In short
An earnout or milestone payment is a portion of the purchase price in an acquisition that the seller receives only if the acquired business hits future targets. In AI company deals, earnouts are standard. They help buyers and sellers agree on a price when the company’s value depends on fast changing technology. Under federal tax law, the seller generally reports the earnout as capital gain under the installment sale rules, unless the IRS treats the payments as compensation. Under Delaware law, most earnout disputes turn on whether the buyer actively prevented the earnout from being met. Recent Delaware decisions show that courts will enforce the exact words of the earnout clause, but they will not fill gaps that the parties should have seen coming. Because AI earnouts often use technical metrics like model accuracy or API volume, precise drafting is especially important.
What are earnouts and milestone payments
An earnout is a promise by the buyer to pay the seller more money after the closing if certain business results are achieved. A milestone payment is a specific sum payable when a defined event happens, like FDA approval or reaching a revenue target. Both are forms of contingent consideration, meaning the final purchase price is not fixed at closing.
For example, ServiceNow bought Moveworks for $2.85 billion in 2025. IMAA Institute When Meta invested $14.3 billion in Scale AI in 2025, the deal combined the investment with hiring CEO Alexandr Wang in an acqui-hire structure. FE International Google struck a $2.7 billion licensing arrangement with Character.ai to bring key researchers back to the company. FE International
In the simplest terms, an earnout protects both sides. The seller gets more money if the company does well. The buyer does not pay full price upfront for results that may never happen.
How common are earnouts in AI deals
Earnouts appear in roughly 40 percent of all M&A deals, according to data from Grant Thornton. Grant Thornton In non life sciences private company acquisitions, the figure is about 20 to 30 percent. Harvard Corp Gov / Fried Frank In life sciences, 91 percent of private bio/pharma deals in the SRS Acquiom study included an earnout between 2021 and 2023. Cooley M&A
AI deals are moving toward the life sciences model. The number of AI startup acquisitions surged 53 percent year over year to 454 transactions globally in 2024. PYMNTS In the first quarter of 2026, 266 AI M&A deals closed, a 90 percent jump from the same period a year earlier. CB Insights via FE International Almost half of all strategic technology deal value over $500 million in 2025 came from AI native companies or deals that explicitly cited AI benefits. Bain via FE International
AI startups command higher valuation multiples. Private AI deals close at 8 to 15 times revenue, compared to 4 to 6 times for traditional SaaS. FE International That premium means larger dollar gaps between what a buyer is willing to pay upfront and what the seller believes the company will be worth. Earnouts bridge that gap.
Also, in deals under $50 million, nearly 47 percent of total consideration is now tied to performance-based payouts. Phoenix Strategy Group For smaller AI startups, the earnout is often the biggest piece of the deal.
How are earnouts taxed under federal law
The seller’s tax bill on an earnout depends on one key question. Is the earnout part of the purchase price for the company, or is it really compensation for the seller’s post closing work? If it is purchase price, the installment sale rules apply and the seller reports capital gain over time. If it is compensation, the full amount is ordinary income when received.
The installment method and contingent payment sales
Under section 453 of the Internal Revenue Code, a disposition of property where at least one payment is to be received after the close of the taxable year in which the disposition occurs is an installment sale. 26 U.S.C. § 453(b)(1) The installment method lets the seller spread the gain over the years the payments come in.
Here is how it works. First, you figure a gross profit ratio. That ratio is the total expected profit (selling price minus the seller’s tax basis) divided by the total contract price. Each year, you multiply the payments you received by that ratio to find your taxable gain. The rest of each payment is a return of your basis. IRS Publication 537
For example, suppose an AI startup sells for $10 million cash at closing plus an earnout that could pay up to $20 million over three years. The seller’s tax basis in the company is $2 million. The maximum total price is $30 million. The gross profit is $28 million. The gross profit ratio is $28 million divided by $30 million, or 93.3 percent. That means 93.3 cents of every dollar the seller receives is capital gain. The remaining 6.7 cents is a tax free return of basis.
But what if the total selling price is not known at closing because the earnout depends on future events that could go either way? The Treasury regulations call this a contingent payment sale. The rules for recovering basis are in Treasury Regulation § 15a.453-1. They give three methods depending on what is fixed by the end of the tax year of the sale. 26 C.F.R. § 15a.453-1
Stated maximum selling price. If the agreement sets a cap on the total possible payments, you use that maximum to compute the gross profit ratio, just as in the example above. All basis is allocated assuming the maximum is met. 26 C.F.R. § 15a.453-1(c)(2) This is the most favorable method for a seller who wants to recover basis quickly.
Fixed payment period but no maximum price. If there is no dollar cap, but the earnout period has a fixed end date, the seller recovers basis in equal annual pieces over that period. 26 C.F.R. § 15a.453-1(c)(3) For instance, a three-year earnout with no maximum dollar amount would let the seller deduct one third of the basis each year. If the payments in a year are less than the basis allocated, the unused basis carries forward. This method can slow down basis recovery if early payments are small.
Neither maximum price nor fixed period. If the deal has no cap and no fixed end date, the regulations say the seller must recover basis ratably over 15 years. 26 C.F.R. § 15a.453-1(c)(4) That is the worst outcome for the seller, because it defers the tax benefit of basis recovery for a decade and a half. It also raises the question whether the transaction is really a sale at all, or a lease or license that produces ordinary income.
A seller can ask the IRS in a private letter ruling to use a different method if the standard rule would substantially and inappropriately defer basis recovery. The taxpayer must show that it is reasonable to conclude the alternative method likely will recover basis at a rate twice as fast as the normal basis recovery rule. 26 C.F.R. § 15a.453-1(c)(7)(ii)
The interest charge on large installment obligations
Congress added section 453A to prevent sellers from indefinitely deferring tax on big gains. It imposes an interest charge on the tax that is deferred when installment obligations exceed a threshold. The charge applies if the sales price of the property exceeds $150,000 and the face amount of all such obligations that arose during, and are outstanding as of the close of, the taxable year exceeds $5 million. 26 U.S.C. § 453A(b) The interest is computed by multiplying the applicable percentage of the deferred tax liability by the underpayment rate in effect under section 6621(a)(2). 26 U.S.C. § 453A(c)
For a founder selling an AI company for a large sum, this charge can be meaningful. Suppose the unrecognized gain tied to installment obligations is $30 million. The deferred federal tax at 20 percent is $6 million. An interest charge at 5 percent on that $6 million comes to $300,000 per year. That is money paid to the IRS simply for deferring the gain.
There is a practical problem. For a contingent earnout, the amount of the obligation at year end may not be known. The regulations do not directly address this. Most practitioners apply a lookback method once the amounts become determinable. The official guidance is not settled, so sellers should consult a tax advisor.
When an earnout becomes ordinary income
The buyer may want the seller to stay on as an employee after the deal. If the earnout is really a payment for those services, the IRS can recharacterize it as compensation. That swaps the 20 percent capital gains rate (plus 3.8 percent net investment income tax) for ordinary income rates up to 37 percent plus payroll taxes. The difference between a payment characterized as wages and one treated as a return of capital can be stark, as illustrated by Lane Processing Trust v. United States, 25 F.3d 662 (8th Cir. 1994), where post sale trust distributions to employees were held to be wages subject to FICA and FUTA taxes because the amounts were tied to job classification, length of employment, and prior wages.
The IRS uses six factors to decide whether an earnout is purchase price or compensation.
- Must the seller work for the buyer to receive the earnout
- Is the seller paid a separate salary that is reasonable
- Are the earnout payments proportionate to the seller’s ownership stake
- Does the total consideration look like a reasonable purchase price
- How does the buyer compensate other employees in similar roles
- How do the parties report the payments on their tax returns and financial statements Tax alert
If the earnout is only paid while the seller is employed, and the amount is not tied to the value of the business, the IRS will likely treat it as compensation. To stay on the capital gain side, the agreement should separate the employment terms from the earnout terms. The earnout should be calculated by reference to objective business metrics and payable regardless of whether the seller continues to work.
How are earnout disputes litigated under Delaware law
Most U.S. acquisition agreements for technology companies choose Delaware law. Two doctrines come up in nearly every earnout dispute, including the implied covenant of good faith and fair dealing and the prevention doctrine. Recent cases from Delaware courts offer a clear message. The written contract controls. Courts will not save a party from a bad deal, but they will punish a buyer that actively sabotages the earnout.
The implied covenant of good faith and fair dealing
Every Delaware contract includes an implied duty that each party will not do anything to destroy the other party’s right to receive the benefits of the deal. But this duty is narrow. It only fills gaps that the parties did not anticipate. The Delaware Supreme Court explained in January 2026 in Johnson & Johnson v. Fortis Advisors that the implied covenant is a gap filling tool of last resort. If a risk was foreseeable when the contract was signed, the parties are expected to have bargained for it. The court will not add a term to protect a party from a risk it could have addressed. Johnson & Johnson v. Fortis Advisors LLC, No. 490, 2024 (Del. Jan. 12, 2026)
This rule puts a heavy burden on the seller. For example, if the buyer has broad discretion to run the business after closing, and the earnout depends on revenue, the risk that the buyer will make decisions that lower revenue is foreseeable. The seller should negotiate for specific protections in the contract. If the seller does not, the implied covenant will not later force the buyer to maximize revenue.
The prevention doctrine
Separately, Delaware law says that if a buyer’s own breach of the contract causes an earnout condition not to happen, the condition may be excused and the earnout may still be owed. This is the prevention doctrine. The line between a buyer’s legitimate business decision and an act to prevent the earnout is often blurry. Several recent cases draw that line.
In Fortis v. Medtronic Minimed (Del. Ch. July 2024), the merger agreement gave Medtronic sole and absolute discretion over development and commercialization. It only restricted actions taken for the primary purpose of frustrating earnout payments. The court dismissed the sellers’ claims because they failed to plead facts showing Medtronic’s decisions were made with that primary purpose. Fortis v. Medtronic Minimed (Del. Ch. July 2024)
But in a March 2026 decision, Fortis Advisors v. Krafton, the buyer terminated key executives and seized operational control precisely to avoid a $250 million earnout. The court found a breach. It reinstated the CEO, extended the earnout period by 258 days, and ordered the buyer not to interfere with the product launch. Law firm analysis
These cases show a clear distinction. When the agreement gives the buyer broad authority, the seller must prove the buyer acted with the specific purpose of killing the earnout. But when the buyer’s actions clearly cross that line, courts are willing to grant strong remedies.
Billion-dollar lessons
Damages for earnout breaches can be enormous. In SRS v. Alexion Pharmaceuticals (Del. Ch. Sept. 2024), the court found the buyer breached its obligation to use commercially reasonable efforts to achieve regulatory milestones and awarded the sellers $130 million for an achieved milestone, later awarding approximately $180.94 million in expectation damages. SRS v. Alexion Pharmaceuticals (Del. Ch. Sept. 2024), SRS v. Alexion Pharmaceuticals (Del. Ch. June 2025) In the J&J Auris Health case, the Chancery Court initially awarded over $1 billion in damages. The Delaware Supreme Court affirmed most of it but reversed $300 million related to the implied covenant claim, because the risk was foreseeable and the contract placed it on the sellers. Vinson & Elkins / Harvard Corp Gov, Delaware Supreme Court
The lesson from the case law is simple. The specific words in the earnout clause decide the case. Sellers should negotiate for specific, objective milestones, a standard of efforts higher than sole discretion, and limits on the buyer’s ability to change the business in ways that would reduce the earnout. Buyers who want maximum flexibility will push for sole discretion and language that only restricts actions with the primary purpose of frustrating the earnout. But even those clauses may not protect a buyer that takes extreme measures, as Krafton shows.
What makes AI company earnouts different
AI acquisitions force earnout drafting to confront risks that do not exist in traditional businesses. The metrics that drive AI value are technical, fast-moving, and hard to benchmark. At the same time, the AI deal market is moving at record speed. Those two forces combine to make AI earnouts especially prone to dispute.
Metrics tied to AI performance, not just financials
In a traditional earnout, the trigger is usually a revenue or EBITDA target. In AI deals, earnouts are increasingly tied to metrics like model accuracy on a specific benchmark, the number of inference API calls, uptime of the AI service, active users of an AI feature, or safety certification milestones.
ServiceNow acquired Moveworks for $2.85 billion to capture its AI-driven platform and rapid ARR growth. ServiceNow, Everest Group Meta agreed to pay Scale AI at least $450 million per year for five years for its services, or more than half of its annual AI spend whichever is less, as part of its $14 billion minority investment. Forbes Google’s deal with Character.ai included a $300 million contingent payment tied to integration milestones and up to $200 million in earn-outs tied to performance targets including the re employment of its co founders. WSJ These are not off the shelf metrics. They require careful definition.
For example, what counts as an API call? If a call fails, does it count? If the model is integrated into a larger system and called indirectly, how is that tracked? The contract must answer these questions. Without clear definitions, the parties will end up in court arguing over what the number means.
The valuation gap is wider, so earnouts are bigger
Private AI companies trade at 8 to 15 times revenue, compared to 4 to 6 times for traditional SaaS. FE International That means a $20 million revenue AI startup can command a valuation of $160 million to $300 million. If 30 percent of that is deferred into an earnout, the earnout pool is $48 million to $90 million. When that much is at stake, litigation is likely if there is any ambiguity.
Also, in deals under $50 million, nearly half of the total consideration is performance-based. Many AI startups fall in that range. The earnout is not a small kicker. It often makes up most of the seller’s consideration.
Deal pace and technology risk
AI M&A volume is breaking records. Q1 2026 saw 266 deals, a 90 percent jump year over year. CB Insights via FE International Deals are getting done fast. Fast deals often mean less time for detailed earnout drafting.
At the same time, AI technology can change overnight. A milestone tied to a specific model version may become irrelevant if the buyer pivots to a new architecture. The contract should address what happens if the acquired technology is replaced. The implied covenant will not fill that gap if the risk was foreseeable, as the Delaware Supreme Court has made clear.
Drafting checklist for AI earnouts
Based on the case law and market trends, here are concrete steps for AI deal lawyers.
- Write out exactly how each technical metric is computed. For example, API call volume means successful inference requests logged by the buyer’s standard monitoring system in the ordinary course, excluding errors and test calls.
- Require the buyer to continue operating the acquired business in the ordinary course and not take actions for the primary purpose of reducing the earnout. Add a specific prohibition on diverting resources or deprioritizing the product.
- Use an independent accounting referee to resolve disputes over earnout calculations. The contract should say the referee’s decision is final and binding absent fraud or manifest error.
- Set a clear earnout period with a fixed end date and a stated maximum payout if possible. That gives the seller the most favorable tax treatment.
- Separate the employment agreement from the earnout. The earnout should be payable based on business results, not continued service, to preserve capital gains treatment.
- Plan for model obsolescence. Include a clause that if the buyer replaces the acquired AI with a successor technology, the earnout metrics adjust to the new technology in a way that does not disadvantage the seller.
Practical note The single most common earnout mistake in AI deals is leaving a metric undefined. If the buyer and seller cannot agree on what API call means, a court will not have an easy answer. Define every term.
Key takeaways
- Earnouts are common in AI M&A because they close the gap between high seller expectations and buyer caution. In smaller AI deals, the earnout can be the largest piece of the seller’s consideration.
- Federal tax law treats an earnout as part of an installment sale, allowing the seller to spread capital gain over the earnout period. The basis recovery method depends on whether the deal sets a maximum price and a fixed earnout period.
- A section 453A interest charge applies to deferred gains from large installment obligations over $5 million, which can add a significant annual cost for sellers in big AI exits.
- If the earnout is tied to the seller’s continued employment, the IRS may tax it as ordinary income. To protect capital gains treatment, the earnout should be based on business metrics and payable whether or not the seller stays on.
- Delaware courts enforce earnout clauses exactly as written. The implied covenant of good faith only fills unforeseen gaps. Sellers must negotiate specific protections in the agreement.
- Recent Delaware decisions have awarded billion-dollar damages against buyers that breached earnout obligations, but courts will not second-guess ordinary business decisions.
- In AI deals, earnout metrics are often technical, such as model accuracy or API volume. Define every metric with precision and plan for technology changes. Poor drafting is the leading cause of earnout disputes.
Frequently asked questions
Q:What is the difference between an earnout and a milestone payment?
A:An earnout usually pays a percentage of future revenue or profit over a period. A milestone payment is a fixed dollar amount paid when a specific event happens, like regulatory approval or a technical achievement. Both are contingent consideration.
Q:How are earnout payments taxed for the seller?
A:The seller generally reports earnout payments as capital gain under the installment sale method. The gain is recognized as payments come in, using a gross profit ratio. If the earnout is recharacterized as compensation, it is ordinary income when received. 26 U.S.C. § 61(a)(1), 26 U.S.C. § 451(a)
Q:Does the section 453A interest charge apply to all earnouts?
A:No. The charge only applies if the sale price of the property is over $150,000 and the total face amount of all such obligations held at year-end is more than $5 million. Many smaller AI deals are below that threshold. 26 U.S.C. § 453A(b)
Q:What is the implied covenant of good faith and fair dealing in earnout disputes?
A:It is a default rule that fills gaps in the contract to prevent one party from undercutting the other’s benefits. Delaware courts apply it narrowly only when the risk was not foreseeable. It cannot rewrite express terms. Johnson & Johnson v. Fortis Advisors LLC, No. 490, 2024 (Del. Jan. 12, 2026)
Q:What was the J&J v. Fortis case about?
A:J&J acquired Auris Health for $3.4 billion upfront plus up to $2.35 billion in earnout payments tied to regulatory and sales milestones. When none were met, sellers sued. The Chancery Court awarded over $1 billion in damages, later partially reduced on appeal. The Delaware Supreme Court clarified limits on the implied covenant. Vinson & Elkins / Harvard Corp Gov
Q:What lessons can AI companies learn from recent earnout litigation?
A:AI companies should draft earnout metrics precisely, include ordinary course operation requirements, and specify what happens if the technology changes. The biggest risk is leaving key terms undefined. Recent cases show courts will enforce the contract as written, not save a party from a bad deal.
Q:How can a seller protect an earnout from buyer manipulation?
A:The seller should negotiate for an efforts standard (like commercially reasonable efforts) rather than sole discretion. The contract should require the buyer to operate the acquired business in the ordinary course and not take actions for the primary purpose of avoiding the earnout. An independent accounting referee can resolve measurement disputes.
Q:What are typical earnout periods in AI deals?
A:Most earnouts last one to five years, with one to three years being the most common. A fixed period helps the seller get favorable tax basis recovery. 26 C.F.R. § 15A.453-1(c)(3)
Q:Are earnouts more common in AI deals than in other sectors?
A:AI deals are moving toward the life sciences model, where earnouts are the norm. 40 percent of all M&A deals have some form of earnout. In smaller SaaS acquisitions (deals under $50M), nearly half of the total consideration is performance-based. Phoenix Strategy Group
Q:What happens if the buyer integrates the acquired AI into a different product?
A:The earnout agreement should address this. Without a specific clause, the seller may lose the earnout if the original product is discontinued. The implied covenant will likely not help if that risk was foreseeable. The seller should negotiate that earnout metrics adjust or survive a technology pivot.
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Junde Liu, JD, LL.M. (Taxation) candidate at UF Law. Originally published on Compute Law Blog. This article is general information and does not constitute legal advice. Reading it does not create an attorney client relationship. The reader should not act on the basis of any content here without first consulting a licensed attorney in the relevant state. Last reviewed for accuracy May 23, 2026.