When Your Startup Is Acquired: Earnouts, Escrows, and the Tax Timeline

The headline price of an acquisition is rarely the amount that arrives at closing. Understanding how holdbacks, earnouts, and stock consideration are taxed helps sellers plan for cash they cannot yet spend.

The press release says the company sold for $200 million. The closing statement shows something smaller, with a portion held in escrow, another portion contingent on hitting targets over the next two years, and perhaps a slice paid in the acquirer's shares. Each piece has its own tax timing.

Escrows and holdbacks

Buyers routinely withhold a percentage of the purchase price, often for twelve to eighteen months, to cover breaches of the seller's representations and warranties. From the seller's side, the tax question is whether that money is counted in the year of closing or when it is released. When at least one payment is received after the tax year of sale, the transaction is an installment sale, which the IRS describes in Publication 537 and which is reported on Form 6252. Under the installment method, gain is recognized proportionally as payments arrive, so the escrowed portion is taxed when released rather than at closing. Sellers can elect out and recognize everything in the year of sale, which is sometimes preferable when a large capital loss is available to absorb the gain.

Publication 537 also notes that the installment method cannot be used for stock traded on an established securities market, which matters when the acquirer is public and pays in its own shares. And part of any deferred payment may be treated as interest even if the agreement does not call it interest, so a portion of a released escrow can be ordinary income.

Earnouts

An earnout ties additional consideration to future performance, such as revenue milestones or product launches. For tax purposes it is a contingent payment sale, and the practical result is that each earnout payment produces gain in the year received. Earnouts paid to founders who continue as employees carry an additional risk: if the payments are conditioned on continued employment, the IRS and the acquirer may treat them as compensation, taxed as ordinary income and subject to payroll taxes, rather than as capital gain on stock. Careful drafting of the earnout agreement is essential.

Stock consideration

When a public acquirer pays in its own shares in a transaction structured as a tax-free reorganization, the seller generally recognizes no gain at closing and carries over basis into the new shares. Cash received alongside stock, sometimes called boot, is taxable up to the gain realized. The deferred gain is taxed when the acquirer's shares are eventually sold, and those shares carry market risk and possibly lockups in the meantime, so sellers face the same concentration questions as any holder of a single large position.

Rates and the QSBS question

For a California seller, the combined tax on a large gain is substantial. Federal long-term capital gains are taxed at 20% above $545,500 of taxable income for single filers and $613,700 for joint filers in 2026, plus the 3.8% net investment income tax, and California taxes the gain as ordinary income at rates up to 13.3%. Whether any of the gain qualifies for the qualified small business stock exclusion depends on the holding period at the time of each payment. Stock acquired after July 4, 2025 earns a 50%, 75%, or 100% exclusion at three, four, and five years; earlier stock still needs five years. A seller slightly short of the threshold may want to explore a Section 1045 rollover, discussed in a separate Insights article, and should remember that California does not conform to either provision.

Option holders and unvested equity

Employees holding unexercised options face a different sequence. Options cashed out in the deal produce ordinary income equal to the spread, withheld at the 22% federal supplemental rate, or 37% above $1 million, plus California's supplemental rate. Unvested equity may be accelerated, assumed by the acquirer, or cancelled, depending on the plan and the deal terms. Because withholding rates are often below a high earner's actual marginal rate, a large cash-out can leave a balance due in April.

Planning across the timeline

Because acquisition proceeds arrive over one to three years, it helps to map each expected payment to a tax year, estimate the liability for each, and set aside cash accordingly. Estimated tax payments may be required in the year of closing to avoid underpayment penalties under the IRS estimated tax rules. Charitable gifts of stock, timing of other gains and losses, and the installment election are all decisions best made before the deal closes.

This article is educational only and does not constitute tax, legal, or investment advice; sellers in an acquisition should consult a qualified tax professional and transaction counsel.

Important Disclosures

Important Disclosures: Propulsion Capital Management is an investment adviser registered with the State of California Department of Financial Protection and Innovation. Registration does not imply a certain level of skill or training. This article is provided for general informational and educational purposes only and does not constitute investment, tax, legal, or accounting advice, nor an offer or solicitation to buy or sell any security or to adopt any particular investment strategy. The information is believed to be accurate as of the date of publication but is subject to change without notice; tax laws and regulations change frequently and their application depends on individual facts and circumstances. Nothing herein should be relied upon as a substitute for personalized advice from a qualified professional. Investing involves risk, including the possible loss of principal, and past performance is no guarantee of future results. Diversification does not ensure a profit or protect against loss. Any examples are hypothetical, are for illustrative purposes only, and do not reflect the experience of any client. Links to third-party websites are provided for convenience; Propulsion Capital Management does not endorse, and is not responsible for, the content of third-party sites. Propulsion Capital Management does not provide tax or legal advice; please consult your tax adviser or attorney regarding your specific situation.