Earnouts in Minnesota Business Sales

What is an earnout in a Minnesota business sale?

An earnout is a contract term that splits the purchase price into a portion paid at closing and a portion paid later if the business meets agreed performance targets. Minnesota has no earnout statute. Because an earnout is purely a creature of contract, Minnesota courts read the parties’ agreement, apply ordinary rules of contract construction, and enforce clear and unambiguous terms as the parties wrote them. When the language is clear and unambiguous, the court enforces the agreement as written; if the language is ambiguous, the court may consider parol (outside) evidence to determine intent, and whether the contract is ambiguous is itself a question of law the court decides. Dykes v. Sukup Mfg. Co., 781 N.W.2d 578, 582 (Minn. 2010). There is no statutory default that fills gaps in your favor.

That makes the drafting load heavier than most sellers expect. The earnout has to define the performance metric, the measurement period, the calculation method, the payment schedule, any cap or floor, and what happens if the business changes hands or changes direction during the earnout window. An earnout is not the same as a purchase price true-up clause, which corrects the closing balance sheet for working capital and similar items. The true-up looks backward at closing-date facts; the earnout looks forward at performance you no longer control.

When does an earnout make sense for a Minnesota seller?

An earnout makes sense when the buyer and seller genuinely disagree on value and the disagreement is about the future. If you believe the company will grow and the buyer is pricing in flat performance, an earnout lets you get paid for the growth if it actually arrives, instead of arguing about a forecast at the closing table. It is a price-gap bridge.

The cost is that the earnout converts a clean exit into a multi-year relationship in which the buyer controls the business and you carry the performance risk. Three questions decide whether the trade is worth it. First, how much of the total price is contingent: a 10 percent earnout is a modest bet, a 50 percent earnout means you have effectively financed half the sale. Second, how measurable the target is: a binary milestone is cleaner than a multi-input profit figure. Third, how much influence you keep: a seller who stays on as a manager can protect the metric, while a seller who walks away depends entirely on the buyer’s good faith and the contract’s covenants. If most of your price is contingent, the metric is soft, and you have no operating role, an earnout is a weak structure for you.

How is an earnout metric chosen, and which metric protects the seller?

The metric is whatever the contract names. The three common choices are a revenue target, an earnings figure such as EBITDA, and a discrete milestone like a contract renewal or a regulatory approval. Each shifts manipulation risk differently, and the choice matters more than any other single earnout term.

Revenue is the hardest metric for a buyer to depress, because revenue is a top-line number that resists accounting adjustment. Its weakness is the reverse: a buyer can hit a revenue target with unprofitable sales, so a pure revenue earnout can pay out even when the business is not actually healthier. An earnings metric like EBITDA is the most exposed to buyer conduct, because earnings depend on cost allocation, intercompany charges, management fees, and integration expenses that the buyer largely controls after closing. A milestone metric is the cleanest when the milestone is genuinely binary and outside the buyer’s discretion. Many sellers compare an earnout against contingent value rights as an alternative to an earnout, which can carry the same milestone logic in a more defined instrument. As a general rule, the more discretion the buyer has over the inputs to the metric, the more drafting protection the seller needs.

How does the implied covenant of good faith and fair dealing protect an earnout?

Minnesota courts imply a covenant of good faith and fair dealing into every contract, and that covenant is the seller’s main protection against a buyer who tries to defeat the earnout. The Minnesota Supreme Court has framed the covenant as a duty not to “unjustifiably hinder” the other party’s performance of the contract (In re Hennepin County 1986 Recycling Bond Litigation, 540 N.W.2d 494, 502 (Minn. 1995)). Two features of that doctrine bear directly on an earnout. First, a party cannot take advantage of the failure of a condition precedent when that party itself has frustrated performance of the condition. An earnout is a condition precedent to your contingent payment, so a buyer who frustrates that condition, for example by starving or winding down the acquired business, cannot escape the payment obligation. Second, you can pursue an implied-covenant claim without first establishing an express breach of contract, because such a claim assumes the parties did not spell out the covenant in the contract’s express terms. That is exactly where earnout disputes arise, over conduct the express earnout terms did not address.

Minnesota’s Uniform Commercial Code states the principle directly for transactions it governs: under Minn. Stat. § 336.1-304, “Every contract or duty within the Uniform Commercial Code imposes an obligation of good faith in its performance and enforcement.” The statutory definition gives the term real content. Under Minn. Stat. § 336.1-201(b)(20), good faith “means honesty in fact and the observance of reasonable commercial standards of fair dealing.” It has both a subjective side, honest intent, and an objective side, commercially reasonable conduct.

Here is the limit you have to understand. In Minnesota the implied covenant “does not extend to actions beyond the scope of the underlying contract,” so it cannot impose new affirmative duties, such as a duty to maximize your earnout revenue, that the parties did not bargain for. Read against the “unjustifiable hindrance” standard, the covenant generally reaches a buyer who takes deliberate action to undermine the earnout metric, such as steering revenue to an affiliate or loading unrelated costs into the earnout period to suppress earnings. It has not generally been read to require the buyer to run the business so as to maximize your payout. Delaware, whose courts decide many earnout disputes, draws the same line: its Supreme Court concluded that an earnout buyer is “free to conduct its business post-closing in any way it chose so long as it did not act with the intent to reduce or limit the earn-out payment,” so the implied covenant “did not inhibit the buyer’s conduct unless the buyer acted with the intent to deprive the seller of an earn-out payment.” Lazard Technology Partners, LLC v. Qinetiq North America Operations LLC, 114 A.3d 193 (Del. 2015). In that case the seller had tried to negotiate a range of affirmative operating obligations and the buyer rejected all of them, so the covenant supplied none of the protections the seller failed to secure expressly. The practical lesson is to negotiate explicit earnout-protection covenants up front. That gap between “do not sabotage” and “must maximize” is exactly where earnout disputes live, and it is why the covenant alone is not enough protection.

How do I keep the buyer from gaming the earnout metric?

The reliable protection is contractual, not the implied covenant. Because the covenant only reaches bad-faith interference, a seller who wants real protection writes it into the agreement. Four drafting moves carry most of the weight.

1. Define the metric precisely. Spell out exactly what counts toward revenue or earnings, including how returns, discounts, and one-time items are treated. A metric defined in a sentence invites a fight; a metric defined in a schedule does not.
2. Lock the accounting method. State that the metric is computed using the same accounting principles, applied consistently, that the business used before closing. This stops the buyer from changing accounting policy to reshape the number.
3. Restrict cost allocations and intercompany dealings. Bar the buyer from charging management fees, allocating corporate overhead, or routing intercompany transactions in a way that depresses the metric during the earnout period.
4. Impose express operating covenants. Require the buyer to operate the business consistently with past practice, maintain the sales force, fund it at agreed levels, or whatever else the metric depends on. Express covenants give you a breach-of-contract claim that does not depend on proving bad faith.

These covenants do the same protective work for the seller that surviving representations do for a buyer. For how post-closing promises hold up, see which representations survive the closing. With express covenants in place, the implied covenant becomes a backstop for conduct you did not anticipate, instead of your only line of defense.

What happens to my earnout if the buyer sells the business mid-earnout?

Minnesota law does not stop a buyer from reselling the business, merging it, or transferring its assets during the earnout period. To the contrary, Minnesota’s Business Corporation Act affirmatively empowers a corporation to sell, lease, transfer, or otherwise dispose of all or substantially all of its property and assets, Minn. Stat. § 302A.661, and to merge with another entity, Minn. Stat. §§ 302A.601–302A.651, subject only to internal governance approvals. No statute freezes the company in place while your earnout runs. There is also no default statutory carryover of the earnout to a later buyer: when the business is resold or its assets are transferred, the transferee assumes the obligation only to the extent the transfer contract provides, and a disposition of assets is not treated as a merger or a de facto merger. Minn. Stat. § 302A.661, subd. 4. That is why an experienced seller negotiates a successor-and-assigns or assumption clause. Your protection is whatever the contract says, so a well-drafted earnout addresses a change of control head-on.

A seller-protective earnout typically does one of three things if the buyer sells or merges the business mid-earnout. It can accelerate the earnout, so a sale triggers immediate payment of the full or a formula-based amount. It can require any successor to expressly assume the earnout obligation as a condition of the deal. Or it can switch to a deemed-earned formula that estimates the earnout based on performance to date. Without one of these, a resale can strip the metric out from under you, leaving you to argue that the buyer structured the sale to defeat the earnout. That argument runs through the implied covenant discussed above, and it is a hard, fact-intensive claim. It is far better to control the outcome with explicit change-of-control language than to litigate the buyer’s intent after the business is gone. A buyer’s resale can also raise Minnesota successor liability in asset sales questions, which is a separate reason to define successor obligations clearly.

How can I secure an earnout payment so I actually get paid?

An earnout is an unsecured promise unless the contract makes it something more. If you take a bare earnout and the buyer later cannot or will not pay, you hold a contract claim and nothing else, and you stand behind the buyer’s secured lenders. Minnesota sellers use four tools to convert that bare promise into a real recovery path.

The first is an escrow or holdback: a portion of the price is held by a third party or retained by the buyer and released as the earnout is earned, so the money exists before the dispute does. The second is a security interest in the business assets, perfected as a UCC Article 9 security interest, which gives you collateral and a priority position. Under Minnesota’s Uniform Commercial Code, a security interest attaches to the collateral once it becomes enforceable, Minn. Stat. § 336.9-203, and once perfected it takes priority over a conflicting unperfected interest and ranks against other perfected creditors by time of filing or perfection, Minn. Stat. § 336.9-322(a). Filing your financing statement early establishes your priority date ahead of other creditors of the business. The third is a guaranty from the buyer’s parent company or principals, adding a second party to collect from. The fourth is a setoff right against a seller note, where the seller financed part of the price and can offset an unpaid earnout against what the seller still owes. These tools are not mutually exclusive, and the right combination depends on the buyer’s balance sheet and how much of the price is contingent.

How should an earnout dispute be resolved under Minnesota law?

Most earnout disputes are accounting disputes, not contract-interpretation disputes, so the contract should pick the forum in advance and split it by issue type. The standard approach is two tracks. Measurement questions, meaning disagreements about how the metric was calculated, go to an independent accountant whose determination binds both parties. Everything else, meaning genuine disputes about what the contract means or whether the buyer breached a covenant, goes to litigation or to arbitration.

If the agreement selects arbitration, Minnesota law makes that choice enforceable. Under the Minnesota Revised Uniform Arbitration Act, an agreement to submit a controversy to arbitration “is valid, enforceable, and irrevocable except upon a ground that exists at law or in equity for the revocation of contract.” Minn. Stat. § 572B.06(a). The same statute divides the gateway questions: the court, not the arbitrator, decides whether a valid arbitration agreement exists and whether the earnout dispute is subject to it, Minn. Stat. § 572B.06(b), while the arbitrator decides whether a condition precedent to arbitrability has been fulfilled and whether the underlying contract is enforceable, Minn. Stat. § 572B.06(c). That division means a court can decide whether an earnout dispute must be arbitrated at all before an arbitrator reaches the merits of whether the earnout was earned. In my experience, the earnout disputes that turn ugly are the ones with no accountant-determination clause, where a routine question about cost allocation becomes a full lawsuit because the contract gave it nowhere else to go. Deciding the forum while both sides are still cooperative is far cheaper than deciding it after the relationship has soured.

How is an earnout taxed when you sell a Minnesota business?

An earnout paid in a later year is, by definition, an installment sale under federal law. IRC § 453 defines an installment sale as a disposition of property “where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs,” and provides that income from an installment sale is taken into account “under the installment method.” Under that method, the income you recognize each year is the portion of the payments received that the gross profit bears to the total contract price, so each earnout payment is taxed by that same gross-profit-to-total-contract-price ratio. IRC § 453(c). Installment treatment is the default, but you can elect out and recognize all gain in the year of sale; you must make that election by the due date, including extensions, for the return covering the year of the sale. IRC § 453(d).

Several complications deserve attention, and all reward early planning. The first is an added federal cost on a large installment sale. Once the property’s sales price exceeds $150,000 and the face amount of your installment obligations outstanding at year-end exceeds $5,000,000, you must pay interest on the deferred tax liability. IRC § 453A. You cannot avoid the $150,000 threshold by splitting one deal into several, because all sales that are part of the same transaction or a series of related transactions count as one. IRC § 453A(b)(5). The charge does not reach an individual’s disposition of personal-use property or property used or produced in the trade or business of farming. IRC § 453A(b)(3). And borrowing against a qualifying installment note is a trap: pledging the note as collateral is treated as receiving a payment on it, which accelerates the deferred gain you were trying to preserve. IRC § 453A(d).

The second complication is imputed interest. A multi-year earnout should carry a market rate of interest. If it does not, the federal imputed-interest rules recharacterize part of each payment as ordinary interest income, which is taxed at a higher rate than capital gain. For a typical contingent earnout the governing rule is IRC § 483, which Congress directed be applied by regulation to contracts under which the liability for, or the amount or due date of, a payment cannot be determined at the time of sale, IRC § 483(f)(1), the exact profile of a contingent earnout. Where the earnout is instead a fixed-payment debt instrument, the original-issue-discount rules of IRC § 1274 impute the interest instead, IRC § 483(d)(1), and those original-issue-discount rules are switched off entirely for a sale where total payments do not exceed $250,000, IRC § 1274(c)(3)(C), so a modest earnout may escape the § 1274 original-issue-discount rules. Because § 483 is displaced only where an issue price is determined under § 1274, though, an earnout too small for § 1274 is not beyond § 483, which can still impute interest, IRC § 483(d)(1).

The third complication is a Minnesota overlay. Under Minn. Stat. § 290.0137(a), a seller who is, or who becomes, a nonresident must include in Minnesota taxable income the full amount realized on a sale of a Minnesota S corporation or partnership interest, “including any income or gain to be recognized in future years pursuant to an installment sale method.” A seller who sells while a Minnesota resident and later becomes a nonresident recognizes the unrecognized installment gain on the final Minnesota resident return, to the extent not already recognized in a prior year. Minn. Stat. § 290.0137(a)(1). The statute defines an installment sale broadly, reaching any IRC § 453 installment sale and any other subchapter-E method that delays reporting a realized gain, so you cannot sidestep the rule by structuring the earnout deferral differently. Minn. Stat. § 290.0137. The same statute lets a nonresident seller elect to defer that recognition instead of accelerating it, Minn. Stat. § 290.0137(b), and a separate paragraph excludes gain already taxed under the acceleration rule from Minnesota taxable income in any future year that the taxpayer files a Minnesota tax return, to the extent that gain has already been subject to tax under the acceleration rule, so the same gain is not taxed twice, Minn. Stat. § 290.0137(c). A seller planning to leave Minnesota after the sale should confirm the current statute and Department of Revenue guidance before assuming the earnout will be taxed year by year. Earnout tax treatment also turns on whether the IRS views the payments as purchase price or as compensation, which is a separate analysis worth running before the deal closes.

Bottom Line

An earnout can be a fair way to close a price gap when you and a buyer disagree about your Minnesota company’s future. Because Minnesota does not regulate earnouts by statute, the contract carries the entire load: the metric definition, the buyer’s operating covenants, the change-of-control language, the security for payment, and the dispute-resolution forum. The implied covenant of good faith and fair dealing is a real protection, but it only reaches bad-faith interference, so it is a backstop and not a substitute for precise drafting. For the wider context of a sale, see the broader process of selling a Minnesota business and my business acquisitions practice. If you are weighing an earnout in the sale of your business, email [email protected] with a brief description to start an intake and conflict check before sending any confidential deal documents.