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Earnouts When Selling or Buying a Business | Complete Guide

Breaking news: In the world of business transactions, there are moments when buyers and sellers find themselves at odds over a company’s value.

Naturally, sellers aim for the highest possible price, while buyers may harbor concerns about the company’s potential for growth as promised, as well as its ability to retain customers and key personnel.

Enter the earnout.

An earnout serves as a valuable tool for bridging the valuation gap and sealing the deal. It’s a financial arrangement wherein the buyer commits to paying the seller a predetermined sum if specific post-closing targets are achieved.

In the intricate realm of buying and selling businesses, reaching a consensus on the right price can prove challenging. Earnouts are a prevalent solution across various transaction structures.

This article aims to enlighten you on what exactly an earnout entails, how it can seamlessly integrate into the sale of a business, and the multitude of considerations that both buyers and sellers must grasp regarding earnouts. We will delve into the overarching objectives, benefits, and hurdles of earnouts, explore their essential components, analyze the legal and tax ramifications, and outline how these arrangements factor into deal structures.

Furthermore, we will provide answers to the following questions within this article:

  • What are the primary objectives of earnouts?
  • What alternatives exist to replace earnouts?
  • How can earnouts be effectively managed?
  • What are the merits and drawbacks of utilizing earnouts?
  • What methods are employed to calculate the appropriate earnout amount?
  • How is the documentation for an earnout structured?
  • What variables influence the likelihood of incorporating an earnout into your transaction?
  • How do earnouts seamlessly integrate into the broader deal framework?
  • What are some typical deal structures where earnouts are a feature?
  • When should earnouts be avoided?
  • What steps can sellers take to safeguard against earnouts?
  • What are the fundamental elements of an earnout?
  • What are the accounting and tax implications entailed in earnout agreements?

Let’s embark on a comprehensive exploration…

Overview

What is an Earnout?

An earnout represents a unique payment structure in which the seller’s compensation is contingent upon specific post-closing events linked to the performance of the acquired company. This contingency can take various forms, such as revenue targets, EBITDA milestones, or even non-financial metrics like key employee retention or patent issuance.

While earnouts are relatively uncommon in smaller transactions, they frequently come into play in mid-market deals. In certain scenarios, as we’ll explore shortly, earnouts can be tied to a substantial portion, potentially up to 25%, of the total purchase price.

For a seller to qualify for an earnout, they must meet or surpass predefined targets or milestones. These objectives can encompass financial metrics like revenue thresholds, gross margins, or net profit goals. Alternatively, they may involve non-financial criteria such as market acceptance, technical achievements, or regulatory approvals within a specified timeframe, typically ranging from one to five years post-closing. A well-structured earnout formula is characterized by its clarity, measurability, objectivity, and resilience against manipulation by either party.

Earnouts can typically be categorized into one of two primary motivations, each serving distinct purposes:

  • Incentivization: Incentive-based earnouts are strategically designed to encourage the seller’s active involvement in growing the business post-closure. These are commonly employed when the seller retains control of the business, and both parties align on the business’s valuation. In such cases, the earnout isn’t used as a means to bridge valuation gaps or mitigate risks. Instead, it serves as a powerful incentive for the seller to maximize the company’s revenue and earnings for the benefit of the buyer.
  • Risk Mitigation: Conversely, risk-mitigation-based earnouts offer a layer of reassurance to the buyer. They come into play when there is disagreement on the company’s valuation or when the business poses challenging risk assessments. In these instances, the earnout functions as a mechanism to reconcile differences in price or provide a safeguard against uncertain risks inherent in the business.

Advantages of Earnouts

Earnouts bring forth a host of compelling advantages:

  • Allocation of Risk vs. Reward: Earnouts excel at distributing risk and reward equitably between the buyer and the seller, particularly when these elements are challenging to precisely gauge during the initial earnout negotiations. They afford the buyer the opportunity to offer a potentially higher reward to the seller while concurrently mitigating their own risk. To illustrate, if the company’s EBITDA surpasses the earnout’s stipulated expectations, the buyer commits to the elevated purchase price. Conversely, if EBITDA falls short, the buyer adheres to the lower purchase price.
  • Bridging Valuation Gaps: Earnouts shine as indispensable catalysts for bridging valuation discrepancies within M&A transactions. They expand the horizons of deal-making by enabling scenarios where buyers and sellers may not see eye-to-eye on the target company’s valuation but can still find common ground for a transaction. Earnouts prove invaluable when there’s a divergence of opinions regarding a business’s future prospects. This tool empowers a broader range of parties to seal deals that might otherwise remain unrealized. For instance, a buyer might harbor reservations about a seller’s growth projections, hindering their willingness to pay a premium for expected business expansion. Enter the earnout, which can make a portion of the purchase price contingent on future growth, providing the buyer with reassurance and the possibility of paying a higher sum if performance exceeds expectations. In certain transactions, earnouts emerge as the linchpin that unlocks the deal. From the buyer’s standpoint, earnouts open the door to the potential of obtaining more if future performance outpaces predictions.
  • Quantifying Potential: Sellers often argue for a higher valuation based on a business’s untapped potential. Conversely, buyers may hesitate to endorse this elevated value, citing unrealized benefits. A straightforward solution arises: the buyer pays the seller for the potential only when it materializes. This not only reduces risk for the buyer but also empowers them to consider a potentially higher purchase price.
  • Managing Uncertainty: Earnouts come into play when uncertainty clouds future events. Will projected revenues materialize? Can key employees and customers be retained? Will that coveted patent or FDA approval be granted? In scenarios where the seller desires a sale, and the buyer is eager to purchase, earnouts provide a unique solution for navigating this uncertainty. They hinge a portion of the purchase price on the occurrence, or non-occurrence, of future events. Earnouts shine brightest when both parties grapple with the unpredictability of events that could significantly impact the business’s value. When the certainty of a pivotal future event remains elusive, earnouts step in to dispel ambiguity.
  • Alignment: Earnouts emerge as a powerful tool for fostering alignment between buyer and seller, particularly when the seller continues to manage the business post-closure. They create a compelling incentive for the seller to wholeheartedly engage during the transition and beyond, especially if the seller commits to supporting the buyer through a consulting agreement. In many middle-market transactions where private equity (PE) firms take the buyer’s role, it’s customary for a substantial portion, typically ranging from 10% to 25%, of the purchase price to be linked to an earnout. This structural choice not only motivates the seller to stay onboard and drive the business’s value but also bolsters the buyer’s prospects of a successful acquisition. It’s a win-win proposition.
  • Tax Advantages: The contingent nature of earnout payments offers a tax advantage by deferring taxation until the payment is actually received. This approach alleviates the immediate tax burden that often accompanies the sale’s closing. Moreover, it proves beneficial for the seller’s shareholders, as it postpones income tax obligations related to the payment.

Disadvantages of Earnouts

While earnouts may initially appear enticing as tools to bridge pricing gaps and foster alignment, it’s crucial to recognize that they come with a host of potential pitfalls. Earnouts are frequently brought up during negotiations but are infrequently formalized.

In smaller transactions, it’s common to mention the possibility of an earnout at the outset. However, parties often abandon the idea once they delve into the intricate process of crafting a well-defined earnout. Due to this complexity, earnouts find more favor among financial buyers, are less frequently employed by corporate buyers, and rarely utilized by individual buyers.

The concept of an earnout is straightforward, but the execution and drafting are challenging—earnouts are intricate, hard to oversee, and frequently give rise to disputes and disagreements. It’s a rarity to encounter an earnout that doesn’t undergo scrutiny, arguments, or even legal action. Earnouts are susceptible to various interpretations and can, at times, unintentionally lead to manipulations by the parties involved. While they may facilitate immediate agreements, without meticulous drafting, they can effortlessly transform today’s accord into tomorrow’s discord.

  • Manipulation Risk: Earnouts, especially those tied to earnings, can be vulnerable to manipulation. Parties may attempt to influence the outcome by adjusting expenses or revenue. For example, in an EBITDA-based earnout, a buyer might reduce the earnout by overspending on certain items that yield long-term benefits but impact current EBITDA. Conversely, a seller could focus on short-term gains to inflate earnings. To mitigate this risk, careful attention to expense definitions and clear guidelines on what can and cannot be adjusted are essential.
  • Interpretation: Earnouts often hinge on specific financial metrics like EBITDA. However, the interpretation of these metrics can vary. Questions may arise about whether adjusted or unadjusted EBITDA should be used, the appropriate owner’s salary, or whether certain expenses can be deducted. To prevent disputes, earnout agreements should define these terms clearly, leaving little room for interpretation.
  • Complexity: Crafting a robust earnout agreement requires a deep understanding of potential issues and a proactive approach to address them. For instance, concerns about trade credit can be resolved by stipulating that gains in profit are reduced by increases in outstanding receivables over a certain age. However, unforeseen situations may arise, such as a large payment received just beyond the defined timeframe. To cover such scenarios, the agreement should include mechanisms for resolution.
  • Close Monitoring Required: Vigilance is key due to the potential for manipulation. Once the buyer assumes control, it can be challenging for the seller to oversee business operations, especially if they’ve retired from the helm. The risk of manipulation increases when the buyer knows that close monitoring is unlikely.
  • Common Disputes: Earnout agreements often lead to post-closing disputes, entailing significant costs and time, whether resolved through arbitration or litigation. Crafting a well-defined dispute resolution mechanism in the purchase or earnout agreement is crucial. Earnouts can sometimes devolve into situations where both parties point fingers, a common reason why professional advisors caution against their use. In certain cases, parties delay agreeing on the purchase price, relying on earnouts as a solution, often post-closure. It’s advisable to establish the business’s value as early as possible in negotiations to avoid relying on earnouts as a last resort.
  • Impact on Synergy and Integration: Earnouts work best when the acquired business remains independent with existing management after the deal. Integration complicates matters, especially if it’s comprehensive. Extensive integration makes it harder to independently assess the target’s financial performance. Lack of integration impedes synergy, which can inflate the purchase price. This absence of synergy can frustrate both the seller and the buyer. Buyers may contemplate eliminating duplicate functions like accounting, legal, and HR. Decisions must be made regarding whether to retain these functions within the target or their own entity. The allocation of costs for duplicated functions becomes a challenge when they exist in only one entity. Earnouts can complicate integration efforts, potentially frustrating the buyer and impacting operational efficiency. Without synergies, buyers often find themselves constrained to offer fair market value (FMV) for the business.
  • Management Competency: When the buyer’s management takes the reins post-closing, there’s a risk of suboptimal performance that can impact the earnout. The business might not thrive as it would under the seller’s control, leading to disputes if earnout targets are missed. One solution is to either let the business remain under the buyer’s control or establish clear operating rules and standards. However, these measures may not fully mitigate the consequences of poor management.
  • Short-Term Focus: Earnouts can incentivize sellers to prioritize short-term gains over long-term objectives. The economic incentive to maximize earnout value may lead sellers to emphasize immediate profits at the expense of factors like product quality and customer/employee retention.
  • Adverse Incentives: The buyer’s goal is to minimize the earnout cost, while the seller aims to maximize its value. This can create misaligned incentives, particularly when the earnout is substantial. While some interests may align, such as an increase in EBITDA benefiting both parties, disagreements can arise in key decisions. For instance, the buyer may prefer long-term growth, while the seller prioritizes short-term gains. This tension can be mitigated if the seller retains control during the earnout period.
  • Tax Rate Fluctuations: Earnout values are typically taxed upon receipt, and there’s a risk of tax rate changes between the deal’s closure and the earnout period, particularly during election seasons.

Determining the Appropriate Amount of an Earnout

In the realm of mergers and acquisitions (M&A), M&A advisors play a pivotal role in facilitating transactions. Their responsibilities extend beyond valuation, encompassing various critical aspects that need meticulous attention. Here’s a breakdown of their role and the complexities of earnouts:

  • Preliminary Valuation: An M&A advisor’s initial task is to provide a preliminary valuation. This assessment goes beyond a single figure; it should present a spectrum of potential values. Alongside this, the advisor delves into possible deal structures, conducts a comprehensive analysis of cash proceeds, delves into the tax implications, and assesses risk factors that might lead to the implementation of an earnout.
  • The Purpose of Earnouts: Earnouts, a common feature in M&A deals, serve dual purposes. They can be designed to mitigate risks or incentivize the seller. Risk-mitigating earnouts are often foreseeable, while those structured to motivate the seller’s ongoing involvement in the business can be less predictable. Importantly, an earnout should enhance the company’s overall value rather than diminish it since it serves as an incentive.
  • Assessing Earnout Feasibility: Armed with a preliminary valuation, the seller can gauge the feasibility of incorporating an earnout. This empowers them to respond effectively when proposed deal structures include this mechanism. It’s essential to recognize that valuation is not a fixed figure but rather a range, and predicting the specifics of an earnout can be challenging. Strategies to bridge price gaps can take diverse forms, with an earnout being just one tool among many.
  • Probability of Target Achievement: When a buyer proposes an earnout, the seller should assess the likelihood of meeting the specified targets and consequently, receiving earnout payments. Typically, the probability of attaining these targets is highest in the initial year and gradually diminishes over time.
  • Challenges in Valuation: Valuing an earnout in present terms is intricate due to its inherent unpredictability. Traditional discounted cash flow methods may yield low values due to the high discount rates necessary to account for earnout-related risks. This complexity makes it challenging to directly compare two earnouts on a financial basis or use formulas in a spreadsheet. Therefore, when an earnout is proposed, sellers should ascertain its level of importance in the deal, whether it’s a core component or an added bonus.

Documenting Earnouts

Earnouts play a pivotal role in M&A transactions and demand meticulous documentation at two crucial junctures:

Letter of Intent (LOI): In the early stages of negotiations, buyers assess a business and often contemplate a deal structure that effectively addresses inherent risks and opportunities. Earnouts can feature prominently in this structure, particularly when the perceived risk is high.

A common pitfall for sellers is accepting vague earnout terms in the LOI, such as, “The purchase price will include an earnout of up to an additional $5 million, with targets to be defined during due diligence.” Clarity is key at this stage. The components of the earnout, including its size, metrics for measurement, thresholds, control over the business, payment terms, and more, should be explicitly defined and documented.

Sellers wield significant negotiation power before accepting an offer, and it’s crucial to leverage this advantage. Agreeing to ambiguous terms or overly restrictive conditions, like extended exclusivity periods, can erode a seller’s leverage. As due diligence proceeds, unresolved issues tend to surface, gradually chipping away at the deal’s attractiveness. To avert this, sellers should invest ample effort in clarifying the earnout and other pivotal aspects before endorsing the LOI.

Purchase Agreement: Subsequently, typically during the due diligence phase, the parties, often represented by the buyer’s legal counsel, embark on crafting the purchase agreement and earnout agreement. At this juncture, the involvement of experienced M&A attorneys and CPAs is imperative. Even a minor oversight in the earnout’s wording can translate into substantial financial consequences, potentially amounting to hundreds of thousands of dollars.

Factors that Affect the Prevalence of Earnouts

Economy’s Influence: The prevalence of earnouts often mirrors the state of the economy. In a buyer’s market, where buyers hold the upper hand, earnouts become more commonplace. Conversely, during a seller’s market, sellers can frequently command higher purchase prices without the need for earnouts. This is especially true when the business is well-marketed, attracting multiple competitive buyers, and carries minimal uncertainties.

In contrast, a buyer’s market tends to usher in deal structures with greater restrictions. These may include stricter representations and warranties, lower financial thresholds, extended indemnity survival periods, larger escrow accounts, and more substantial earnouts. The rationale behind these shifts is partly rooted in the seller’s limited options in a sluggish economy, while the buyer assumes heightened risks in a less favorable market. Consequently, buyers may seek to redistribute some of this risk by incorporating earnouts.

Industry-Specific Trends: The utilization of earnouts varies across industries. Professional service sectors like healthcare, law, and accounting, where client and employee retention holds paramount importance, frequently employ earnouts. A significant chunk of the purchase price might hinge on earnouts contingent on maintaining clients or staff. Industries exposed to product-related risks, such as pharmaceuticals reliant on patent approvals or FDA clearance, also commonly feature earnouts as integral components of purchase prices.

In high-tech sectors, where businesses may experience rapid growth, sometimes at rates of 50% to 100% annually, buyers might be inclined to pay a premium, but only if this growth trend persists. In such cases, earnouts represent a pragmatic means to address this uncertainty, besides lowering the purchase price or remunerating the seller with stock in the post-acquisition entity. Similarly, service-centric companies frequently embrace earnouts when concerns about customer or employee retention loom large.

Size Matters: Earnouts find greater prominence in the middle market and among large publicly traded corporations. In the sale of public companies, buyers often compensate sellers with their own stock, a strategy akin to earnouts as it grants the seller an equity stake in the acquiring entity. This approach, known as a Type B reorganization, bears the distinct advantage of tax deferral for both buyer and seller. However, in practice, earnouts are notably more prevalent within the middle market. Here’s why:

  • Incentive Alignment: Earnouts can serve as compelling incentives for post-closing ownership and management. This is feasible because existing stakeholders can maintain control over the business following the acquisition.
  • Stand-Alone Entities: Middle-market companies frequently continue to operate as stand-alone entities after the sale, a crucial factor for effective earnout monitoring.
  • Information Gap: Privately-owned mid-market firms often have limited available information, rendering risk assessment more challenging.
  • Stock-for-Stock Transactions: It’s worth noting that stock-for-stock acquisitions (Type B reorgs) aren’t typically suitable for most mid-market enterprises. This is primarily because the acquiring party is often not a publicly traded company, and the seller usually seeks a cash buyout.

Integration Matters: Regrettably, earnouts are most prevalent in scenarios where the acquired companies remain independent entities post-acquisition, with minimal integration between the buyer and the target. This limitation is regrettable because it means the seller misses out on potential compensation for synergies. Without substantial integration, synergy opportunities diminish, potentially resulting in a lower purchase price from the buyer.

Corporate Leadership Influence: Interestingly, some argue that CEOs with Republican affiliations, often perceived as more conservative in their approach, are less inclined to pursue acquisitions compared to their Democrat counterparts. When they do engage in acquisitions, it’s more likely to involve companies within the same industry, backed by robust financial and operational data. Furthermore, they tend to favor cash transactions over earnouts in structuring deals, reflecting their distinct preferences.

Earnouts & Deal Structure

How Earnouts Fit into Overall Deal Structure

In the realm of deal structures, a tapestry of elements often weaves together, encompassing cash, debt, earnouts, consulting agreements, employment contracts, escrows, and more. To navigate the landscape effectively, it’s paramount to grasp how earnouts seamlessly integrate into the overarching deal structure. When evaluating the allure of an offer, every facet of the transaction warrants dissection into two fundamental categories: contingent elements, such as earnouts, and non-contingent components.

Middle-market transactions, in particular, tend to comprise three core ingredients: cash, earnouts, and escrow. Typically, cash takes the lion’s share, representing around 70% to 80% of the transaction’s overall value. Meanwhile, earnouts and escrows collectively make up the remaining 20% to 30% of the purchase price. Nevertheless, it’s worth noting that earnouts can occasionally ascend to occupy as much as 75% of the purchase price.

The optimal scenario for sellers entails an upfront cash payment, reflective of the company’s present valuation, reduced by the proportion of earnouts tailored to hedge against substantial and unpredictable risks. The remaining compensation aligns in the form of an earnout, skillfully designed to galvanize and incentivize sellers, particularly those poised to continue steering the ship post-closing.

Typical Deal Structures

What role do earnouts fulfill within the broader context of a deal structure? Let’s shed light on some prevailing principles pertaining to the fundamental components of the purchase price…

Small Transactions: Those with a Purchase Price of $5 Million or Less

  • Cash: Cash holds the lion’s share of consideration in virtually all transactions. For smaller deals, the cash down payment typically spans from 50% to 100%. It’s quite uncommon to encounter transactions with less than a 50% cash down payment. Should seller financing enter the equation, the norm leans toward a down payment falling in the range of 60% to 70%.
  • Third-Party Financing: Small transactions frequently involve bank financing. If third-party financing plays a role, it’s furnished to the seller as cash upon closing. An important note is that when a third party, like a bank, places a lien on the business’s assets, the seller’s note assumes a subordinate position to the senior lender. In small business scenarios, the SBA 7(a) loan reigns as the prevailing form of third-party financing, with an approximate cap of $5 million. It’s worth mentioning that earnouts may also hinge on lender approval.
  • Seller Financing: Smaller transactions commonly feature seller financing via a promissory note, encompassing roughly 70% to 80% of all deals. These notes typically span three to five years, sporting interest rates ranging from 5% to 8%. It’s crucial to discern that seller financing differs from earnouts, given its predetermined sum and payment schedule. Conversely, an earnout hinges on a future event, rendering the amount unpredictable. If payments are contingent on events, they fall under the earnout category rather than a promissory note.
  • Escrows: Smaller transactions tend to eschew escrows or holdbacks, primarily due to the prevalence of seller financing. Seller financing often steps in as a substitute for an escrow or holdback, capitalizing on the ‘right of offset’ feature, accessible in most states. This right empowers the buyer to offset indemnification or other claims (e.g., material misrepresentation, fraud, etc.) against any outstanding amounts within a seller note.
  • Earnouts: Earnouts are a rarity in smaller acquisitions, potentially stemming from the parties’ relative lack of sophistication in this domain. Earnouts are found in less than 5% of smaller transactions. Their scarcity can be attributed to the intricacy and expense associated with negotiating and meticulously drafting earnouts. In the middle market, buyers, particularly private equity groups, are well-versed in crafting earnouts and are prepared to remunerate their professional advisors accordingly. Conversely, stakeholders in smaller transactions lean toward streamlined deal structures, aiming to minimize professional fees.

Let’s delve into some typical deal structures often encountered in the realm of smaller transactions:

Scenario 1:

  • 100% cash down

Scenario 2:

  • 50% cash down
  • 50% seller financing over 60 months at a 6% interest rate

Scenario 3:

  • 70% cash down
  • 30% seller financing over 36 months at a 6% interest rate

Scenario 4:

  • 20% cash down
  • 60% bank financing through an SBA 7(a) Loan – disbursed to the seller in cash upon closing
  • 10% seller note over 36 months at a 6% interest rate – subordinated to the SBA lender and placed on full-standby (entailing that the seller may not receive any payments until the SBA lender is fully compensated)

Now, let’s explore the dynamics of mid-sized transactions, typically falling within the $5 to $50 million purchase price range:

  • Cash: Cash remains the predominant consideration method in mid-market transactions, constituting between 70% and 100% of the total for larger deals.
  • Stock: Stock exchanges become more common in sizable transactions, particularly when the buyer is a publicly-traded entity. Sellers generally prefer stock that’s liquid and actively traded. Equity rollovers also find application here, where the seller retains a portion of the equity in the target company. For instance, a buyer may acquire 70% of their stock or equity during the closing, while the seller keeps 30% of the equity, a process referred to as ‘rolling over’ the seller’s equity.
  • Third-Party Financing: Although less prevalent than in smaller transactions, bank financing is still a consideration, with the nature and extent dependent on the buyer type, whether financial or strategic. Any third-party financing usually takes the form of cash provided to the seller at the closing. In cases involving a seller note, it’s typically subordinated to the senior lender’s claims, and earnouts may require lender approval.
  • Seller Financing: In mid-sized deals, seller financing sees somewhat less use, typically ranging from 10% to 30% of the total purchase price.
  • Escrow: Escrows, or holdbacks, are commonly employed in mid-market transactions to fund potential indemnification claims arising from a seller’s breach of representations and warranties outlined in the purchase agreement. These escrows typically amount to 10% to 25% of the purchase price and align with the reps and warranties’ survival period, which generally spans 12 to 24 months.
  • Earnouts: Following cash, earnouts emerge as one of the most frequently incorporated components in middle-market mergers and acquisitions (M&A) transactions. Earnouts typically represent 10% to 25% of the total purchase price.

Here are some typical deal structures often encountered in middle-market transactions:

Scenario 1:

  • 80% cash upfront
  • 20% earnout

Scenario 2:

  • 60% cash upfront
  • 20% earnout
  • 20% escrow (holdback)

Scenario 3:

  • 50% cash upfront
  • 20% seller financing over 48 months at 6% interest
  • 20% earnout
  • 10% escrow

Scenario 4:

  • 50% cash upfront
  • 30% third-party financing
  • 20% escrow

Objectives of Earnouts

Primary Objectives of an Earnout

Here are the overarching objectives behind using an earnout strategy in M&A transactions, which are applicable across the board:

  • Bridge Valuation Gaps: Earnouts serve as a valuable tool for resolving disagreements over a business’s value. They come into play when the seller believes the business holds significant untapped potential, likely to be realized in the near future. In times of hot M&A markets, where high prices may only be justified with an earnout component, they effectively bridge the gap between what a buyer is willing to pay based on their outlook and the value derived from current financial performance. These contingent payments, such as earnouts, allow the parties to allocate the risk associated with future performance. They reward the seller if specific objectives are met while minimizing the buyer’s risk in case these objectives fall short.
  • Address Uncertainty: Without an earnout, the primary method to address uncertainty is by reducing the purchase price. Risk and reward are intrinsically linked; higher risk necessitates a lower reward to account for the elevated uncertainty. Earnouts offer a unique solution by reducing the buyer’s uncertainty risk and thereby allowing the seller to reap higher rewards. For instance, if a business exhibits substantial growth potential, an earnout enables the seller to be compensated if this potential becomes a reality.
  • Align Interests: Earnouts are a potent instrument for aligning the interests of both buyer and seller. They frequently serve as incentives to encourage the seller to remain actively involved in operating the business after the transaction’s closure, especially when the buyer is a financial entity. Earnouts also address the imbalance in information — sellers typically possess a deeper understanding of the business and exert more influence if they continue as CEO. Consequently, earnouts can provide the buyer with confidence that the seller will contribute to a smooth transition. Additionally, they can be employed to retain and motivate key managers within the target firm.
  • Mitigate Risk: By diminishing uncertainty, earnouts concurrently reduce risk for the buyer. For instance, a buyer’s risk can be curtailed by withholding a portion of the purchase price until crucial milestones are achieved, such as successful customer transitions, resolution of litigation, or obtaining regulatory approvals like FDA clearance. Earnouts serve as a safeguard against overpayment when the future value of the business remains ambiguous. Buyers are less likely to overpay with an earnout structure in place, as it mitigates their risk. This risk reduction, in turn, enables buyers to offer a more generous purchase price.
  • Align Timing: Many entrepreneurs express the desire to sell their company after the next significant achievement. The solution? Selling the company now but incorporating an earnout that rewards the seller upon the attainment of that future milestone. In numerous cases, having the backing, name, or reputation of a larger competitor increases the chances of closing that next big deal.

Specific Objectives of an Earnout

Here’s a specific objective of employing an earnout in a particular M&A transaction:

Mitigating Business-Specific Risks

Customer Risk: Earnouts prove effective in reducing risks, especially in businesses with substantial customer concentration. During the transition phase, customer losses can occur, particularly if there are changes in personnel that customers have relationships with. When a business relies heavily on just a few customers for the majority of its sales, or when the primary value lies in the customer base, it’s prudent to make a portion of the purchase price contingent on retaining these customers post-closure. This situation often arises when a business depends on revenue from customers without long-term contracts or when a significant contract renewal is imminent. Buyer concerns regarding customer concentration typically emerge when it surpasses 10% of total revenue. It becomes a significant concern when it exceeds 20%-30%. If customer concentration goes beyond 30%-50%, selling the business might only be feasible if the owner is open to a substantial portion of the purchase price relying on customer retention. While there are other ways to address customer retention, earnouts offer the greatest potential for maximizing the seller’s purchase price.

Key Employee Risk: Although less common than mitigating customer concentration risks, earnouts can also be employed to reduce key employee retention risks. The primary tool for addressing the risk of key employees departing after the sale is a retention agreement. These agreements outline specific bonuses paid to employees at designated milestones post-closure. For instance, a seller might offer key employees a bonus equivalent to 10%-20% of their annual salary and base it on their tenure. The amount can be more substantial for instrumental employees. Bonuses are typically disbursed at intervals of 90, 180, and 360 days following the closure. It’s crucial to maintain fairness among employees to prevent resentment. Releasing bonuses in stages ensures employees stay engaged and prevents them from leaving with the bonus to establish competing businesses. Some buyers also incentivize employees with options or other equity forms to secure their commitment to the business.

Product Risk: While relatively uncommon in M&A transactions, product-related risks can be effectively managed using earnouts when they do arise. For instance, if a seller has developed a new product scheduled for release post-closure, a potential buyer might propose paying the seller a percentage of the product’s sales. This is especially relevant when the company has invested significantly in the development and testing of the product. A similar arrangement could be structured to compensate the seller upon obtaining a patent or securing FDA approval for a product.

Third-Party Risk: Risks linked to third parties are frequently encountered in mid-market transactions. However, most parties typically aim to address these risks before closing, especially when third-party approval is a prerequisite. In cases where closing can proceed without third-party consent but there are still potential risks tied to these parties (e.g., concerns about opportunistic rent increases by a landlord), earnouts may serve as a risk mitigation tool. Conversely, if the transaction hinges on third-party approval, like regulatory clearance or license issuance, earnouts are generally not a suitable approach.

Addressing General Transactional Risks & Deal Structure

An Alternative to Escrow: Earnouts frequently serve as an alternative to traditional escrows or holdbacks in M&A deals. The extent to which earnouts replace escrows hinges on the likelihood of the seller receiving the earnout. To opt for an earnout instead of an escrow or holdback, there should be a relatively high probability that the seller will attain a substantial portion of the earnout amount. For instance, if the appropriate escrow amount for the transaction was set at $500,000, both parties should reasonably anticipate that the seller stands a good chance of earning at least $500,000 through the earnout. If breaches of representations and warranties occur, those amounts may offset against what the seller is due via the earnout. In cases where there’s no escrow, and the seller’s probability of earning a significant earnout amount is low, the buyer may recognize that the seller views the earnout as more of a bonus and may lack the necessary motivation for handling indemnification claims, especially if the earnout is the sole remedy for funding such claims.

Dependent on Representations: When a buyer lacks confidence in a seller’s representations or struggles to verify the seller’s claims, they may opt to bring less cash to the closing table and structure a larger portion of the consideration as an earnout. In this context, the earnout is primarily employed as a risk-mitigation tool.

Creative Deal Structuring: Earnouts also serve as a remarkably effective tool for devising innovative transaction structures that might not otherwise materialize. A common scenario involves selling a business to insiders, such as employees or family members, who lack the immediate cash to purchase the business outright. In such cases, the business can be sold with an earnout arrangement, granting control gradually to the insiders as payments are made. This gradual transfer of control can be facilitated through the incremental sale of equity (e.g., stock) to the buyer. This approach offers the seller the advantage of maintaining control until a significant portion of the payments is received.

Control is typically transitioned once the seller has received anywhere from 50% to 99% of the payments. Several protective provisions can be included in the earnout and shareholders agreement to safeguard the seller’s interests in the business, such as drag-along rights, dual-class shares with varying voting rights, and a buy-sell provision. An inherent advantage of this structure is that the seller can promptly regain control of the business if the buyer defaults on payments. Given that the seller remains the majority shareholder, retaining control doesn’t necessitate legal action in case of buyer default.

It’s worth noting that this approach is usually recommended when no other buyers are willing to acquire the business. Caution is warranted when contemplating the sale of a business through an earnout to family members. This situation can place considerable stress on the buyer, particularly if the seller’s retirement hinges on the ongoing success of the business. The seller’s retirement might become contingent on decisions made by their family members, and the desire to maintain control over a business they’ve managed for decades can be overwhelming. Such circumstances and pressures can strain relationships and should be approached with careful consideration.

When Earnouts Should Not be Used

Earnouts should not be employed solely as a shield for buyers against the general external uncertainties associated with running a business. While they often serve to mitigate uncertainty, their design should not aim to safeguard buyers from the broader economic and market-related risks inherent in any business operation. It’s crucial to exercise caution during negotiations to ensure that earnouts are appropriately utilized and do not shift the overarching business risks onto the seller post-closing. However, drawing a definitive line in this regard can be challenging.

For instance, if a business generating $2 million in EBITDA is valued at a baseline $10 million with a 5.0 multiple in the absence of uncertainty, the seller should not accept an offer featuring an earnout that values the company at a reduced baseline of 3.0 multiple ($6 million) while offering the potential for the seller to earn $4 million through an earnout. Conversely, if the same business is on the verge of securing a significant customer that will boost revenue by 25%, it might be suitable to structure a portion of the purchase price as an earnout contingent on securing that new customer. In such a case, the baseline value should remain at $10 million, and an earnout could be established based on the successful acquisition of the new customer.

Earnouts should primarily address specific uncertainties and situations in which the seller is willing to bear the associated risks. If there is no particular uncertainty within the business (such as customer, employee, or product risk) beyond the general economic and market conditions, then employing an earnout is unlikely to be a reasonable choice.

Moreover, earnouts should not be utilized to postpone a company’s valuation to a later point in time. While they can help bridge valuation gaps, parties should not evade discussions about the purchase price when negotiating the letter of intent. Although this tendency is common among risk-averse novice buyers, it holds less sway with experienced buyers, such as private equity firms. Unsophisticated buyers often propose vague earnouts in a letter of intent due to their risk aversion or reluctance to determine the true worth of the company. Essentially, they are deferring their valuation decision to a later stage, which, if unchecked, can jeopardize the deal in the future.

Tips for Using Earnouts

Prerequisites to Using an Earnout

Certain prerequisites must be firmly established before parties can earnestly contemplate the inclusion of an earnout in their agreement.

Cash at Closing: It is imperative that the seller receives an adequate amount of cash at the time of closing, excluding the earnout, to ensure their contentment. In most scenarios, sellers should be prepared to consider any amounts specified in the earnout agreement as a bonus rather than a critical component of the purchase price. The uncertain nature of earnout receipts means sellers should not become overly reliant on them, either financially or emotionally.

Trust & Confidence in the Buyer: Given that earnouts are susceptible to interpretation and potential manipulation by either party, trust plays a pivotal role. Establishing trust is paramount for both the buyer and seller. Without it, the seller may find themselves in a position where close monitoring becomes necessary to prevent potential earnout manipulation. Even with vigilant oversight, the earnout can be subjected to manipulation, leaving the seller with limited recourse, often involving dispute resolution procedures outlined in the purchase agreement. It’s worth noting that earnouts frequently give rise to disputes, but maintaining a fair and trusting relationship between the parties can significantly expedite and streamline resolution processes. In the absence of trust, disputes can escalate into costly and protracted affairs.

For sellers considering retirement, trust becomes even more critical. Retiring sellers often prioritize peace of mind, and the last thing they want is to contend with a toxic relationship marked by the specter of prolonged litigation. Paradoxically, trust serves as the most potent means of averting complications related to earnouts. Buyers often propose earnouts due to a lack of trust in the seller’s assertions. Therefore, whether you are the seller or buyer, projecting yourself as a composed, trustworthy individual in all interactions is essential. Keeping emotions in check is paramount, as even a single instance of losing one’s temper can imperil the transaction structure.

Honesty stands as the cornerstone of trust-building, particularly in the realm of business transactions. In the process of selling a business, nothing surpasses the unvarnished truth in terms of reliability. Prospective buyers are adept at conducting exhaustive due diligence, leaving no stone unturned. Even the tiniest inconsistency is unlikely to escape their scrutiny. If a buyer perceives anything less than complete forthrightness from the seller, they will respond by fortifying the deal with added safeguards – often through mechanisms like earnouts, escrows, and representations and warranties. What was once an appealing proposition can swiftly unravel. Buyers will introduce numerous provisions to mitigate the consequences of potential falsehoods and the associated risks. In the worst-case scenario, they may withdraw from the deal altogether. However, when a buyer believes they are dealing with an honest, conscientious, and dependable seller, they are inclined to propose a more conservative deal structure with a larger upfront cash component.

Trust also assumes paramount importance in situations where the buyer will assume control of operations post-closing. The seller must place their trust in the buyer’s competence and ability to effectively manage the business in this new phase. Additionally, the seller must have faith in the buyer’s strategic direction or be prepared to relinquish control entirely. For many entrepreneurs accustomed to steering the ship for decades, letting go can be a challenging feat. Trust is equally pivotal in the context of rollups, where the seller’s prospects hinge on the buyer’s adept execution of their strategy. If the buyer lacks essential skills necessary for sound business operation, the seller risks alienating key customers and employees, which could significantly impact earnout payments.

In the event that the buyer suggests an earnout arrangement, it becomes imperative that due diligence is a two-way street – meaning that the seller should conduct a thorough evaluation of the buyer, both operationally and financially. Soft skills such as communication and management capabilities should be scrutinized, particularly if the envisaged relationship extends beyond the closing phase, akin to a long-term partnership. If the buyer has executed previous acquisitions, the seller is well within their rights to request contact with former owners of the acquired companies, a reasonable and often granted inquiry.

Control also looms large in the landscape of earnout agreements, often serving as fertile ground for disputes. Control over the business equates to the power to influence the earnout. If the seller retains control over post-closing business operations, they should wield a meaningful degree of influence over these operations. On the other hand, if the buyer assumes control, they gain the ability to manipulate earnings to reduce the earnout amount. This can be effortlessly accomplished if the buyer owns another company, allowing for the transfer of revenues or expenses between the two entities. While top-line metrics like revenue are challenging to manipulate, lower-level metrics such as EBITDA are more susceptible to such alterations. Regardless, all earnouts remain susceptible to manipulation, underscoring the critical significance of control in any earnout agreement.

Control over the course of an earnout arrangement is often addressed by incorporating specific language into the agreement that dictates how the party managing the business should operate. For instance, the agreement may stipulate that the buyer must ‘manage the business in a manner that maximizes the earnout amount’ or ‘avoid intentionally minimizing the earnout amount through business operations.’ Such broad yet essential language comes into play when there are multiple tactics available to manipulate the earnout.

Stand-Alone (Minimal Synergies): One of the primary limitations of earnouts lies in their capacity to support integration efforts. Once the target business becomes integrated into the parent company, gauging the earnout’s performance can become incredibly challenging, if not entirely unfeasible. Earnouts find their most suitable applications when the business in question remains autonomous post-closing or continues to function as a distinct subsidiary under the buyer’s umbrella, particularly when the existing management team stays in place.

Consequently, earnouts are generally reserved for businesses slated to maintain their stand-alone status after the deal or for scenarios where the earnout can be assessed objectively. Examples include:

  • An earnout contingent on unit sales of a product (e.g., $1.00 per sale of each unit of ABC Software).
  • Retention of crucial employees or clients.
  • Achieving specific milestones like a product launch or securing a patent or FDA approval.

Broad-based financial metrics, such as revenue or EBITDA, pose considerable challenges when two businesses are integrated.

In cases where synergies are anticipated between the target company and the acquirer, a viable alternative often considered is a stock-for-stock transaction structure. However, this option tends to be more appealing for the seller if the acquirer is a publicly traded company with a well-established market for its shares. From the buyer’s perspective, this structure offers the advantage of using equity as a means of transaction payment, fostering a robust alignment of interests between the buyer and seller.

Motivation: When the owner intends to continue with the business post-sale, it’s crucial that they remain highly motivated. If the seller is experiencing burnout, opting for an earnout structure might not be advisable unless the business is not overly reliant on the owner’s personal involvement. Sellers should exercise caution when expressing their level of burnout, as buyers might become wary if they perceive the seller’s motivation to diminish after the sale. Buyers may also raise concerns if the seller appears less than enthusiastic about earning the potential payout from the earnout. Demonstrating a strong commitment to executing the strategic plan necessary for the earnout can alleviate such concerns.

Location: International or cross-border transactions can introduce significant complexities into the structure of earnouts. While international legal standards are increasingly converging with U.S. laws in these scenarios, acquisitions involving domestic companies can have legal implications if the target firm has substantial foreign operations. In cases where a foreign buyer is acquiring a U.S.-based company, the transaction typically falls under the purview of U.S. attorneys, and the seller’s legal counsel does not necessarily require specialized knowledge of international law. Conversely, when a U.S.-based company is acquiring a foreign entity, it is advisable to engage foreign legal counsel. Nevertheless, these transactions often share similarities in handling and documentation with domestic deals, though specific nuances may necessitate attention.

Irrespective of the legal framework, having an efficient dispute resolution system in place is paramount. Earnouts tend to be less favored in countries where contract enforcement is relatively lax. In most international transactions, selecting a neutral jurisdiction for the ‘choice of law’ provision is common practice to discourage disputes. These nuances can also impact the dynamics of an earnout arrangement. For instance, a neutral ‘choice of law’ provision can discourage the seller from initiating disputes while potentially encouraging the buyer to test the boundaries, knowing that the seller is disinclined to engage in litigation.

Tips for Drafting an Earnout

  • Exercise Caution with Unsolicited Offers: When business owners receive unsolicited offers, it’s important to be vigilant. These offers often include earnouts that make up a significant portion of the purchase price. Many sellers, especially those without extensive experience, may find it challenging to assess the true value of such offers. In such cases, it’s advisable to engage the expertise of an experienced M&A advisor, attorney, and CPA to thoroughly evaluate the offer. Unsolicited offers are rarely the highest possible price and are typically extended by opportunistic buyers looking for a bargain. The maximum value of a business is usually realized through a controlled auction process, where numerous potential buyers are confidentially approached.
  • Appropriate Earnout Size: The size of an earnout should correspond to the level of risk inherent in the business. For instance, if a business relies heavily on a single customer for 80% of its revenue, it would make sense for the earnout to constitute a significant portion of the purchase price. Conversely, if the business is relatively low-risk and lacks major uncertainties, the earnout should serve as a tool to incentivize the seller rather than shift post-closing operational risks onto them.
  • Consider the Duration: It’s essential to exercise caution when it comes to the duration of earnouts. While earnouts can extend up to five years in some cases, this is relatively rare. Typically, earnouts lasting longer than three years should be approached with caution.
  • Flexibility is Key: In cases where a business carries substantial, uncertain risks, both parties should be prepared to exhibit flexibility in structuring the transaction. This might entail reducing the purchase price to account for heightened risk or incorporating protective mechanisms within the deal to mitigate the buyer’s exposure.
  • Timing Matters: To maximize the purchase price, it’s often advantageous to delay the sale until the business’s earnings have materialized. The more potential is realized and risks are minimized, the higher the purchase price can be negotiated. Conversely, if unrealized potential and uncertainties are transferred to the buyer, the seller is likely to receive a lower valuation for their business.
  • Precise Metric Definition: Earnouts based on revenue are generally less susceptible to manipulation, easier to monitor, and preferable for sellers. If the earnout is linked to a profitability metric, it’s imperative to have a clear and well-defined measurement. Additionally, responsibilities for managing the business, accounting, and financial aspects should be carefully allocated between the buyer and the seller.
  • Realistic Thresholds: Avoid overly aggressive or all-or-nothing earnout structures, which can introduce unnecessary complexity and risk into the deal.

Tips for Preventing an Earnout for the Seller

Presale Preparation

Proactive Risk Management: To avoid earnouts as a seller, proactive preparation is key. Conduct a thorough business assessment to identify potential risk factors that could trigger earnout proposals in a deal. By minimizing these risks before approaching buyers, you can significantly reduce the likelihood of earnout discussions. Buyers are more likely to propose earnouts when they have lower confidence in your business.

Owner Independence: A critical aspect is the level of owner dependence. If your business is perceived as heavily reliant on you, with personal relationships with employees and customers, and your identity tightly woven into the business, buyers may view this as risky. Such perceptions can lead to lower purchase offers or earnout proposals. However, if you’ve built a strong management team and your business operates independently of you, you’re more likely to receive a higher cash portion at closing.

Long-Term Value: Even if you’re not planning an immediate sale, minimizing business risks is wise from an operational standpoint. This proactive risk management not only reduces the potential for earnouts but also enhances your business’s overall value. Remember, value is closely tied to the balance between potential returns and risks, so lowering risks inherently boosts your business’s value.

Presale Due Diligence:

Prior to initiating the sales process, it’s essential to conduct presale due diligence. This preemptive measure mirrors the buyer’s due diligence process and aims to uncover potential issues that buyers are likely to identify. By proactively addressing these concerns before listing your business, you can minimize risks and enhance its market appeal. While a buyer’s initial letter of intent (LOI) may not include an earnout provision, if they encounter significant undisclosed issues during due diligence, they may seek to mitigate these risks by reducing the purchase price or proposing an earnout. It’s not uncommon for earnouts to surface as a solution when unanticipated problems arise later in the deal. To counter this, engaging a third party, such as an accountant, attorney, or M&A advisor, to conduct presale due diligence and help resolve identified issues is a crucial strategy.

Negotiating Posture & Momentum

Strategies for Earnout Prevention: In addition to conducting presale due diligence, two powerful tools for avoiding earnouts are a strong negotiating position and effective negotiation skills. A robust negotiating position arises from having multiple potential buyers and the freedom to choose whether to sell. Maintaining a composed demeanor throughout negotiations is key to upholding this posture, as honesty and trust play pivotal roles in earnout prevention.

Managing Expectations: It’s crucial to set clear expectations with buyers, ideally through a third-party intermediary like an M&A advisor, right after the Letter of Intent (LOI) is accepted. This includes conveying that renegotiating the deal post-acceptance is not an option.

Maintaining Momentum: Momentum during the sale process is critical. Some buyers intentionally slow negotiations, hoping to wear down the seller over months of exclusive discussions. This can leave sellers in a vulnerable position, susceptible to last-minute changes.

Preventing Retrading: Retrading, where buyers seek to renegotiate the purchase price during late-stage due diligence, can be averted by preparing your business for sale thoroughly. By minimizing potential flaws that buyers could exploit as leverage and by standing firm in negotiations, you can send a message that you won’t easily succumb to such tactics.

Emotional Preparedness: As a seller, it’s essential to understand the rigorous nature of due diligence and be emotionally ready for this process. Buyers will conduct meticulous investigations, and you should remain composed and open throughout, avoiding overreactions or secrecy that might trigger buyer concerns and increase the likelihood of earnout proposals.

Alternatives to Consider

Earnouts are not a universal solution. They don’t fit every deal. The primary purpose of an earnout is to resolve pricing differences, manage risks, and motivate the seller. When there’s a disparity in price expectations, it’s crucial to identify the underlying cause and then select the right approach to address it. The key is to align the deal structure with the parties’ objectives. Generally, buyers aim to ensure that sellers remain committed. Typically, a combination of strategies is employed to reduce risks and maintain the seller’s engagement.

Equity

Equity is a suitable choice if the seller plans to stay with the business long-term and retain control. Typically, it involves the seller rolling over a portion of their shares. For instance, the buyer might acquire 70% of the seller’s shares, leaving the seller with a 30% stake. When dealing with lengthy earnouts spanning five years or more, it’s often more practical to opt for equity incentives. The primary benefit of equity is its ability to align incentives effectively over the long haul, whether for 5, 10, or even 20 years. It encourages the seller to consider both short-term gains (distributions) and long-term growth in the business’s value. Parties should also outline how the seller will eventually liquidate their shares, usually through a future exit, with well-drafted bylaws, shareholders’ agreements, and buy/sell agreements being essential.

Employment Bonuses

Employment bonuses share similarities with earnouts, but they find their niche when the seller assumes a well-defined role within the business, like continued involvement in marketing efforts. While earnouts typically hinge on broad business metrics like revenue and EBITDA, employment bonuses target specific aspects of the business. This approach is better suited when the seller’s post-closing involvement doesn’t entail managerial responsibilities but rather focuses on distinct, non-management roles.

Consulting Agreement

Consulting agreements resemble employment bonuses but serve a different purpose – easing the business transition from seller to buyer. Typically, these agreements involve the seller providing ad-hoc assistance to the buyer at an hourly rate, with ongoing availability for transition-related matters via phone or email. This arrangement is ideal when the buyer seeks long-term transition support from the seller, especially if the seller won’t be involved in the business’s day-to-day operations. It’s worth noting that both employment and consulting agreements have a tax drawback for the seller, as payments are subject to ordinary income tax rates, although they are deductible for the buyer.

Escrows & Holdbacks

In an escrow arrangement, both parties appoint an impartial third-party escrow agent responsible for holding a portion of the purchase price, typically around 10% to 25%. This reserved sum is set aside to address any post-closing indemnification claims that may arise. It remains under escrow for a specific period, typically lasting 12 to 24 months, known as the ‘survival period.’ This fund is governed by a formal escrow agreement and can only be released upon mutual agreement between the buyer and seller, outlining the conditions for its release and dispute resolution procedures.

Escrows are intrinsically linked to the representations and warranties defined in the purchase agreement. They serve as a safeguard, ensuring that the buyer can readily recover damages in cases where the seller has engaged in fraudulent activities, made substantial misrepresentations, or provided inaccurate information about the business. Interestingly, an earnout can be seamlessly integrated with an escrow arrangement, allowing earnout payments to be held in escrow until they are due, providing the seller with assurance regarding the availability of funds when the time comes. Additionally, in some scenarios, earnouts can be used in lieu of traditional escrows, and any indemnification claims can be offset against earnout payments.

Representations & Warranties (R&W)

Reps and warranties are a substantial portion of the typical middle-market M&A purchase agreement, accounting for approximately half of its content. Representations involve the declaration of past or existing facts, while warranties encompass promises that these facts will remain true. They serve as a means to compel the seller to disclose critical information about the business before finalizing the purchase agreement.

If any of these representations and warranties are later found to be inaccurate or breached, meaning the seller knowingly or unknowingly provided false information to the buyer, the buyer is entitled to seek indemnification. The specifics of reps and warranties can be the subject of intense negotiation in most transactions. They often include thresholds, both minimum and maximum, and other conditions that trigger when an indemnification claim can be initiated.

For instance, if there’s a minimum threshold, often referred to as a “floor,” set at $25,000, the buyer may not pursue indemnification for claims below this amount. Reps and warranties essentially serve as a risk allocation tool between the buyer and seller. When the buyer has particular concerns about specific risks associated with the business, these can often be addressed through strongly worded representations and warranties in the agreement, thus obviating the need for an earnout. Moreover, these representations and warranties can be backed by an escrow arrangement for added security.

Type B Reorganization

A Type B reorganization involves a stock-for-stock exchange where the buyer swaps the seller’s shares for stock in its own company, essentially exchanging ownership stakes. In this arrangement, the seller acquires shares in the buyer’s company, and conversely, the buyer gains ownership in the seller’s company. Importantly, the target company (seller) continues to operate independently as a subsidiary of the buyer.

This structure is most suitable when the seller is a publicly-traded company with readily tradable shares or when the seller doesn’t need immediate liquidity and perceives strategic benefits in merging with the buyer. If the stock isn’t easily traded, the seller may find themselves holding less liquid shares, making it challenging to convert them into cash. Typically, there are restrictions on when the seller can sell these shares, and they may request “registration rights” to improve their ability to sell the stock.

The primary advantage of a Type B reorganization is its tax-deferred nature, as the seller doesn’t incur taxes until they eventually sell the new shares.

Seller Financing

Instead of opting for an earnout, another approach is structuring a portion of the purchase price as a seller note or promissory note. This method offers the advantage of a “right of offset,” allowing the buyer to offset amounts owed under the seller’s note against indemnity claims. Essentially, it provides the buyer with the ability to deduct any indemnification claims from the seller note. This can lead to arguments against the necessity of an escrow or holdback, given the protection offered by the right of offset in the seller note.

Additionally, the parties can incorporate negative covenants within the note to reduce payments if the business’s performance falters, although such clauses are relatively uncommon. It’s important to note that structuring part of the purchase price as a seller note is most suitable when the buyer is concerned about the accuracy of representations and warranties in the purchase agreement. However, it is not typically a direct substitute for an earnout, as the right of offset is primarily linked to the purchase agreement’s indemnification provisions and may not address the business’s financial performance.

Royalties & Licensing Fees

Royalties and licensing fees find their strongest application when tied to product sales, especially in scenarios where the seller is on the cusp of launching a new product, making revenue prediction a challenging task. This approach is also quite handy when the seller has an array of products in various stages of development, whether they are part of the company’s portfolio or independent ventures. I recently encountered a situation fitting this description with an online retailer specializing in proprietary automotive parts. While a significant 90% of their revenue came from one product line, they had a second product line in development poised to contribute around 30%-40% of the revenue once launched. We explored the option of segregating this product line into a separate company, but it proved to be a complex endeavor. Instead, we found that implementing a royalty or licensing fee arrangement was the most pragmatic and effective solution.

Clawbacks or Reverse Earnout

A clawback is essentially the reverse of an earnout. In a clawback arrangement, the seller receives the full payment at closing and is then obligated to refund the buyer if specific targets outlined in the agreement are not achieved. It’s worth noting that clawbacks aren’t typically favored by either buyers or sellers. Buyers may be reluctant to go through the process of reclaiming funds, and sellers may find it undesirable to repay money they’ve likely already put to use. Clawbacks are more prevalent in situations where funds are provided to a business for expansion purposes, and the business owner has not utilized the funds as initially intended.

Key Elements of an Earnout

Size

Earnouts typically constitute a portion of the purchase price, usually ranging from 10% to 25%. However, there are instances where a larger earnout may be considered. These situations include:

  • Selling the business to insiders like employees or family members who may not have the necessary cash for a substantial down payment.
  • Dealing with exceptionally high risks, such as having a customer concentration exceeding 30% or concentrated risks associated with products or employee retention.

Measurement (Metric)

The cornerstone of an earnout is its underlying formula. Regardless of the chosen metric, there’s always room for interpretation and potential manipulation by the involved parties. However, opting for a metric that is objectively defined and verifiable by a third party minimizes this risk.

When selecting the metric, it’s crucial to contemplate post-closing business operations. Who will be in charge, the buyer or the seller? Will the business merge with another? What are the buyer’s primary concerns? Is the earnout intended to mitigate risk or motivate the seller? Understanding these transaction dynamics and underlying motivations is essential for structuring a successful earnout.

Depending on the circumstances, revenue may be the right choice, while in other scenarios, metrics like EBITDA or non-financial factors might be more suitable. There’s no universal solution, but a well-informed decision can lead to a more effective earnout arrangement.

Financial Metrics

Earnouts can take various forms, hinging on revenue, gross profit, net profit, or their variations. Typically, sellers lean toward revenue-based earnouts, while buyers tend to favor profit-based ones, as profit is their primary concern. It only makes sense to align the earnout with what the buyer values most and can reasonably afford. But what happens if a business generates substantial revenue but lacks profitability? How would the earnout be funded in such a scenario?

For sellers who won’t retain control post-closing, a revenue-based earnout may be the wiser choice. If the earnout is profit-based and the buyer manages the business, it opens the door to potential manipulation of expenses, leading to higher dispute potential.

Simplicity is key. Complex earnout agreements often breed disputes. Sellers typically prefer straightforward performance metrics like sales, units sold, or gross profits. These metrics are less prone to manipulation compared to profit-based ones. In fact, revenue-based metrics are used approximately twice as often as earnings-based ones, simplifying the process and reducing the likelihood of disagreements.

Regardless of the chosen financial metric, disagreements may persist over measurement methods or expense allocation. The more intricate the agreement and calculation, the higher the chance of disputes. Opting for metrics higher on the profit and loss statement, such as revenue, tends to minimize conflicts.

Revenue: Basing an earnout on revenue can present challenges because a company’s revenue growth may not align with profitability. A business could experience substantial revenue growth while remaining unprofitable, or it might become highly profitable with slower revenue growth. Revenue-focused earnouts incentivize sellers to boost sales while potentially overlooking cost management. This singular focus on revenue might come at the expense of crucial aspects like employee retention and product quality. Since revenue-based metrics disregard expenses, sellers might favor heavy spending on advertising, marketing, or other cost-driving activities. They may also lower prices, impacting profitability, or extend trade credit to maximize revenue. While revenue metrics are less susceptible to manipulation, their primary drawback is their failure to consider the bottom line—profits.

Gross Profit: In scenarios with flexible pricing, buyers might opt for earnouts tied to gross profit, especially in sales-centric industries. Similar to revenue-based earnouts, gross profit targets share some challenges. However, they find greater suitability in industries where gross margins play a pivotal role and where custom pricing is prevalent.

Profit (EBITDA, Net Income): Earnouts based on profit measurements, such as EBITDA or net income, require meticulous definitions of profit. Numerous factors, including income taxes, distributions, amortization, goodwill, non-compete clauses, interest, perks, and deductions, must be clearly outlined. The treatment of capital expenditures and the ability to amortize goodwill or non-compete expenses should also be specified. If the seller continues to operate the business, guidelines for their annual salary must be established. In cases of acquisition by a competitor, allocation of corporate overhead between companies needs clarity. Defining profit and instituting rules to maximize earnout value is essential for effective profit-based earnouts.

Royalties (# of Units): Royalty-based earnouts compensate sellers per unit of product sold, offering a straightforward measurement method. This approach is well-suited for transactions where buyers intend to reward sellers based on successful product launches.

Irrespective of the chosen financial metric, parties should also address the following considerations:

  • How is the earnout measurement conducted? Following GAAP or a modified GAAP approach?
  • How do bad debts affect earnout calculations? Are reserves set up for bad debts, or are they deducted from earnings upon write-off? What’s the write-off timeline (e.g., 30, 60, or 90 days)?
  • What post-closing accounting methods will be employed for the target? Will the buyer maintain existing accounting policies? Will financials be prepared using cash-basis or accrual-basis methods? Will the earnout be based on financial statements or tax returns?

Non-Financial Metrics

Non-financial milestones and targets can serve as the basis for earnouts in certain transactions. These milestones can encompass a wide range of specific events or outcomes. To ensure clarity and minimize potential disagreements, any non-financial metric or milestone should be as specific and objective as possible.

Here are some examples:

  • Retention of Key Customers: Earnouts can be structured to release in stages as key customers are retained.
  • Retention of Key Employees: Earnouts may be contingent on the retention of critical management or other key personnel.
  • Product Launch: Sellers can receive earnout bonuses for achieving a successful product launch.
  • Third-Party Approvals: Earnouts can be linked to obtaining approvals from third parties, such as landlords or governmental authorities.
  • Patents: Earnouts might be based partially or entirely on securing final approval for a USPTO patent.
  • FDA Approval: Earnouts can be tied to the successful attainment of FDA approval.

Thresholds

Some earnouts are structured with specific conditions for the seller to receive payments. These conditions might include reaching a minimum revenue threshold or averaging performance over several years. Earnouts can take various forms, from all-or-nothing arrangements to proportional payments. In some cases, sellers receive periodic payments throughout the earnout period. However, disputes often arise when the performance falls short of the specified minimums.

Typically, earnouts are paid as a percentage of a financial metric, rather than following an all-or-nothing model. But what happens when there are fluctuations in revenue or EBITDA? For instance, if an earnout grants the seller 3% of revenue only if annual revenue surpasses $10 million, how should the amount be calculated if the business generates $12 million in the first year, $20 million in the second, and $8 million in the third? Do the high-revenue years compensate for the low ones? Is there a cap on the upside if revenue reaches $100 million? The structure of multi-year earnouts is typically customized for each deal, with no standardized approach.

Here’s a summary of the primary methods for establishing earnout thresholds:

Minimums (Cliffs, Floors): With a cliff payment structure, the earnout is only paid when a specific target is met. If the target isn’t achieved, there’s no payment. Cliffs are advisable when the thresholds are set very low. For instance, if the cliff is set at $10 million, the seller would receive no earnout if the revenue falls below $10 million but would receive it if it exceeds $10 million. In this case, the earnout might be structured to pay the seller 5% of revenue only when revenue surpasses $10 million.

Tiers: Tiered payments involve a series of targets. The earnout amount can increase or decrease as each target is reached. For example, the earnout might pay the seller 5% of EBITDA up to $3 million, 6% of EBITDA up to $5 million, and 7% of EBITDA if it exceeds $7 million annually.

Maximums (Caps, Ceilings): A cap sets an upper limit on the earnout amount, increasing the buyer’s total liability. Caps can be applied annually or over the entire duration of the earnout. For instance, an earnout may pay the seller 5% of EBITDA up to $5 million. If the business generates $10 million in EBITDA, the seller would earn $250,000 ($5 million x 5% = $250k). Alternatively, the earnout could pay the seller 5% of EBITDA, with the total value of the earnout not exceeding $1 million over its lifetime.

Combinations: Earnout structures can combine cliffs, tiers, and caps. For example, an earnout might be structured as follows:

  • EBITDA under $1 million = 0% (cliff)
  • EBITDA between $1-3 million = 3% (tier 1)
  • EBITDA between $3-5 million = 5% (tier 2)
  • EBITDA exceeding $5 million = 0% (cap)

Let’s explore some additional nuances in earnout structures:

Sliding Scales: In situations where a cliff seems unlikely to be met for the year, it can demotivate the seller. A sliding scale offers a more motivating alternative. It provides the seller with some bonus, even if the metric falls considerably short of the target.

Mixed Metrics: Earnouts can incorporate multiple metrics simultaneously. For instance, an earnout might pay the seller 3% of revenue above $10 million, but only if EBITDA exceeds $2 million (the cliff). This example combines both revenue and EBITDA metrics. However, it’s essential to note that earnouts with multiple metrics can become intricate quickly.

Cumulative Thresholds: Some earnouts feature cumulative performance thresholds. In this scenario, the seller must compensate for shortfalls below the threshold in any period before earning the full earnout. For example, if the earnout pays the seller 1% of revenue above $10 million, and the seller generates only $8 million in revenue in the first year, they must generate $12 million in the second year to start accruing the earnout. Additionally, if the company exceeds the metrics, any surplus may carry over from one year to the next. In the example mentioned, if the seller generates $12 million in the first year, they would receive a payout even if they only generate $9 million in the second year because $2 million would carry over from the first period. This is sometimes referred to as a ‘carry-forward provision,’ where excesses are carried over to meet minimums in future years. On the other hand, a ‘carry-back’ provision would enable the seller to apply current-year excesses to previous years’ deficiencies, allowing them to make up for missed goals in the past. Essentially, it spreads the revenue or earnings throughout the entire period, rather than confining the earnout to one specific time frame.

Time Period

Let’s delve into the concept of the measurement period in earnouts:

Measurement Period: The measurement period serves as the foundation for calculating the earnout, determining the timeframe over which performance will be evaluated. In the realm of transactions, it’s common to find measurement periods spanning from one to three years, constituting around two-thirds of cases. Within this period, there can be multiple payment triggers, adding layers of complexity to the earnout structure. For instance, consider a three-year measurement period with annual payments, each contingent on meeting predefined thresholds like minimums, maximums, or tiered goals. Typically, these payment triggers align with the financial reporting cycle, often coinciding with calendar or fiscal years (e.g., January to February).

Short vs. Long Terms: The choice between shorter and longer measurement periods carries distinct implications. Shorter terms tend to involve fewer variables, offering a clearer path to earnout calculation. Conversely, longer terms introduce more uncertainty, making them susceptible to external events that may impact performance. In theoretical terms, longer earnout periods may have a lower present value when evaluated through discount cash flow analysis. Furthermore, the extended duration raises the potential for disputes. However, circumstances may warrant a longer measurement period, particularly if the seller and management team intend to oversee the business for an extended period. In such cases, buyers may opt for equity grants rather than earnouts. Additionally, some buyers index long-term earnouts to inflation, ensuring that the earnout reflects real growth while factoring out inflationary effects.

Control

Equity Control Shift: With the earnout contingent on post-closing performance, it’s crucial to recognize that equity control of the business has shifted to the buyer. To mitigate potential conflicts arising from this shift, buyers often grant sellers a degree of control over day-to-day operations during the earnout period. This measure prevents buyers from manipulating the business to minimize earnout payments. The extent of control granted to the seller varies significantly and hinges on the specifics of each deal. Sellers may retain authority over key strategic decisions, maintain control over accounting practices, or secure access to vital financial information.

Contractual Safeguards: In addition to these provisions, earnout agreements frequently incorporate clauses that mandate the buyer to operate the business without diminishing the earnout’s value or to run it in a way that maximizes the earnout’s potential. Such language ensures that the buyer adheres to consistent practices and avoids actions detrimental to the earnout’s performance. Even in the absence of explicit contractual obligations, many state laws enforce an implied duty of good faith, prohibiting buyers from intentionally manipulating the earnout.

Strategic Role Post-Closing: Sellers should proactively decide their preferred role in the business following the closing. Identifying your strengths, passions, and areas of maximum value contribution is pivotal. It doesn’t necessarily mean staying as the CEO; many buyers appreciate sellers who focus on revenue growth aspects like sales and marketing. By shedding management responsibilities and dedicating 100% effort to revenue-focused areas, sellers can significantly impact business growth and, subsequently, the earnout. Embrace your core competencies, especially those that bring you joy – whether it’s product evangelism, industry engagement, content creation, sales training, marketing, or another facet of the business.

Controls and rights within an earnout agreement can extend to various critical areas, each requiring clear delineation:

Strategic Control: The buyer can opt to grant the seller a degree of strategic control over the business. This strategic influence allows the seller to participate in decisions that shape the company’s future, particularly those involving long-term investments with implications beyond the earnout period. These strategic decisions may encompass aspects like product quality, brand development, and research and development (R&D), versus short-term objectives like sales and marketing. It’s prudent to set minimum budgets for sales and marketing to avoid disputes. Staffing decisions can also be a point of contention, as they can significantly impact earnings. Alternatively, the agreement may stipulate that significant changes to the business model during the earnout period require mutual consent. However, excessive restrictions on operational flexibility may hinder execution. Sellers should be mindful that most buyers are reluctant to accept stringent operational constraints. As an alternative, certain long-term costs incurred by the buyer, such as R&D or legal fees for patent acquisition, may be excluded from the earnout calculation.

Financial Control: Financial control closely aligns with strategic control. When a buyer has multiple companies under their ownership, they might redirect revenue or expenses among these entities, affecting the earnout amount. Granting the seller control over financial aspects like budgeting and expenses can alleviate concerns about potential manipulation. It’s crucial to address the impact of financing and interest expenses in the earnout agreement. Considerations include the funding of the business, sufficiency of working capital, and the source of additional cash if needed.

Accounting Control: Accounting practices wield substantial influence over a business’s reported earnings. The application of Generally Accepted Accounting Principles (GAAP) allows for discretion in areas like depreciation methods and expense accounting. Questions may arise about the treatment of contingent liabilities, establishment of bad debt reserves, expensing of capital expenditures under Section 179, and allocation of corporate overhead in shared expense scenarios. The seller should recognize how these practices can impact earnings and, consequently, the earnout. While many earnout agreements specify the continuation of historical accounting practices, it’s advisable for the seller to seek their CPA’s input on the earnout language regarding post-closing financial preparations. Although depreciation might be less relevant if the earnout metric relies on revenue or EBITDA, the buyer retains the ability to manipulate earnout amounts if accounting practice restrictions are not in place. Access to accounting and financial information, often referred to as audit rights, should also be addressed within the earnout terms to ensure transparency.

Payment

The earnout agreement must provide clear details regarding payment frequency, whether it’s on a quarterly, annual, or other schedule, and the method of payment, which could be in the form of cash, stock, or promissory notes. For annual payments, precise payment dates should be specified. Will they be disbursed 60 days after the year-end or 90 days? Contingency plans for disputes should also be outlined.

In cases where payment involves a combination of forms, a well-defined formula must be established to calculate the conversion rate between them. Additionally, it’s essential to determine the source of funds for the earnout payments. Does this amount count as an additional expense affecting future earnout calculations? In simpler terms, is the earnout deducted from earnings when computing subsequent earnout payments?

Dispute Resolution

The earnout agreement must provide clear and unambiguous guidelines for resolving disputes related to the earnout. Typically, earnouts are integrated into the purchase agreement, and dispute resolution procedures are governed by the purchase agreement. Alternatively, the parties can draft a separate earnout agreement that outlines distinct dispute resolution methods not covered in the purchase agreement.

Attorneys often have distinct preferences when it comes to dispute resolution mechanisms. Some attorneys may strongly advocate for mediation, while others may favor arbitration. Arbitration is sometimes preferred because it tends to be quicker, cost-effective, and allows the parties to select an arbitrator with expertise relevant to the dispute. The cost considerations associated with institutions like the American Arbitration Association may also be taken into account by attorneys.

In addition to the conventional dispute resolution options, the agreement should include provisions for third-party confirmation. This entails engaging an independent third party, such as a CPA firm, to make impartial determinations. The extent to which these determinations are binding should be carefully delineated in the agreement.

Lastly, the potential implications of including a ‘loser pays attorney’s fees’ clause should be thoroughly examined, as the optimal approach may lie somewhere between the extremes in the event of a dispute.

Protections to Ensure Payment

As an earnout represents a deferred portion of the purchase price, sellers may seek protective measures to ensure its payment. Earnouts typically constitute unsecured contractual obligations, differing from the safeguards found in promissory notes and security agreements. Nevertheless, there are provisions that can be incorporated to protect the seller’s interests.

One option is to include a provision that restricts shareholder distributions or loans until the earnout payments are fulfilled. This prioritizes earnout payments before any funds are extracted from the business by the parent company.

Another approach is to hold aside or escrow the earnout amount as it’s earned. For instance, if the earnout agreement stipulates payment of 1% of revenue exceeding $5 million, 1% of revenue can be set aside once the revenue surpasses this threshold. This amount can be promptly allocated to ensure availability.

In cases where the buyer is an individual, it may be prudent to request personal guarantees from both the buyer and their spouse to secure the earnout. However, securing the earnout obligation with the business’s assets is a less common provision, as few buyers are inclined to agree to such terms.

Misc. Provisions

Determining the parties involved in the earnout is a crucial step. In cases with multiple parties, it’s essential to establish how earnout payments will be distributed among them. Contingencies must also be considered, such as scenarios where the seller is unable to continue running the business due to health reasons, and the buyer takes over. In such cases, would the seller still receive the earnout payments as agreed upon?

Additionally, the impact of a business acquisition should be addressed. If the business is acquired by a new buyer, would the earnout obligations be assigned to the new entity, and who would be responsible for fulfilling the payment commitments?

Contingency planning for unforeseen events, including acts of nature or unexpected geopolitical situations, is advisable. While it’s impossible to predict every potential scenario, earnout agreements can be renegotiated when unexpected events arise. However, this process is greatly facilitated when there is a strong foundation of goodwill and trust between the buyer and seller. A positive working relationship ensures that most disagreements can be resolved quickly and amicably.

Legal, Accounting & Tax Implications

Hiring Professionals

When it comes to hiring professional advisors for your business dealings, my top recommendation is crystal clear: work exclusively with seasoned advisors, particularly those with extensive experience in buying and selling businesses. Surprisingly, opting for a seemingly ‘affordable’ advisor lacking real-world experience can ultimately prove far costlier than investing in the expertise of the most ‘expensive’ but highly experienced advisors.

Let me illustrate this with a common scenario involving CPAs who, with the best of intentions, can inadvertently jeopardize deals by offering unsolicited opinions on a business’s value. These opinions may be grounded in logic applicable only to publicly traded companies or involve valuation methods like DCF that don’t align with the realities of small to mid-sized businesses. For instance, you might encounter a CPA suggesting that a reasonable multiple for a business is seven to nine times EBITDA when, in truth, market multiples are closer to three or four times. Unfortunately, such well-intentioned but inaccurate assessments are not uncommon in the world of CPAs. Therefore, if a CPA or any other advisor ventures to opine on your company’s value, it’s entirely fair to inquire about their personal involvement in transactions of this nature.

Selling a business is a delicate dance involving myriad trade-offs. Price is inextricably linked to the risk-reward balance. When perceived risks run high, buyers may either propose a lower purchase price or seek to mitigate those risks through transaction structuring, such as earnouts or robust representations and warranties. For your advisor to effectively guide you through this intricate process, they must possess a profound understanding of your business from an operational perspective. This way, they can aptly evaluate how a buyer’s proposed deal mechanisms harmonize with the overarching deal structure.

Your advisors must also grasp the inherent risks within your business, especially those that potential buyers might discern. Bear in mind that a buyer’s risk perception can vary widely from one individual to another. Your advisor’s ability to comprehend these dynamics enables them to discern how a buyer’s proposals intersect with the comprehensive deal structure and their risk assessment. Consequently, your advisor can propose alternative deal structures that align with both parties’ objectives.

The best advisors are characterized by their extensive, pertinent experience. They intimately comprehend your business and industry and are adaptable enough to accommodate the needs of all parties involved. Negotiating a deal necessitates navigating countless trade-offs, demanding flexibility and concessions from both you and your advisor to successfully close the deal. Simultaneously, your advisor should possess the experience required to identify instances where a buyer’s demands are unreasonable, advising you when it’s judicious to stand firm.

This understanding is imperative if they are to provide valuable insights into the transaction structure, rather than simply acquiescing to your requests. The most invaluable advisors assume a technical role, leveraging their wealth of experience to contribute far more than their primary mandate. This is especially crucial when a transaction structure incorporates an earnout, renowned for its complexity. Don’t enlist an advisor who treats your transaction as a learning opportunity — instead, ensure you have advisors with substantial, relevant experience in drafting and negotiating earnouts.

M&A Advisors

Engaging an M&A advisor offers a pivotal advantage in their role as intermediaries. By enlisting an intermediary to negotiate on your behalf, you gain the ability to preserve goodwill and defuse potential conflicts with the other party. This becomes especially invaluable when both the buyer and seller anticipate an enduring post-closing relationship. Negotiations over price can quickly turn adversarial, but an adept M&A advisor can maintain composure in these high-stakes discussions, shielding you from the stresses of direct negotiation. This, in turn, allows you to maintain focus on your business while minimizing the potential for interpersonal discord with the buyer. This facet becomes even more critical if your transaction incorporates an earnout.

Additionally, an investment banker can play a pivotal role by offering an initial estimate of your company’s value and proposing preliminary transaction structures. This includes gauging the likelihood and extent of an earnout in buyers’ offers. They can also evaluate your business, identifying potential risk factors that a buyer may perceive, and devise a strategy for mitigating these concerns. Ideally, establishing a relationship with your M&A advisor several years in advance allows for strategic guidance on actions to enhance your business’s value over time.

When collaborating with M&A advisors, it’s essential to comprehend the timeline for their compensation tied to the earnout. Most advisors typically anticipate payment once you receive the earnout funds. However, certain advisors may be amenable to collaborating with you to estimate the earnout amount and negotiate an early payment arrangement, streamlining the ongoing administrative aspects of monitoring the earnout.

Legal Considerations

When you’re in the process of selling your business, engaging the services of an attorney is a requisite, unless your business falls into the small category, typically less than one million dollars in the purchase price. In the context of a transaction involving an earnout, it becomes paramount that your attorney possesses practical experience in negotiating earnouts that align with the scale of your business.

Collaboration between your attorney and accountant is pivotal when it comes to evaluating and negotiating the specifics of the earnout. Earnouts encompass legal and accounting intricacies, necessitating a synergistic effort between these professionals to ensure the earnout is meticulously structured.

It’s crucial to acknowledge that no contract can provide comprehensive protection for both parties involved. The multitude of variables and uncertainties makes it impossible to predict and preemptively address every potential scenario. Consequently, your attorney should maintain a degree of flexibility, and trust between you and the buyer is of paramount importance.

Given the intricate nature of earnouts, legal disputes are not uncommon. Thus, it’s imperative that your attorney possesses a deep understanding of the common challenges and potential issues that can arise within earnout arrangements.

Here’s a comprehensive list of questions and potential concerns that a seller should proactively address:

  • Who covers attorney’s fees in the event of a dispute, and what happens if one party prevails?
  • What’s the preferred method for dispute resolution: mediation, arbitration, or litigation?
  • What role do third parties play in dispute resolution, and are their decisions legally binding?
  • Can earnout payments be recouped based on other terms outlined in the purchase agreement?
  • In what form are the earnout payments made, and how is the pricing allocated for federal and state income tax purposes?
  • What happens if there’s a change of control after the closing? Does the earnout agreement terminate, get assigned to the buyer, or involve a termination fee? Note that around half of earnouts accelerate upon a change of control.
  • Does the buyer hold a right to offset against the earnout for indemnification claims or other breaches outlined in the purchase agreement? Alternatively, could there be a right to offset against future earnout payments?
  • Will the earnout payments be placed in escrow?
  • If the buyer assumes control of the business, will they provide representations and warranties regarding their ability to operate the business effectively?

Accounting Considerations for the Buyer and the Seller

An accountant plays a pivotal role in crafting an earnout agreement, primarily because of the intricate tax and accounting considerations involved.

In accordance with generally accepted accounting principles (GAAP), a buyer is obligated to estimate the fair value of an earnout and reflect it as a liability on the opening balance sheet. This liability serves as an estimation of what the buyer is likely to owe the seller based on the earnout agreement. The liability remains on the balance sheet until it’s settled and must be periodically reassessed to align with the anticipated payments to the seller.

The complexity of these accounting rules is why earnouts are relatively uncommon in publicly traded firms. Any increase in the earnout amount is recorded as a loss on the buyer’s income statement, leading to reduced earnings and earnings per share (EPS). In lieu of earnouts, public companies often opt to compensate the seller with stock in the merged entity, aiming to incentivize the management team post-closure. Managing equity is notably simpler than handling an earnout and doesn’t impact the income statement or EPS.

Tax Considerations for the Buyer and the Seller

The tax treatment of earnouts carries significant weight for both the buyer and seller, prompting important considerations. Sellers primarily ponder whether payments will be categorized as capital gains or ordinary income. On the other side, buyers are concerned about the deductibility of the earnout payment. Regrettably, the answer to these questions often comes with a ‘it depends,’ and the landscape of taxation is marked by a mix of case law interpretations. Consequently, it is of utmost importance that both parties engage their tax advisors at the earliest stage of the process.

As a general guideline, installment payments are typically recognized as capital gains income, forming part of the purchase price. Conversely, most forms of individual compensation, such as consulting agreements, tend to be subject to ordinary income tax rates. If the payment is deductible for the buyer, it often results in the seller being taxed at ordinary income rates. This naturally creates a divergence in preferences, with buyers favoring deductible payments and sellers preferring earnouts to be taxed at ordinary income tax rates.

The potential tax implications for both parties should be carefully considered. For instance, a comparison between the seller’s marginal tax bracket and the likely taxation of the buyer can help minimize the overall tax burden, regardless of who is responsible for the payment. In other words, with effective tax planning, it’s possible to expand the proverbial pie by allocating earnout payments to the party with the more favorable tax position and then equitably sharing the tax benefits between both parties.

It’s also worth noting that tax implications may evolve over time, particularly with changes in presidential administrations. An accountant or CPA should assess whether the tax rates are based on current rates or those applicable at the time of the business sale.

Summary of Tax Implications and Considerations of Earnouts

  • Allocation: In the context of buyers, earnouts are typically categorized as ‘excess purchase price.’ This earnout allocation can either be assigned to the assets acquired or goodwill (with amortization over 15 years). Subsequently, it is either expensed or capitalized (depreciated) based on the rules governing that specific asset class. It is of paramount importance that both parties reach an agreement on the allocation, which should include an estimated value for the earnout.
  • Deductibility by Buyer: When structured as a form of compensation income, the earnout becomes deductible for the buyer and is reflected as an expense on the buyer’s Profit and Loss statement. Simultaneously, the seller regards it as ordinary income. Typically, if it’s deductible for the buyer, it aligns with ordinary income for the seller. Characterizing the earnout as part of the purchase price leans towards the seller treating it as a capital gain, hence non-deductible for the buyer.
  • Spreading Out Income: Earnouts also offer the option of spreading income for the seller, aiding in tax mitigation scenarios where the seller might otherwise face higher marginal tax rates. Generally, higher income leads to a higher tax burden as a percentage of income. By receiving payments over multiple years, sellers can even out their income, avoiding spikes in certain years and thereby staying within lower marginal tax brackets.
  • Compensation Income: Earnout payments tied to the seller’s continued involvement with the business are treated as a form of compensation and are recorded as expenses on the buyer’s income statement. The seller, in turn, recognizes this as ordinary income. For tax purposes, it’s crucial that an earnout is not contingent on the seller’s ongoing employment and treats all shareholders consistently, irrespective of their continued involvement.
  • Imputed Interest: If the seller doesn’t charge the buyer interest on the estimated earnout amount, a portion of each earnout payment falls under ‘imputed interest rules.’ Essentially, the IRS views an earnout as a loan from the seller to the buyer and mandates interest on the loan. Failure to charge interest leads to the IRS imputing interest, resulting in a portion of the earnout payments being taxed at ordinary income rates. This applies even when payments are made in stock, typically taxed at capital gains rates. The only way to circumvent ‘imputed interest’ is for the seller to levy a minimum interest on the estimated earnout amount, although it may lead to low actual taxes, compliance with these rules is essential.
  • Deferred Payments: Deferred notes with contingency elements, often present in earnouts, are typically treated as capital gains for the seller. In cases where deferred payments lack interest, they are partially viewed as interest income (taxed as ordinary income) and partially as sale proceeds (taxed at capital gains rates).
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