricing method, usually run as a Monte Carlo simulation, fits metric-based earnouts on revenue, EBITDA, or bookings. The payoff has thresholds, tiers, and caps, which makes it nonlinear, exactly the property that breaks single-point expectations. It also replaces the argument about the right discount rate with an argument about volatility, which is at least an assumption you can benchmark against comparable public companies. If Monte Carlo and volatility inputs sound familiar, it's the same machinery behind the [option pricing model used in 409A allocations](https://409.ai/articles/409a-allocation-methods-opm-pwerm-backsolve), pointed at a different payoff.
Pick by the nature of the risk, not by convenience. A $20 million EBITDA-triggered earnout valued with three hand-picked scenarios is the kind of thing an auditor circles.
Discount rates need two adjustments, not one
Here's where a lot of internal models go sideways. Valuing an earnout takes two distinct steps: adjusting for the risk in the underlying metric, and discounting the resulting payment from the payment date back to today at a rate that reflects the payer's credit risk and the time value of money.
Teams routinely collapse those into one WACC and call it finished. WACC prices the risk of the whole business, not the risk of a specific revenue threshold, and it says nothing about whether the acquirer will still be solvent in 24 months. In a risk-neutral option framework the metric risk is handled inside the simulation, and only the credit-adjusted rate is applied to the payoff. Double-counting risk understates the liability, which inflates goodwill, which creates an impairment problem later.
Then it moves every quarter, and the direction feels backward
ASC 805-30-25-6 requires the buyer to classify the earnout as a liability or as equity, applying ASC 480-10 and ASC 815-40. Most cash-settled earnouts are liabilities. A fixed number of acquirer shares, settled with no cash alternative, can qualify for equity classification.
The classification decides the next two years. Under ASC 805-30-35-1, a liability-classified earnout gets remeasured to fair value every reporting period with changes running through earnings. An equity-classified one is never remeasured, and settlement stays inside equity.
Follow the liability version through. The acquired business beats plan, revenue now tracks toward $38 million, and the earnout liability moves from $11.2 million to $18 million. The buyer records a $6.8 million charge in a quarter when the acquisition is performing beautifully. Miss instead, and the liability releases into income, handing the buyer a gain in a quarter when the deal is going badly. Every CFO who has had to explain that on an earnings call remembers it.
That same bad news usually travels further. A business missing its earnout targets by a wide margin is a business whose acquisition-date forecasts were optimistic, which is precisely the trigger to test goodwill for [impairment under ASC 350](https://409.ai/articles/goodwill-impairment-private-company-asc-350). The earnout release and the write-down often show up in the same quarter.
The measurement period is not a second chance
ASC 805-10-25-13 through 25-19 give the acquirer up to one year to adjust provisional amounts, but only for information about facts and circumstances that existed at the acquisition date. Learning in month eight that a major customer churned in month seven is not a measurement-period adjustment. Discovering in month eight that the customer had already given notice before closing is. The distinction decides whether the change lands in goodwill or in earnings, and auditors treat it as a bright line.
What sellers should pin down before signing
Define the metric with painful precision. Whose revenue recognition policy applies, how shared costs get allocated after integration, what happens when the acquirer repositions your pricing or folds your sales team into theirs. An earnout on EBITDA that the buyer controls isn't much of an earnout.
Know who actually receives the money. Earnout proceeds run through the same waterfall as closing consideration, so preferred stock gets paid before common does. If the closing payment barely cleared the preference stack, the earnout may be the only piece common shareholders ever see, or it may disappear into the same preference. Our walkthrough of [liquidation preferences and the exit waterfall](https://409.ai/articles/liquidation-preferences-waterfall-common-stock-exit) covers how that math plays out.
On the tax side, contingent payment sales have their own rules. The IRS covers them in [Publication 537, Installment Sales](https://www.irs.gov/publications/p537), including how the installment method applies when the total price is not fixed and how interest gets imputed on deferred payments. This is advisor territory, and the structuring decisions made in the purchase agreement drive the answer.
Finally, if part of the earnout is settled in the acquirer's stock and the acquirer is private, someone has to value those shares, both for the fair value measurement and for anything the acquirer grants your team afterward. That circles back to the buyer's own [409A valuation and its ASC 718 expense](https://409.ai/articles/asc-718-stock-based-compensation-startup-guide).
The takeaway
An earnout is two agreements wearing one name: a payoff formula that the lawyers negotiate, and a fair value measurement that the accountants and valuation specialists produce. Founders spend their energy on the first and inherit the consequences of the second. Ask the buyer's team how they intend to measure it, whether the arrangement is being treated as consideration or as compensation, and what happens to the earnout definition after integration. Those three answers move more money than another turn on the maximum.
If you are on the buyer's side of one of these, the day-one measurement isn't optional, and it doesn't survive a spreadsheet built the night before the audit. Our [purchase price allocation service](https://409.ai/products/purchase-price-allocation) covers contingent consideration alongside the intangible asset work, with the model documentation your auditor is going to ask for.