News flash: Sometimes buyers and sellers can’t agree on the value of a company.
The seller is interested in getting the highest-possible price, of course, while the buyer might be apprehensive about the company’s ability to grow as promised or keep customers and key employees.
Enter the earnout.
An earnout is a useful means of bridging a valuation gap and getting a deal done. It’s a financial arrangement in which the buyer agrees to pay the seller a predetermined amount if certain targets are met post-closing.
In the complex world of buying and selling a business, coming to an agreement on the proper price for a business can be difficult. An earnout is a common tool used in many transaction structures.
This article will educate you about what an earnout is, how it can fit into the sale of a business, and the many factors and concerns that both buyers and sellers need to understand about earnouts. We will discuss the general purposes, advantages, and challenges of an earnout, the key elements of an earnout, the legal and tax implications involved, and how deal structures may be put together.
We will also answer the following questions in this article:
- What are the primary goals of earnouts?
- What are the alternatives to earnouts?
- How are earnouts manipulated?
- What are the advantages and disadvantages of earnouts?
- How do you calculate how much the earnout should be?
- How is an earnout documented?
- What factors affect how likely an earnout will be a part of your transaction structure?
- How do earnouts fit into the overall deal structure?
- What are some typical deal structures that include an earnout?
- When should earnouts not be used?
- How can the seller prevent an earnout?
- What are the key elements of an earnout?
- What are the accounting and tax implications of an earnout?
Let’s do a deep dive…
Table of Contents
- What is an Earnout?
- Advantages of Earnouts
- Disadvantages of Earnouts
- Determining the Appropriate Amount of an Earnout
- Documenting Earnouts
- Factors that Affect the Prevalence of Earnouts
- Earnouts & Deal Structure
- How Earnouts Fit into Overall Deal Structure
- Typical Deal Structures
- Objectives of Earnouts
- General Objectives of an Earnout
- Specific Objectives of an Earnout
- When Earnouts Should Not be Used
- Tips for Using Earnouts
- Prerequisites to Using an Earnout
- Tips for Drafting an Earnout
- Tips for Preventing an Earnout for the Seller
- Alternatives to Consider
- Key Elements of an Earnout
- Measurement (Metric)
- Time Period
- Dispute Resolution
- Protections to Ensure Payment
- Misc. Provisions
- Legal, Accounting & Tax Implications
- Hiring Professionals
- M&A Advisors
- Legal Considerations
- Accounting Considerations for the Buyer and the Seller
- Tax Considerations for the Buyer and the Seller
- Summary of Tax Implications and Considerations of Earnouts
What is an Earnout?
An earnout is a form of deferred payment to the seller that is contingent on certain events occurring post-closing in a manner that depends on the performance of the acquired company. An earnout can be tied to revenue, EBITDA, or a non-financial metric such as retention of key employees or the issuance of a patent.
Earnouts are rare in smaller transactions but common in mid-market deals. In some circumstances, as you’ll see below, an earnout can be tied to as much as 25% of the purchase price.
To receive an earnout, the seller must meet or exceed specific targets or milestones. These can include financial thresholds for revenue, gross margins, or net profit. They can also include non-financial thresholds such as market acceptance, technical achievements, or regulatory approvals within a specified period, usually one to five years after closing. A good earnout formula is easily defined, measured, objective, and not capable of being manipulated by either party.
Earnouts generally fall into one of two camps. The primary difference between the two is the underlying motivation of the buyer and can be distinguished as follows:
- Incentivization: Incentive earnouts are designed to motivate the seller to grow the business after the closing. This category of earnout is common when the seller remains in control of the business after the closing and the parties agree on the valuation of the business. In this case, the earnout is not used to bridge a price gap or mitigate risks. Rather, it is used purely to incentivize the seller to maximize the company’s revenue and earnings for the buyer.
- Risk Mitigation: This type of earnout brings some form of comfort to the buyer. It is used to bridge any price gaps when the parties disagree on the valuation or when risks are difficult to estimate in the business.
Advantages of Earnouts
Earnouts offer the following benefits:
- An Allocation of Risk vs. Reward: Earnouts are an excellent method for allocating risk and reward between the buyer and seller, especially if the risks and rewards cannot be reliably measured when the earnout is negotiated. An earnout allows the buyer to pay a higher potential reward to the seller while simultaneously reducing the buyer’s risk. For example, if EBITDA exceeds the expectations outlined in the earnout, the buyer will pay the higher purchase price. If EBITDA falls short, the buyer will pay the lower purchase price.
- The Bridging of Valuation Gaps: The primary allure of earnouts is their potential as deal catalysts for bridging valuation gaps in M&A transactions. Thanks to earnouts, the deal-making universe can more readily expand. An earnout allows buyers and sellers to disagree on the valuation of the target company but still manage to agree on a transaction. Earnouts are the primary tool used when the seller and buyer can’t agree on a business’s prospects. The very existence of such a tool enables more parties to close deals that otherwise would not happen. A buyer may not feel enough confidence in a seller’s projections to pay a premium price for the expected growth of the business. To close such a valuation gap, a portion of the purchase price could be contingent on growth, as specified in the earnout. In some transactions, earnouts are the only way to make a deal happen. From the buyer’s perspective, earnouts make the prospect of getting more later possible if future performance exceeds expectations.
- A Price Tag on Potential: A seller may argue for a higher valuation based on potential. However, the buyer may be reluctant to agree to the higher value, arguing that the benefits have not been realized. The simple solution is for the buyer to pay the seller for the potential only when it is realized. This lowers the risk for the buyer and enables them to pay a potentially higher purchase price.
- The Management of Uncertainty: Earnouts can be used where there is uncertainty regarding a future event. Will projected revenues be realized? Will key employees and customers stay on board? Will that patent or FDA approval be granted? If the seller wishes to sell now and the buyer wishes to buy, the only method for managing this uncertainty is to make a portion of the purchase price dependent on the occurrence, or non-occurrence, of a future event or events. Earnouts are best used when the parties cannot agree on the certainty of future events that could materially affect the value of the business. If a future event is likely to have a material impact on the value of the business and its certainty is difficult to predict, an earnout can bring clarity to ambiguity.
- Alignment: Earnouts are an excellent tool for creating alignment between the buyer and seller, particularly in situations where the seller will remain after the closing to operate the business. Earnouts create a strong incentive for the seller to cooperate fully during the transition and after it is finalized if, for instance, the seller agrees to help the buyer via a consulting agreement. In many middle-market deal structures where a private equity (PE) firm is the buyer, it’s common for 10% to 25% of the purchase price to be tied to an earnout. Such structure incentivizes the seller to remain with the business to maximize the purchase price and helps ensure that the acquisition is successful for the buyer. Win-win.
- Taxes: Since the payment is contingent on an earnout, it is not taxed until it is received. This lightens the tax burden incurred at the closing of the sale. It is also useful for the seller’s shareholders since it defers income taxes on the payment.
Disadvantages of Earnouts
While earnouts can be seductive due to their ability to bridge price gaps and create alignment, earnouts are loaded with potential problems. Earnouts are commonly negotiated but rarely signed.
For smaller transactions, it’s common to mention the possibility of an earnout at the outset. However, the parties usually drop the idea of an earnout once they understand the true complexity of properly drafting an earnout. Due to this complexity, earnouts are primarily used by financial buyers, less commonly used by corporate buyers, and rarely used by individual buyers.
The concept of an earnout is simple, but properly creating and drafting an earnout is difficult — they are complex, hard to manage, and often lead to conflict and disagreement. It’s rare to find an earnout that isn’t debated, argued, or eventually litigated. Earnouts are susceptible to different interpretations and sometimes to subconscious manipulation by the parties. While they can enable parties to agree now, unless properly drafted, they simply convert today’s agreement into tomorrow’s dispute.
- Earnouts are Easily Manipulated: The primary disadvantage of earnouts is that either party can easily manipulate them. Earnouts based on some form of earnings are most subject to manipulation, much more so than earnouts based on revenue. Either party can also influence earnouts due to unclear accounting principles. If an earnout is tied to EBITDA, a buyer can deflate the earnout amount by overspending on R&D, advertising, marketing, product development, excessive salaries to “insiders,” and so on. Some of these expenses reap benefits years into the future but reduce EBITDA now, thus benefiting the buyer in the long run. If the seller is in charge, the seller can do the exact opposite by neglecting the long-term strategy and making a hockey-stick projection on the earnings by focusing on the short-term. The seller could also run aggressive marketing campaigns or loosen trade credit to customers.
- Interpretation: Earnouts can also be subject to interpretation. For example, if an earnout is tied to EBITDA, how exactly is EBITDA calculated? Is EBITDA or adjusted EBITDA being used? What is an appropriate salary for the owner if they will continue to operate the business? Can goodwill be amortized as an expense and deducted from earnings when calculating EBITDA? Can the new entity incur debt? If so, is the interest expense deducted from EBITDA for purposes of calculating the earnout? If mechanisms aren’t created for addressing these questions, they remain open to interpretation by either party and therefore open to dispute.
- Complexity: To address the possibility of manipulation by either party, earnouts must be meticulously drafted. Problems must be anticipated and addressed. For example, imagine addressing the implications of loosening trade credit: This problem can be avoided by including in the earnout clause a provision that the incremental gain in profit is reduced by the incremental gain in outstanding receivables more than 90 days old. But what if a customer pays a large balance at 91 days? How is this addressed?
- Require Close Monitoring: Due to the possibility of manipulation, earnouts must be closely monitored. It may be difficult for a seller to police the business once the buyer is in command. The last thing a retired seller may want to do is monitor the operations of a business they no longer own. If the buyer knows they will not be closely monitored, the earnout is more susceptible to manipulation.
- Disputes are Common: Earnout agreements commonly result in post-closing disputes, which are costly and time-consuming, whether resolved by arbitration or litigation. The dispute mechanism in the purchase agreement or earnout agreement should be carefully considered and drafted. Earnouts can lead to uncomfortable situations where both parties are pointing fingers at one another. This is the most common reason why earnouts are discouraged by professional advisors. In some situations, the parties defer an agreement on the purchase price to a later time, thinking that an earnout will solve their problem. Oftentimes, this “later time” is after the closing. While deal momentum is essential, the parties should agree on the value of the business as early as possible in the negotiations. Earnouts should not be used to avoid contentious valuation issues and should be reserved as a last option.
- Make Synergies & Integration Difficult: Earnouts are best used when the business will remain as a stand-alone business with existing management after the closing. When the purchased business is going to be integrated into an existing business, the more thorough the integration, the more difficult the earnout will be to monitor. Integration increases the difficulty of independently accounting for the financial performance of the target. A lack of integration means the businesses cannot achieve synergies, which can drive up the purchase price. This lack of synergy not only frustrates the seller but can frustrate the buyer as well. Buyers may wish to eliminate certain duplicate functions in the business, such as accounting, legal, and HR. Do they eliminate these in the target or in their entity? How do they allocate the cost of these duplicate functions if they are only performed in one entity? Earnouts make integration difficult, which can frustrate the buyer and handicap them operationally. Without synergies, most buyers will be limited to paying fair market value (FMV) for the business.
- Buyer can be a Poor Manager: If the buyer’s management team will operate the business after the closing, there is a chance they will perform poorly, adversely affecting the earnout. The business may perform more poorly than if it had remained under the seller’s control. If the targets outlined in the earnout are not met, the seller may question the buyer’s management team’s abilities, leading to further disputes. The only solution is to allow the business to remain under the buyer’s control or to establish rules and standards by which the business is run. However, these rules are unlikely to mitigate the negative consequences of a poor manager.
- Emphasize Short-Term Profits: Earnouts can incentivize the seller to focus on the short-term at the expense of the long-term. Because the seller has an economic incentive to maximize the value of the earnout, the seller may prioritize profits over long-term objectives, such as product quality or retention of customers and employees.
- Creates Adverse Incentives: Since the buyer must pay more for the business if the targets are met, the buyer has an incentive to minimize the earnout. The opposite is true for the seller — the seller has an incentive to maximize the earnout value. While the parties may be aligned in some respects — an increase in EBITDA is good news for both — adverse incentives can underlie key decisions. The larger the earnout, the greater the divide becomes. Misaligned incentives are balanced by the buyer’s desire to see the business perform well. However, the buyer may prefer that the business focuses on long-term growth at the expense of the short-term. The seller will feel most comfortable if they remain in control of the business during the earnout period.
- Tax Rates May Increase: In most cases, the parties do not pay taxes on the value of the earnout until payments are received. There is a risk that tax rates can increase between the closing and the earnout period. This risk is heightened if a presidential election is coming up.
Determining the Appropriate Amount of an Earnout
An M&A advisor should provide a preliminary valuation that includes a range of potential values, possible deal structures, an analysis of the cash proceeds, tax implications, and an assessment of risk factors in a business that may lead to an earnout.
Earnouts are designed primarily to mitigate risks or to incentivize the seller. Earnouts proposed to mitigate risks can often be anticipated. Earnouts designed to incentivize the seller to continue operating the business can’t be predicted, however, and because they are an incentive, they should not cut into the potential value of the company.
With a preliminary valuation in hand, the seller can determine to what extent an earnout is reasonable, putting them in a position to respond quickly to proposed deal structures that include an earnout. Remember that valuation is a range concept, and an earnout can only be anticipated to a certain degree. Strategies designed to bridge price gaps come in many forms, and an earnout is just one of many devices that can be used.
Once a buyer proposes an earnout, the seller should determine the probability of achieving the targets, therefore, receiving the earnout payments. Generally speaking, the probability of meeting targets is highest in the first year and decreases with each passing year.
Because the seller can’t accurately predict what they will receive, an earnout’s present-day value is difficult to measure. Due to this uncertainty, using discounted cash flow techniques can result in an extremely low value due to the discount rate required to account for the risk associated with the earnout. This makes it difficult to compare two earnouts on a financial basis or to use formulas in a spreadsheet. The overall deal structure and its components, such as earnouts, are some of the many factors to consider with a letter of intent (LOI). When an earnout is proposed, the seller should determine to what extent they are dependent on the earnout and to what extent the earnout is frosting on the cake or simply a bonus.
Earnouts are documented at two stages in the transaction:
Letter of Intent (LOI): When buyers initially assess a business, they often visualize a deal structure that addresses the risks and opportunities inherent in the business. They may perceive the business to have an excessive amount of risk and consider an earnout as a primary element of the purchase price.
A mistake commonly made by sellers is to accept a vague earnout in the LOI, such as “The purchase price will include an earnout that will pay the seller up to an additional $5 million in the purchase price, with targets to be negotiated and agreed upon during the due diligence period.” It’s critical to be as specific as possible in the language of the earnout. The key elements of the earnout should be clearly defined and documented, including the size of the earnout, measurement metrics, thresholds, who controls the business, when and how payments are made, and so forth.
The seller has the most negotiating leverage prior to accepting an offer and should use this leverage to their advantage. Agreeing to vague terms or restrictive elements in the LOI, such as a long exclusivity period, will result in a loss of leverage for the seller. The more issues the buyer uncovers during due diligence, the less attractive the deal will be with time. Slowly, the buyer will start hacking away at the purchase price and increasing the protective elements of the transaction. For this reason, the seller should spend as much time as possible clarifying the earnout and other key elements of the transaction before accepting an LOI.
Purchase Agreement: The parties (typically, the buyer’s counsel) begin preparing the purchase agreement and earnout agreement during the due diligence period. It’s critical that an attorney and CPA experienced in M&A transactions are involved in the process. A small mistake in the language of the earnout can cost hundreds of thousands of dollars.
Factors that Affect the Prevalence of Earnouts
Economy: Earnouts are more common in a buyer’s market. In a seller’s market, sellers can often demand a higher purchase price with no earnout, especially if the business is properly marketed with multiple buyers competing to buy the business and if there are no major uncertainties in the business. On the other hand, deal structures are more restrictive in a buyer’s market. For example, deals may include more stringent representations and warranties, lower baskets, longer indemnity survival periods, larger escrows, and larger earnouts. This is partly because a seller may have fewer choices in a down economy, and the buyer may be assuming more risk in a less-than-favorable market. In this scenario, the buyer may attempt to offset the risk by shifting some of it to the seller.
Industry: Earnouts are used more frequently in some industries than others. For example, earnouts are common in professional service firms — healthcare, law, accounting, and the like — due to the sensitive nature of retaining clients and employees. A substantial portion of the purchase price may be structured as an earnout that is dependent on the retention of clients or employees. Pharmaceutical and other businesses that face product risks, such as those dependent on the issuance of patents or FDA approval, also commonly tend to have earnouts as a component of the purchase price.
Earnouts can also be common in high-tech transactions to bridge price gaps. Tech businesses may be growing at a steady pace — sometimes as much as 50% to 100% annually — meaning a buyer may be willing to pay a high price for the business, but only if the growth rate continues. An earnout is the only sensible tool to account for this uncertainty, other than reducing the purchase price or paying the seller with stock in the surviving entity. Earnouts are also common in service-based companies if the retention of customers or employees is a concern. Earnouts can also be used when the parties come from different industries, and the buyer has difficulty accurately gauging the risks associated with the business and the industry.
Size: Earnouts are more common in the middle market and for large publicly traded companies. In the sale of public companies, the buyer often pays the target (the seller) with the buyer’s stock. This serves a similar purpose to an earnout because the seller has an equity interest in the surviving entity. This is known as a Type B reorganization and has the primary benefit of being tax-deferred for both the buyer and the seller. Earnouts are much more commonly used in the middle market for the following reasons:
- They can be an incentive for ownership and management post-closing. This is possible because existing ownership and/or management can maintain control after the closing.
- It is more common for mid-market companies to be stand-alone entities post-closing, which is required to monitor an earnout properly.
- Less information is available on privately-owned companies, making risk more difficult to estimate.
- Stock-for-stock acquisitions (Type B reorgs) are not suitable for most mid-market companies because the buyer is commonly not a public company, and the seller usually wants to cash out.
Integration: Unfortunately, earnouts are most common in companies that will remain as stand-alone businesses after the closing, with little integration between the acquirer and the target. This is unfortunate because this precludes the seller from being paid for synergies. Without integration, there will be fewer synergies, meaning the buyer is likely to pay less for the company.
Corporate Governance: Interestingly, some have opined that Republican CEOs, who are often viewed as more conservative than Democrat CEOs, are less likely to make acquisitions than their counterparts. If they do make acquisitions, they are more likely to pursue companies in the same industry with significant financial and operating information. They are more likely to use cash and less likely to use earnouts in the deal structure based on their opinions.
Earnouts & Deal Structure
How Earnouts Fit into Overall Deal Structure
Most deal structures will combine various elements, such as cash, debt, earnouts, consulting agreements, employment agreements, escrows, holdbacks, and so forth. It’s important to understand how earnouts fit into the overall deal structure before considering their validity. When assessing the attractiveness of an offer, all elements of the transaction should be broken into contingent (such as earnouts) and non-contingent components.
Most middle-market transactions tend to be composed of three primary components: cash, earnouts, and escrow. Cash usually represents between 70% and 80% of the transaction value, while earnouts and escrows account for the remaining 20% to 30% of the purchase price, although earnouts can be as high as 75% of the purchase price. Ideally, the seller should receive cash at closing based on the company’s current value, less the amount of earnouts designed to mitigate significant and uncertain risks. The balance of payment should be in the form of an earnout designed to incentivize the seller if they will be operating the business after the closing.
Typical Deal Structures
What role do earnouts play in an overall deal structure? Here are some common guidelines regarding the primary components of the purchase price…
Small Transactions: $5 Million or less in Purchase Price
- Cash: Cash accounts for the majority of consideration in all transactions. For smaller transactions, the cash down payment ranges from 50%-100%. We rarely see transactions with less than 50% cash down. If seller financing is involved, we normally see a down payment of 60%-70%.
- Third-Party Financing: Bank financing is common for small transactions. If third-party financing is involved, it’s delivered to the seller in cash at closing. One important consideration is that if a third party (e.g., bank) is placing a lien on the assets of the business, then the seller’s note will be subordinated to the senior lender. The SBA 7(a) loan is the most common form of third-party financing for small businesses and has a limit of approximately $5 million. Earnouts may also be subject to the approval of the lender.
- Seller Financing: Seller financing in the form of a promissory note is prevalent in smaller transactions, with approximately 70%-80% of all transactions having some form of seller financing. The terms of most notes range from three to five years with interest rates ranging from 5%-8%. Seller financing differs from earnouts in that a fixed amount and payment schedule are agreed to in advance. In contrast, an earnout is contingent on a future event, and the amount is therefore unpredictable. If the payment is contingent on events, then it’s an earnout, not a promissory note.
- Escrows: Escrows, or holdbacks, are less common in small transactions due to the prevalence of seller financing. Seller financing is often used in lieu of an escrow, or holdback, due to the ‘right of offset’ ability in most states. The right of offset offers the buyer the ability to offset an indemnification or other claim (e.g., material misrepresentation, fraud, etc.) against any outstanding amounts in a seller note.
- Earnouts: Earnouts are rare in smaller acquisitions, likely due to the parties’ lack of sophistication. Less than 5% of smaller transactions contain an earnout. Earnouts are time-consuming and costly to negotiate and properly draft. Buyers in the middle market, such as private equity groups, are accustomed to drafting earnouts and are prepared to pay their professional advisors accordingly. Parties in smaller transactions prefer to keep the deal structure simpler and minimize professional fees.
Here are a few samples of common deal structures we encounter for smaller transactions:
- Scenario 1:
- 100% cash down
- Scenario 2:
- 50% cash down
- 50% seller financing @ 60 months @ 6% interest
- Scenario 3:
- 70% cash down
- 30% seller financing @ 36 months @ 6% interest
- Scenario 4:
- 20% cash down
- 60% bank financing SBA 7(a) Loan – delivered to the seller in cash at closing
- 10% seller note @ 36 months @ 6% interest – subordinated to the SBA lender and on full-standby (the seller may not receive any payments until the SBA lender is paid in full)
Mid-Sized Transactions: $5-$50 Million in Purchase Price
- Cash: Cash also accounts for the majority of consideration in mid-market transactions. The amount of cash down ranges from 70%-100% for larger transactions.
- Stock: Stock is common in larger transactions in which the buyer is a publicly-traded firm. Sellers generally prefer that the stock is liquid with sufficient trading activity. Equity rollovers are also used, but the buyer does not use stock in the buyer’s company to purchase the target. Instead, the seller is retaining equity in the target — in other words, the seller’s equity is being rolled over with the target. For example, a buyer may purchase 70% of the buyer’s stock (or equity) at closing, while the seller retains 30% of the equity. The seller’s 30% equity is said to ‘roll over.’
- Third-Party Financing: Bank financing is less common for larger transactions than smaller transactions, although the amount and form depend on the type of buyer — financial or strategic. If third-party financing is involved, it is delivered in the form of cash to the seller at closing. If a seller note is also involved, it will be subordinated to the senior lender. Earnouts may also be subject to the approval of the lender.
Seller Financing: Seller financing is less common for mid-sized transactions and commonly ranges from 10%-30% of the total purchase price.
- Escrow: Escrows, or holdbacks, are commonly used in mid-market transactions and fund any indemnification claims for a seller’s breach of representations and warranties (R&W) which are contained in the purchase agreement. Escrows commonly range from 10%-25% of the purchase price and are often held in line with the reps and warranties’ survival period, which normally ranges from 12 to 24 months.
- Earnouts: After cash, earnouts are the most frequently used component, but not necessarily the largest component, of middle-market merger-and-acquisition (M&A) transactions. Earnouts typically comprise 10%-25% of the purchase price.
Following are a few samples of common deal structures we encounter for middle-market transactions:
- Scenario 1:
- 80% cash down
- 20% earnout
- Scenario 2:
- 60% cash down
- 20% earnout
- 20% escrow (holdback)
- Scenario 3:
- 50% cash down
- 20% seller financing @ 48 months @ 6% interest
- 20% earnout
- 10% escrow
- Scenario 4:
- 50% cash down
- 30% third-party financing
- 20% escrow
Objectives of Earnouts
Primary Objectives of an Earnout
The following are the general, high-level objectives of using an earnout that can apply to all M&A transactions:
Bridge Valuation Gaps: Earnouts are commonly used to resolve opinions regarding a business’s value, such as when the seller feels the business has significant potential that is likely to be realized in the near future. When M&A markets are hot, high prices can often only be justified with the inclusion of an earnout as a fundamental component of the purchase price. Earnouts bridge the price a buyer may be willing to pay based on the seller’s outlook of the business versus a value based on current financial performance. Contingent payments, such as earnouts, enable the parties to allocate the risk of future performance — they reward the seller if certain objectives are met while minimizing the buyer’s risk if the objectives are not met.
Address Uncertainty: Absent an earnout, the only way to address uncertainty is through a reduced purchase price. Risk and reward are highly correlated. If the risk is higher, then the reward must be lowered to account for the increased risk. By reducing the risk of uncertainty for the buyer, the seller can achieve a higher reward. No other mechanism creates this dynamic. For example, if the business appears to have a solid growth opportunity ahead, an earnout allows the seller to get paid if this growth opportunity is realized.
Align Interests: Earnouts are a powerful tool for aligning interests between buyer and seller — they are commonly used as an incentive to motivate the seller to stay on board and continue operating the business post-closing. The seller must be incentivized if they remain to operate the business, which is common if the buyer is a financial buyer. Earnouts also address information asymmetries — the seller knows much more about the business than the buyer and has a greater degree of influence on the business if they remain as CEO. Earnouts can provide the buyer comfort that the seller will stay to facilitate a smooth transition. Earnout agreements can also be used to retain and motivate key target firm managers.
Mitigate Risk: By reducing uncertainty, earnouts reduce risk for the buyer. For example, risk is reduced for the buyer if a portion of the purchase price is held back until key customers have successfully been transitioned, litigation has been settled, or FDA approval has been obtained. An earnout helps prevent a buyer from overpaying if they are unclear about the future value of the business. With an earnout, the buyer is less likely to overpay. By holding back a portion of the purchase price, the buyer’s risk is reduced. It’s this risk reduction that enables the buyer to pay a higher purchase price.
Align Timing: “I want to sell my company after the next big sale.” We have all said it before. What’s the solution? Sell the company now but include an earnout that compensates the seller on ‘that next big sale.’ In many cases, there is an increased chance of closing the next deal if the company now has a larger competitor’s support, name, or reputation.
Specific Objectives of an Earnout
The following are specific objectives of using an earnout that can apply to a particular M&A transaction:
Addressing Risk Specific to a Business
- Customer Risk: An earnout is an effective tool for mitigating risks in businesses with high customer concentration. The business may lose customers during the transition period, especially if there are changes with any employees that a customer may have a relationship with. If the business has significant customer concentration where a few customers are responsible for the bulk of the sales, or the primary value of the business is the customer base, then it is appropriate for a portion of the purchase price to be contingent on retention of the customers after the closing period. Such a scenario is common if the business is dependent on revenue from a customer without a long-term contract in place, or in situations in which a large contract is coming up for renewal. Customer concentration generally starts to become a concern for buyers once it reaches 10% of the total revenue. It becomes a critical concern once customer concentration exceeds 20%-30%. Once customer concentration exceeds 30%-50%, the business may be unsaleable unless the owner is willing to make a significant portion of the purchase price contingent on retention of the key customer. There are other methods of mitigating the impact of customer retention, but an earnout has the greatest potential of maximizing the purchase price for the seller.
- Key Employee Risk: Earnouts can also be used to reduce risks associated with retaining key employees, but this is less common than using earnouts to reduce customer concentration risks. The primary tool for reducing the risk of key employees leaving after the closing is a retention agreement. A retention agreement is an agreement to pay an employee a specific bonus at specified milestones after the closing. For example, a seller may choose to offer each key employee a bonus based on a percentage of their annual salary and tenure. A reasonable retention agreement might compensate an employee based on 10%-20% of their annual salary. The amount can be significantly more if the employee is instrumental to the business. The bonus can then be released at increments of 90, 180, and 360 days following the closing. Care should be taken not to cause ill-will by favoring some employees over others. Releasing the bonus in tranches prevents employees from running off with the bonus and forming a competing business. Buyers also sometimes incentivize employees with options or other forms of equity to ensure they remain with the business and are adequately engaged.
- Product Risk: Product risks are less common in M&A transactions, but earnouts are a useful tool to mitigate risks associated with the company’s products when such a risk exists. For example, if a seller has developed a new product that will not be released until after the closing, a prospective buyer may offer to pay the seller a percentage of the sales generated from the product, especially if the company invested a significant amount developing and testing the product. A similar structure could be created to pay the seller if a patent is awarded or if FDA approval is obtained for a product.
- Third-Party Risk: Risks associated with third parties are common in mid-market transactions. However, most parties normally attempt to resolve these risks before closing, as third-party approval is often required. If closing can occur without the approval of a third party, then an earnout may be used to mitigate any risks possibly associated with the third party, such as if there is a risk that a landlord will opportunistically increase the rent. On the other hand, if a third party’s approval is required to close the transaction, such as a regulatory approval or the issuance of a license, then an earnout is not suitable.
Addressing General Transactional Risks & Deal Structure
- Alternative to Escrow: Earnouts are often used in lieu of an escrow or holdback. The degree to which this is the case is dependent on the likelihood that the seller may receive the earnout. There should be a relatively high probability that the seller will receive enough of the earnout to substitute for an escrow or holdback. For example, if an appropriate escrow amount for the transaction would have been $500,000, the parties should expect that the seller will have a high probability of receiving at least $500,000 via the earnout. If there are breaches regarding the reps and warranties, those amounts may be offset against any amounts due to the seller for the earnout. If there is no escrow, and the seller has a low probability of receiving a significant amount via the earnout, then the buyer may be aware that the seller may treat the earnout as a bonus and not be incentivized if an indemnification claim is on the horizon. This is especially true if the earnout is the buyer’s sole remedy for funding indemnification claims.
- Representations: If a buyer is not confident in a seller’s representations or cannot verify the seller’s claims, they may bring less cash to the closing and structure more of the consideration as an earnout. In this sense, the earnout is being used strictly as a tool for mitigating risk.
- Creative Deal Structuring: Earnouts are also a highly effective tool for creatively structuring transactions that otherwise would not happen. Perhaps the most common scenario is selling a business to insiders such as employees or family members who do not have the cash to pay for the business upfront. In such a situation, the business c0uld be sold to the insiders on an earnout basis, with control slowly ceded to the insiders as the payments are made. This slow transition of control can be facilitated through the gradual sale of equity (i.e., stock) to the buyer. This gives the seller the advantage of retaining control until the majority of payments are received. The seller will have to cede control at some point — usually, once they receive 50%-99% of the payments. Numerous protective provisions can be included in the earnout and shareholders agreement that protect the seller’s interest in the business, such as drag-along rights, dual-class shares with different voting rights, and a buy-sell provision. The advantage of this structure is that the seller can immediately regain control of the business if the buyer stops making payments. Since the seller is still the majority shareholder, the seller will not need to litigate to retain control if the buyer defaults.
This is normally only recommended if no other buyers are willing to purchase the business. Caution should be used when considering the sale of a business via an earnout to family members. This situation can place incredible stress on the buyer if the seller’s retirement is dependent on the business’s continued success. The seller’s retirement may depend on decisions made by their children, and the seller may feel an overwhelming desire to control a business they were accustomed to running for decades. Such a situation and pressure can strain relationships and should be cautiously considered.
When Earnouts Should Not be Used
Earnouts should not be used solely to insulate the buyer from the general external risks of operating a business. While earnouts are often used to minimize uncertainty, they should not be designed to protect the buyer from general economic and market-related risks. There are risks in any business, and the new owner should be solely responsible for absorbing the outcomes of these risks. Care should be taken during negotiations to ensure that earnouts are properly used and do not transfer the general risks of operating the business to the seller after closing. Unfortunately, there is no clear line here.
If a business that generates $2 million in EBITDA has a baseline value (with no risks of uncertainty) of $10 million at a 5.0 multiple, then the seller should not accept an offer with an earnout that values the company at a baseline 3.0 multiple ($6 million) and offers the seller the potential to earn $4 million via an earnout. If, on the other hand, that same business is about to land a large customer that will increase revenue by 25%, it may be appropriate to structure a portion of the purchase price as an earnout contingent on obtaining the new customer. In this case, the baseline value should be $10 million, and an earnout could be structured based on the acquisition of the new customer.
Earnouts should be primarily used to address uncertainty and situations in which the seller is willing to bear the risk of that uncertainty. If there is no specific uncertainty in the business (customer, employee, product risk) beyond general economic and market conditions, then an earnout is unlikely to be reasonable.
Earnouts should also not be used to defer a company’s valuation to a later point in time. While earnouts can bridge valuation gaps, the parties should not avoid discussions regarding the purchase price when negotiating the letter of intent. While this is common for risk-averse novice buyers, this is less common for experienced buyers, such as PE firms. It is common for unsophisticated buyers to propose a vague earnout in a letter of intent because they are either risk-averse or unwilling to decide what the company is truly worth to them. In essence, they are deferring their decision to a later time, and if left unchecked, this will certainly lead to killing the deal at a later stage.
Tips for Using Earnouts
Prerequisites to Using an Earnout
The following is a list of prerequisites that should be present before the parties consider an earnout.
Cash at Closing: The seller should receive enough cash at closing, excluding the earnout, to be satisfied. In other words, the seller should ideally be prepared, in most circumstances, to not receive any amounts due in the earnout agreement. The seller should not be highly dependent on receiving the earnout, whether financially or emotionally, especially if the certainty of receiving the earnout is low. It’s best to treat the earnout as a bonus instead of a critical component of the purchase price. Earnouts are used to mitigate uncertainty, and the seller should be emotionally prepared to accept the uncertain nature of receiving the earnout.
Trust & Confidence in the Buyer: Earnouts are subject to interpretation and manipulation by either party – it’s paramount that the parties trust one another. Absent trust, close monitoring will be required by the seller to ensure the buyer does not manipulate the earnout. Even with close monitoring, the earnout can be manipulated, and the seller’s only recourse in these situations is to pursue the dispute resolution options outlined in the purchase agreement. Disputes are common in earnouts — and trust, not the law, is the most powerful prevention. Even the most carefully drafted earnout doesn’t guarantee a painless transaction. Most earnouts lead to disputes, but disputes can be quickly and efficiently resolved if the parties maintain a fair and trusting relationship. Absent trust, the disputes will turn costly and consume enormous amounts of time and money.
If the seller is retiring and values their peace of mind, then trust with the buyer is even more important. The last thing a retiring seller may want to deal with is a toxic relationship with the potential for litigation that may drag on for years. Ironically, trust is the most powerful weapon for preventing earnouts. Buyers often propose earnouts because they lack trust in the seller. As a seller or a buyer, you must present yourself as a level-headed, trustworthy individual in all interactions. Never lose your cool. Never. Ever. Losing your temper, even once, can spell doom for the transaction structure.
The key to developing trust is honesty. When selling a business, truth is the safest lie. Buyers will conduct painstakingly meticulous due diligence that is bound to uncover the most infinitesimal of inconsistencies. If a buyer discovers the seller has been anything but forthright, they will likely pile on the protections — in the form of earnouts, escrows, and reps and warranties. A once attractive deal will instantly erode. The buyer will construct numerous provisions to minimize the impact of any additional untruths and their attendant risk — that is, if they don’t walk away entirely. If the buyer believes the seller to be a straight-laced, conscientious, reliable individual, they are more likely to propose a conservative deal structure with more cash down at closing.
Trust is also important in situations where the buyer will control operations after the closing. The seller must trust the buyer’s skills and abilities to manage the business post-closing properly. The seller must also trust the buyer’s strategy or be willing to let go entirely. Many entrepreneurs, however, find it difficult to let go after being at the helm for decades. Trust is likewise important in rollups, in which the seller’s upside will depend on the buyer’s ability to execute their strategy. If the buyer lacks the key skills required to operate the business deftly, the seller could scare off key customers or employees. These errors can have a major impact on the earnout payments.
If the buyer proposes an earnout, it’s critical that due diligence be mutual — in other words, the seller should also perform due diligence on the buyer — both operationally and financially. Soft skills such as communication and management skills need to be assessed if there is to be a continuing relationship after the closing, just as in any long-term relationship. If the buyer has completed other acquisitions, the seller can ask to speak with the past owners of acquired companies. Such a request is reasonable and often granted.
Control: Disputes regarding control are common. Whoever has control of the business possesses the ability to manipulate the earnout. If the seller oversees operating the business post-closing, then the seller should have a meaningful amount of control over the business’s operations. If the buyer has control, the buyer will have the ability to hold down earnings to minimize the earnout amount. If the buyer owns another company, this can be effortlessly accomplished by moving revenues or expenses between the two companies. Top-line metrics, such as revenue, are more difficult to manipulate than metrics lower on the P&L, such as EBITDA. An earnout based on EBITDA is much more easily manipulated than revenue, but all earnouts are subject to manipulation. Control is, therefore, a critical component of any earnout agreement.
The parties often address the issue of control by including language in the earnout agreement that requires the party operating the business to do so in a specific manner. For example, the agreement may require the buyer ‘to operate the business in a manner to maximize the amount of the earnout’ or to ‘not operate the business in a way to intentionally minimize the amount of the earnout.’ Such broad language is best suited when a party has a wide array of weapons available to manipulate the earnout.
Stand-Alone (Minimal Synergies): One of the chief disadvantages of earnouts is their inability to facilitate integration. When the target becomes integrated into the parent company, measuring the earnout becomes difficult, if not impossible. Earnouts are most commonly used when the business remains as an independent business or as a sovereign subsidiary of the buyer when existing management remains in place.
As a result, earnouts are either reserved for businesses that will remain a stand-alone business post-closing or for situations in which the earnout can be objectively measured. Examples include:
- an earnout based on unit sales of a product (e.g., $1.00 per sale of each piece of ABC Software)
- retention of key employees or customers
- a product launch
- issuance of a patent or FDA approval
Broad-based financial metrics, such as revenue or EBITDA, are difficult to monitor if two businesses will be integrated.
If synergies are likely to be achieved between the target and acquirer, a common alternative is a stock-for-stock transaction structure. However, these are usually only attractive for the seller if the acquirer is publicly traded and has a liquid market for their shares. Such a structure is attractive to the buyer because they can use their equity as currency to pay for the transaction, and it creates a strong alignment between the buyer and seller.
Motivation: If the owner remains with the business, they should be sufficiently motivated. If the seller is burned out, then it may not be wise to consider an earnout unless the business is not dependent on the owner’s personal efforts. Some buyers may become cautious if the seller tells them they are selling because they are burned out. A buyer may rightfully become concerned that the seller will disappear after the sale and want nothing to do with the business after the closing occurs. It’s wise for the seller to downplay the extent of their burnout. Buyers can also become concerned if a seller does not appear to be sufficiently motivated to receive the money they can potentially earn in the earnout agreement. They often reason that the seller has crunched the numbers and accounted for the risk of losing the earnout. It’s wise for a seller to demonstrably express an eager intent in executing the strategic plan necessary to receive the full amount of the earnout.
Location: International or cross-border transactions can materially impact the structure of earnouts. While international law is commonly merging with US law when it comes to international transactions, acquisitions of domestic companies can have legal implications if the target has substantial foreign operations. If a foreign buyer is purchasing a US-based company, the transaction is customarily handled by US attorneys, and the seller’s attorney does not need to have specialized knowledge of international law. If a US-based company is acquiring a foreign company, foreign legal counsel is advised. However, these transactions are commonly handled and documented comparably to US-based transactions. The legal concepts are similar, but nuances may exist that need to be addressed.
Regardless of the law, it’s critical that an efficient system exists for resolving disputes. Earnouts are unpopular in countries with relatively lax enforcement of contracts. In most international transactions, it’s common to choose a neutral location for the ‘choice of law’ provision to discourage disputes. These distinctions can also have a bearing on the earnout. For example, a neutral ‘choice of law’ provision can discourage the seller from disputing the earnout and encourage the buyer to ‘push the limits,’ knowing that the seller is disincentivized to litigate.
Tips for Drafting an Earnout
- Be Careful of Unsolicited Offers: We see many business owners with attractive businesses receive an unsolicited offer from a buyer that includes an earnout that makes up 50%, or more, of the purchase price. Many sellers lack the experience to judge the merits of an offer. If a seller receives an unsolicited offer, it’s best to retain an experienced M&A advisor, attorney, and CPA to assess how attractive the offer is. Unsolicited offers are rarely going to be the top price that can be obtained and are normally received from bottom fishers who hope to get lucky and pick up a company at a steal. A business’s price can normally only be maximized through a controlled auction in which hundreds of buyers are confidentially contacted.
- Appropriate Size: The earnout size should be proportional to the amount of risk inherent in the business. If customer concentration is 80%, it would be sensible for the earnout to comprise a major element of the purchase price. On the other hand, if there are no major risks or uncertainties in the business, the earnout should be designed as a tool to incentivize the seller and not simply transfer the risk of operating the business to the seller post-closing.
- Appropriate Length: Earnouts that last longer than three years should be considered with caution. We have seen earnouts work for as long as five years, but that is rare.
- Be Flexible: If a business has sizable, uncertain risks, then both parties should be prepared to be flexible in the structure of the transaction. Either the purchase price must be reduced to account for the increased risk, or protective deal mechanisms must be included to reduce the buyer’s risk.
- On Timing: In order to maximize the purchase price, it’s best to postpone the sale until earnings have materialized. The more the potential is realized, and the more the risks are reduced in the business, the higher the purchase price. The more unrealized potential and uncertain risks are transferred to the buyer, the less the seller will receive for their business.
- Carefully Define the Metric: Earnouts based on revenue are less subject to manipulation, are easier to monitor, and are strongly preferred for sellers. If the earnout is based on some profitability measure, that must be clearly defined, and control over the business, accounting, and financials must be carefully allocated between the buyer and the seller.
- Use Realistic Thresholds: Avoid steep cliffs or all-or-nothing earnouts.
Tips for Preventing an Earnout for the Seller
As a seller, one of the best methods for preventing an earnout is to prepare your business for sale well in advance. For example, during our business assessment, we identify potential major risk factors that could lead to an earnout as a component of the transaction structure. If you minimize risks that a buyer is likely to see in your business, it’s far less likely a buyer will propose an earnout in the first place. The lower the overall confidence level a buyer has in your business, the more likely they will propose an earnout. One of the most critical areas is the degree to which the business is dependent on the owner. If the buyer considers the business to be highly dependent on the owner — with the owner having close personal relationships to the employees and customers, and the business’s identity is tied closely to the owner — the buyer will consider this excessively risky and counter the risk through a low purchase price or an earnout. If the owner has developed a strong management team, and the business does not depend on the owner, the seller will receive more cash down at closing.
Most earnouts are proposed due to major risks in the business or uncertainty. Both can be mitigated to some extent in advance of the sale. Even if you don’t plan to sell your business in the near future, it’s still sensible to minimize your business risks from an operational standpoint. Mitigating risks will reduce the possibility of an earnout and likely increase the value of your business. Value is simply an element of potential return and risk. The lower the risk, the higher the value.
Presale Due Diligence
Presale due diligence is conducted before you begin the sale process. Presale due diligence mimics the due diligence a buyer will perform and is designed to uncover issues a buyer is likely to uncover. By performing your own due diligence in advance, you will be able to identify and minimize risks before you put your business on the market. While a buyer may not have proposed an earnout in their letter of intent (LOI), if they uncover material issues during due diligence that represents increased transactional risks, they will attempt to reduce this risk by either reducing the purchase price or proposing an earnout. Yes, it’s common for buyers to propose earnouts in the later stages of the deal if they uncover problems that were not initially disclosed. The only antidote to this is to retain a third party — such as an accountant, attorney, or M&A advisor — to perform presale due diligence and then address the problems you uncover.
Negotiating Posture & Momentum
Aside from presale due diligence, the next best tools in your arsenal for preventing earnouts are a strong negotiating position and negotiating skills. Your negotiating posture comes from having many buyers to negotiate with and not ‘having’ to sell. Posture can also be maintained through an even disposition throughout all discussions and negotiations with the buyer. Honesty and trust go a long way toward preventing an earnout.
Setting expectations with buyers is also critical and is best done through a third-party intermediary, such as an M&A advisor. Many buyers will feel the seller out to detect the likelihood of renegotiating at later stages in the deal. You need to set expectations when the LOI is accepted that renegotiating after an offer is accepted is not an option.
Momentum is also critical during the process. Many buyers intentionally slow down the process in an attempt to wear down the seller. Several months of negotiations and the obligation to exclusively negotiate with the buyer puts many sellers in a weak position. As a result, sellers are likely to cave into last-minute tinkering.
Preparing your business for sale along with expert negotiating skills can also prevent ‘retrading.’ Retrading is when the buyer attempts to renegotiate the purchase price at later stages in a transaction after an LOI has been signed and agreed upon. This renegotiation usually occurs during the tail end of the due diligence period. During due diligence, unscrupulous buyers will search every nook and cranny of the business for any flaw they can find. They then use these flaws as negotiating leverage for a price decrease. They may overreact to the bad news and tell you how distraught they are. But then they’ll let you know that they might be willing to move forward if you are willing to lower the price or restructure a portion of the consideration as an earnout. By preparing your business for sale, you minimize the number of flaws a buyer may discover during due diligence that they can use as leverage. And maintaining your negotiating posture sends buyers the subtle message that you aren’t susceptible to such ploys.
As a seller, it’s critical to understand the role of due diligence and be prepared for the thoroughness of the process. You must understand that every buyer will perform meticulous due diligence. You should be emotionally prepared to survive this painstaking period and not take personal offense at a buyer’s requests. Buyers will become nervous if you overreact or become secretive and will be more likely to structure part of the purchase price as contingent payments, such as earnouts.
Alternatives to Consider
Earnouts are not a magic bullet. They are not suitable for all transactions. Earnouts should primarily be used to bridge price gaps, mitigate risks, and incentivize the seller. If the seller and buyer cannot agree on a price, they should determine the reason for the price gap. Once the cause is determined, the parties can decide which mechanism is appropriate to bridge the gap or address the buyer’s concerns. First, start by evaluating the parties’ objectives, and then decide what deal structure is most appropriate to meet those objectives. Generally speaking, buyers want to ensure sellers have as much skin in the game as possible. In most cases, several of these tools are used collectively to mitigate the risk and keep the seller on the hook.
Granting equity is most appropriate if the seller will remain in the business long-term and will retain control. Technically, equity is not normally granted but instead is rolled over. In other words, the buyer may only purchase 70% of the seller’s shares, for example, and the seller retains a 30% interest. Long-term earnouts of five years or more should probably be replaced with equity incentives. The primary advantage of equity as an alternative to earnouts is that it does a better job of aligning incentives and can be used as a long-term strategy for 5, 10, or 20 years. Equity incentivizes the seller to think both short-term (profits can be taken out as distributions) and long-term (growth in the value of the business). The parties should also consider how the seller will eventually liquidate their shares.
In most cases, this will happen through another exit in the future. It’s paramount that the parties draft bylaws and/or a shareholders’ agreement and a buy/sell agreement.
Employment bonuses are similar to earnouts. However, they are more suitable when the seller plays a more defined role in the business, such as remaining involved in marketing. Earnouts tend to be based on high-level metrics for the business, such as revenue and EBITDA, while employment bonuses incentivize the seller in more discrete areas of the business. This would be more appropriate if the seller does not wish to play a management role in the business after the closing but instead prefers to play a more defined role absent of management duties.
Consulting agreements are similar to employment bonuses, but they are often designed to facilitate the business’s transition from the seller to the buyer. In most consulting agreements we see, the seller agrees to help the buyer on an ad-hoc basis at a flat hourly fee and is available anytime by phone or email to assist with detailed transition matters. This is most fitting when the buyer wants to ensure the seller will be available to help long-term with the transition but where the seller lacks control or influence over the performance of the business. The primary disadvantage of employment and consulting agreements is that they are tax-inefficient to the seller. Any payments are taxed at ordinary income tax rates, but payments are deductible to the buyer.
Escrows & Holdbacks
With an escrow, the parties appoint an independent third-party escrow agent to hold a portion of the purchase price, usually 10%-25%, to satisfy post-closing indemnification claims. This amount is normally held in escrow for a period of 12 to 24 months, called the ‘survival period.’ The money is governed by an escrow agreement and is normally only released upon the buyer and seller’s mutual agreement. The escrow agreement defines when the funds are released and the method for handling disputes. Most disputes are made in the last few weeks before the escrow period expires. Escrows are tied to the representations and warranties in the purchase agreement. They are used to ensure the buyer can easily recover damages if the seller has committed fraud, made material misrepresentations, or otherwise made an inaccurate representation regarding the business. An earnout can also be combined with an escrow with the earnout payments held in escrow until the payment is made. This would assure the seller that cash is available to pay the earnout when it is due. Earnouts can also be used in lieu of escrow, and indemnification claims can be deducted from earnout payments.
Representations & Warranties (R&W)
Reps and warranties constitute about half of the content in a typical middle-market M&A purchase agreement. Representations are statements of past or existing facts, and warranties are promises that facts will be true. Reps and warranties force the seller to make key disclosures regarding the business before signing the purchase agreement. If any representations and warranties prove to be untrue or are breached — in other words, if the seller knowingly or unknowingly lied to the buyer — the buyer has a right to indemnification. Reps and warranties are strongly debated in most transactions and often include minimums, maximums, and other mechanisms that trigger when an indemnification claim can be filed. For example, if a minimum (usually called a floor) is $25,000, the buyer may not file an indemnification claim if the claim is less than $25,000. Reps and warranties are fundamentally a method for allocating risk between the buyer and seller. If the buyer is concerned about certain specific risks in the business, it may be possible to address the buyer’s risks through strongly worded representations and warranties regarding the business, instead of an earnout. The R&W can then be funded with an escrow.
Type B Reorganization
A Type B reorganization is a stock-for-stock exchange in which the buyer pays for, or ‘exchanges,’ the seller’s shares with stock in its own company. Put simply, the seller and buyer are exchanging shares. The seller receives stock in the buyer’s company — and the buyer receives stock in the seller’s company. The target (seller) remains as a stand-alone subsidiary of the buyer. This is most practical when the seller is a publicly-traded firm with a ready market for their shares, or the seller does not require liquidity now and sees a strategic advantage in merging with the buyer. If the stock is not readily traded, the seller will now hold illiquid shares and have difficulty cashing out the investment. Regardless, in most cases, the seller has restrictions regarding when they can sell the shares and may argue for ‘registration rights,’ which enhances the seller’s ability to sell the stock. A Type B reorganization’s primary advantage is that it is tax-deferred since the seller will not pay taxes until the new shares are sold.
Instead of structuring part of the purchase price as an earnout, the parties can structure it as a seller note (promissory note). The advantage of a seller note is the ability to offset the note against indemnity claims, otherwise known as a ‘right of offset.’ This right gives the buyer the ability to deduct amounts due under the seller’s note for any indemnification claims. The seller could then argue that an escrow or holdback is not needed due to the right of offset in the seller note. The parties can also include negative covenants in the note that reduce the payments if the business performs poorly. However, these are rarely seen. Structuring a portion of the purchase price as a seller note is best used when the buyer is concerned about the reps and warranties’ veracity in the purchase agreement and is not normally a suitable replacement for an earnout. The seller note would only have a right of offset based on the purchase agreement’s indemnification language. This normally would not address the financial performance of the business.
Royalties & Licensing Fees
Royalties and licensing fees are most applicable if tied to product sales and are commonly used if the seller has a product in development that is expected to be launched shortly but for which the revenue is difficult to predict. They may also be used when the seller has numerous other products in development, either owned by the company or independently. I recently encountered this situation with an online retailer of proprietary automotive parts. Fully 90% of the revenue was generated from one product line, but the seller had a second product line in development that was expected to comprise approximately 30%-40% of the revenue once the line was launched. We discussed cordoning off the product line into a separate company. However, doing so would have proven to be too difficult, so we decided that a royalty or licensing fee would be the most practical approach.
Clawbacks or Reverse Earnout
A clawback is simply a reverse earnout. Money is given to the seller at closing and then ‘clawed back’ if the targets are not met. Instead of withholding a portion of the purchase price, the seller receives the entire amount and must then reimburse the buyer if the goals outlined in the agreement are not met. Clawbacks are not popular with buyers or sellers — buyers don’t want to chase a seller down to get their money back, and sellers don’t want to give back money they have likely already spent. Clawbacks are most common when money is provided to a business for expansion purposes and the business owner has not used the funds.
Key Elements of an Earnout
Earnouts are usually limited to 10%-25% of the purchase price. A larger earnout may be applicable in unique circumstances, such as:
- The sale of the business to insiders such as employees or family members who do not have a sufficient cash down payment.
- When there are excessively high risks, such as customer concentration that exceeds 30% or concentrated risks related to products or employee retention.
The primary element of an earnout is the formula on which it is based. Regardless of what metric is used, it will still be subject to manipulation and interpretation by the parties. But the more clearly objective and defined the target is, the less the metric will be subject to manipulation. Ideally, the metric can be independently confirmed by a third party.
Before deciding on the metric, it’s important to consider how the business will be run after the closing. Will the buyer or the seller be in control of the business? Will the business be integrated with another business? What are the primary concerns of the buyer? Is the earnout being considered to mitigate risk or incentivize the seller? Understanding the dynamics of the transaction and the parties’ underlying motivations and concerns is a prerequisite to structuring an earnout.
Depending on the situation, it may make more sense to use revenue, while in other situations, an earnout based on EBITDA or a non-financial metric may be more appropriate. There is no one-size-fits-all solution.
Earnouts can be based on revenue, gross profit, net profit, or some variation. Sellers usually prefer earnouts based on revenue rather than profits, while buyers usually prefer earnouts based on profits. After all, buyers care most about profits. Therefore, it makes sense to base the earnout on what the buyer values most and what the buyer can actually afford to pay. What if the business produces high revenues but is unprofitable? Where would the money come from to pay the earnout?
An earnout based on revenue may be most sensible for the seller if they will not control the business after closing. If the earnout is based on profits, and the buyer controls the business, the buyer can easily deflate the earnout amount by manipulating the expenses. Earnouts based on profit have a higher likelihood of disputes.
The simpler, the better. Complicating the earnout agreement is a sure-fire way to lead to disputes. Sellers often prefer simpler performance measurements, such as sales, units sold, or gross profits. These performance measurements are less likely to be manipulated than profits. In transactions that use revenue or some form of earnings as a metric, revenue is used approximately two-thirds of the time, roughly double the frequency of the use of earnings.
Regardless of the financial metric chosen, the parties may continually disagree on how the numbers are measured or how expenses are allocated. The more complicated the agreement and calculation, the more likely there will be disagreements. The higher the metric is on the P&L (e.g., revenue), the less likely there will be disputes.
- Revenue: The problem with basing an earnout on revenue is that a company can grow revenue dramatically but remain unprofitable, or it can become highly profitable but with slower top‐line growth. Revenue growth does not always correlate with profits. Earnouts based on revenue obviously motivate the seller to focus on increasing sales and to ignore expenses. The seller, therefore, has no incentive to keep costs down. This may also come at the cost of other aspects of the business, such as employee retention or product quality. Because a revenue metric ignores sales, the seller may prefer to spend heavily on advertising, marketing, or other expenses that drive sales. Sellers may also decrease pricing, which can dramatically reduce profitability, or loosen trade credit to maximize revenue. While metrics based on revenue are less likely to be manipulated, their primary drawback is that they neglect the bottom line — profits.
- Gross Profit: In cases where pricing is flexible, buyers may prefer to base the earnout on gross profit. This is common in industries that depend on salespeople and in which pricing is flexible. A target based on gross profit is susceptible to the same problems as a target based on revenue. However, the use of gross profits may be more suitable for certain industries in which gross margins are critical and when the business proposes custom pricing for each job.
- Profit (EBITDA, Net Income): There are multiple ways to define profit — SDE, EBIT, EBITDA, adjusted EBITDA, net income, and so on. Earnouts based on any profit measure must be extremely detailed and must include a clear definition of profit. What is the effect of income taxes, distributions, amortization, goodwill, the non-compete, interest, perks, and other deductions? How do capital expenditures affect the earnout? F0r example, can the buyer amortize the goodwill or non-compete expense from the acquisition and deduct it from earnings to calculate the earnout amount? If the seller remains to operate the business, what is their annual salary? If a competitor purchases the company, how is corporate overhead allocated between companies? If the buyer remains to operate the company, profit should be clearly defined, and rules should be instituted to ensure that the business is run to maximize the value of the earnout.
- Royalties (# of Units): Royalty-based earnouts may pay the seller per unit of product sold. This is perhaps one of the simplest earnouts to measure and is appropriate for transactions where the buyer wishes to pay the seller for successful product launches.
- Regardless of the financial metric chosen, the parties should also consider the following:
- How is the earnout measured? GAAP? Modified GAAP?
- How do bad debts affect the earnout calculation? Are reserves established for bad debts, or are they deducted from earnings when they are written off? When are they written off? 30 days, 60 days, 90 days?
- How will accounting for the target be done post-closing? Will the buyer continue to use the same accounting policies? Will the financials be prepared using cash-basis or accrual-basis accounting methods? Will the earnout be based on financial statements or tax returns?
Some transactions use non-financial milestones or targets to measure the earnout. An earnout can be based on achieving virtually any milestone, such as specific events or other results. Any non-financial metric or milestone should be as specific and objective as possible to minimize the potential for disagreement.
Examples include the following:
- Retention of Key Customers: Earnouts can be released in stages as key customers are retained.
- Retention of Key Employees: Earnouts can be based on the retention of management or other key employees.
- Product Launch: Earnouts can be structured to pay the seller a bonus for a successful product launch.
- Third-Party Approvals: Earnouts can be tied to receiving approvals from third parties, such as landlords or governmental authorities.
- Patents: Earnouts can be partially or entirely based on obtaining final approval for a USPTO patent.
- FDA Approval: Earnouts can be tied to FDA approval.
Some earnouts are structured so that the seller only receives an earnout payment if certain thresholds are met, such as a minimum amount of revenue, or they may be based on the average of performance over a specified number of years. The earnout can be all or nothing or proportionate. Other earnouts may involve periodic payments rather than a lump-sum payment at the end of the earnout period. Disputes are common if the target falls short of minimums.
Most earnouts are paid proportionally as a simple percentage of a financial metric, instead of being paid on an all-or-nothing basis. But what happens if there are peaks and valleys in revenue or EBITDA? For example, if an earnout pays the seller 3% of revenue only if annual revenue exceeds $10 million, what should the amount be if the business generates revenue of $12 million in the first year, $20 million in the second year, and $8 million in the third year? Do the high years offset the low years? What if the revenue is $100 million? Is there an upside limit? Multi-year earnouts are negotiated on a deal-by-deal basis, with no standard approach.
Here is a summary of the primary tools for creating thresholds:
Minimums (Cliffs, Floors): With a cliff payment, once a target is met, the earnout is paid. But if that target isn’t met, there’s no payment. In other words, the target is either hit or it isn’t, resulting in a payment or no payment. Earnouts with cliffs are not recommended unless the cliffs are very low.
In other words, if the cliff is $10 million, the seller receives nothing if the revenue is $9.5 million but receives the earnout if the revenue is $11 million. In this instance, an earnout might be worded to pay the seller 5% of revenue only if revenue exceeds $10 million (the ‘cliff’).
Tiers: Tiered payments consist of a series of targets. The earnout can increase or decrease as each target is hit. 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 per year.
Maximums (Caps, Ceilings): A cap is an overall limit on the earnout amount and is designed to increase the buyer’s total liability. A cap, ceiling, or limit can be placed in each period (typically a year) or over the lifetime of the earnout. For example, the earnout may pay the seller 5% of EBITDA up to $5 million in EBITDA. If the business generates $10 million in EBITDA, the seller will earn $250,000 ($5 million x 5% = $250k). Or an earnout can pay the seller 5% of EBITDA, but in no event does the seller’s total value of the earnout over the earnout agreement’s lifetime exceed $1 million.
Combinations: Earnouts can also include combinations of cliffs, tiers, and caps. For example, an earnout may pay the seller based on the following schedule:
- Under $1 million EBITDA = 0% (cliff)
- $ 1-3 million EBITDA = 3% (tier 1)
- $ 3-5 million in EBITDA = 5% (tier 2)
- Greater than $5 million in EBITDA = 0% (cap)
Sliding Scales: If a cliff is unlikely to meet the minimum for the year, the seller has little incentive to continue exerting effort. A sliding scale is a suitable replacement for a cliff and would pay the seller some bonus, even if the metric fell way short of the target.
Mixed Metrics: Earnouts can also include more than one metric. For example, an earnout can pay the seller 3% of revenue above $10 million, but only if EBITDA exceeds $2 million (the cliff). This example references both revenue and EBITDA. Earnouts that include more than one metric can quickly become complicated.
Cumulative Thresholds: Earnouts can also include cumulative performance thresholds. This is when the seller must make up deficits below the threshold in any period before an earnout is paid. For example, if the earnout pays the seller 1% of revenue above $10 million and the seller only generates $8 million in revenue the first year, the seller must generate $12 million in revenue in the second year before the earnout begins accruing. If the company exceeds metrics, the threshold may also carry over from year to year. For instance, in the example above, if the seller generates $12 million in the first year, the seller would get paid even if the seller only generated $9 million in the second year, since $2 million would carry over from the first period. This is sometimes called a ‘carry forward provision.’ In other words, excesses are carried over to meet minimums in future years. A ‘carry back’ would allow the seller to apply excesses in current years to previous years’ deficiencies. This would allow the seller to make up for missed goals in the past. In essence, the revenue or earnings are being spread throughout the entire period as opposed to constraining the earnout to one time period.
The measurement period is the time period on which the earnout is based. Approximately two-thirds of transactions have time periods from one to three years. There can also be several payment triggers within the time period. For example, the earnout can be based on a three-year time period but have annual payments, which are then based on thresholds such as minimums, maximums, tiers, etc. Most payment triggers are annual and coincide with the financial reporting period (e.g., Jan-Feb).
Shorter terms have fewer variables, while longer terms are more uncertain and more susceptible to external events. Longer earnout periods are theoretically of lower value if measured using a discount cash flow. The further out the payment, the more likely a dispute may be. However, a longer time period may be used if the seller and management team remain to operate the business long-term, but many buyers may grant the team equity instead of an earnout. Some buyers also index long-term earnouts to inflation so the earnout is based on real growth excluding inflation.
Although the earnout is based on the business’s performance after the closing period, equity control of the business has shifted to the buyer. To address this conflict, the buyer often gives the seller some degree of control over the business’s day-to-day operations during the earnout period. Without this control, the buyer could manipulate the business to minimize the amount of the earnout payments. The seller can retain rights over key strategic decisions that need to be made, control over accounting practices, or access to financial information. The exact amount of control that is given to the seller is highly deal-specific.
In addition to these provisions, the earnout agreement may contain language that requires the buyer to operate the business in a manner that does not harm the value of the earnout, or to operate the business in a manner to maximize the value of the earnout, or to operate the business consistent with past practices. Absent such a contractual requirement for how the buyer is to operate the business, most state laws carry an implied duty of good faith that would indirectly prohibit the buyer from intentionally manipulating the earnout.
It’s critical for sellers to decide in advance what role they prefer to have in the business, if any, after the closing. What is your genius zone? What do you most enjoy doing in the business? Where do you provide the most value? You don’t necessarily need to remain as CEO. Many buyers prefer that you focus on business areas that will grow revenue, such as sales and marketing. This is also where many entrepreneurs excel, but they are often bogged down with management minutiae. If they were relieved of their management duties and could focus 100% of their efforts on sales or marketing, they could have an enormous impact on the growth of the business and, therefore, the earnout. Focus on your core competence, preferably one that makes you happy — whether it be product evangelist, industry events, speaking engagements, content production, integration, sales training, marketing, or some other aspect of the business.
Controls and rights can also be granted in the following specific areas:
- Strategic Control: The buyer can also grant the seller some degree of strategic control over the business. This can afford the seller a say in strategic decisions or control over the decision-making process. One of the key decisions involves how much money is spent on long-term goals whose benefits may extend beyond the earnout period. These long-term goals could include product quality, branding, and research and development (R&D), versus short-term objectives such as sales and marketing. It may also be sensible to establish minimum budgets for sales and marketing. Another contentious area may be the hiring of new staff, which can significantly dampen earnings. As an alternative to addressing specific areas of the business, the agreement can also specify that no material changes will be made to the business model during the earnout period without both parties’ consent. However, this lack of agility can dampen execution ability. Sellers should be mindful that most buyers will be hesitant to accept restrictions on how they run the business. As an alternative, it could be clarified that certain long-term costs the buyer may incur would be excluded from the earnout calculation. Examples include R&D, new product development costs, legal fees for obtaining patents, litigation, capital expenditures, relocation costs, and so on.
- Financial Control: Closely related to strategic control is financial control. If the buyer owns multiple companies, it may be easy for the buyer to steer revenue or expenses from one company to another, materially impacting the amount of the earnout. Providing the seller control over the finances, such as budget and expenses, can provide the seller comfort that the earnout will not be manipulated. The impact of financing and interest expenses should also be considered and addressed in the earnout agreement. How will the business be funded? Is working capital adequate to operate the business? What if additional cash is needed? Will this be supplied internally or externally (e.g., banks)? Will the interest on this be deducted from earnings when calculating the earnout?
- Accounting Control: The business’s accounting practices significantly influence the earnings of the business. GAAP guidelines are highly discretionary in certain areas, such as how capital expenditures are depreciated (e.g., straight-line vs. accelerated), and allow for significant differences in accounting for expenses. For example, how are contingent liabilities accounted for? Is a reserve established for bad debt? Are capital expenditures allowed to be expensed under Section 179? How is corporate overhead allocated between two companies if expenses are shared between the target and the buyer’s company? The seller should understand the potential impact this can have on earnings, and therefore the earnout. While most earnout agreements specify that the business must continue its historical accounting practices, it’s wise for the seller to obtain their CPA’s opinion on the language in the earnout addressing how the books are prepared post-closing. While depreciation may be a moot point if the earnout is based on revenue or EBITDA, the buyer has many tools at their disposal to manipulate the amount of the earnout if restrictions are not established regarding the company’s accounting practices. The earnout should also grant the seller access to accounting and financial information, sometimes known as audit rights.
The earnout agreement should specify when payments are due, be it quarterly, annually, etc., and in what form the payments will be made (e.g., cash, stock, notes). If payments will be made annually, the agreement should outline exactly when those payments will be made. Will they be paid 60 days after the end of the year? 90 days? What happens if there is a dispute? If the form of payment is shared, a formula must be created to determine the conversion rate. Finally, where does the money come from to pay the earnout? Is this a further expense for calculating the earnout? In other words, is the earnout amount deducted from earnings for purposes of calculating future earnout payments?
The earnout agreement should clearly specify how disputes regarding the earnout are handled. Most earnouts are incorporated into the purchase agreement, and the earnout is subject to the dispute resolutions outlined in the purchase agreement. As an alternative, the parties can draft a separate earnout agreement that contains different dispute resolution options than those outlined in the purchase agreement.
In most cases, an attorney will have strong preferences regarding dispute resolution. Some attorneys strongly prefer mediation, while others prefer arbitration. Attorneys may prefer arbitration over litigation because it’s faster and cheaper, and the parties can choose an arbitrator with relevant knowledge and expertise. The American Arbitration Association exists, but an attorney may consider it expensive. Aside from the standard dispute resolution options, the agreement should include a third-party confirmation option. Under this scenario, a third party, such as a CPA firm, would be retained to make an independent decision. The extent to which this is binding should also be considered. Finally, the impact of a ‘loser pays attorney’s fees’ clause should be carefully considered as the correct answer may be somewhere in the middle in the event of a dispute.
Protections to Ensure Payment
Because an earnout is a deferred component of the purchase price, the seller may retain some protections to ensure the earnout is paid. Most earnouts are an unsecured contractual obligation. While it’s unlikely a buyer will grant the seller the same protective provisions included in a promissory note and security agreement, other provisions can be included to protect the seller. Earnouts have less risk of nonpayment because cash generated from the business can be used to make earnout payments.
Nevertheless, a provision can be included that prohibits shareholder distributions or loans until the earnout payments have been made. This would ensure payments are made first under the earnout before the parent company can extract any money from the business.
It’s also possible that the earnout amount could be held aside or escrowed as it is earned. For example, if an earnout agreement pays the seller 1% of revenue above $5 million, then 1% of revenue could be set aside once revenue exceeds $5 million. This could be immediately ‘expensed’ from the business to ensure these amounts are made available.
If the buyer is an individual, it may be wise to ask that the buyer, and their spouse, personally guarantee the earnout. The seller could also ask for the earnout obligation to be secured by the assets of the business; however, few buyers will agree to this provision.
The parties to the earnout must be determined. If there are multiple parties, how are the earnout payments allocated among them? What happens if the seller is unable to continue operating the business due to poor health and the buyer takes over? Would the seller still earn the payments due under the earnout?
What happens if the business is acquired? Would the earnout be assigned to the new buyer? If so, who would be obligated to pay the amounts due? What if any act of God occurs, such as a hurricane or earthquake, or Canada drops a nuclear bomb on us (hey, you never know)? Earnouts are commonly renegotiated when the parties encounter unexpected events, but such renegotiations require a sound working relationship between the buyer and seller.
Earnouts are tricky and difficult to draft. It’s impossible to anticipate every possible event. It’s critical that the buyer and seller maintain goodwill and trust. If so, nearly any potential disagreement can be easily and quickly worked out.
Legal, Accounting & Tax Implications
My number one piece of advice in hiring professional advisors is to work with only experienced advisors — specifically advisors who have deep experience buying and selling businesses. An ‘affordable’ advisor lacking real-world experience will prove to be much more costly than the most ‘expensive’ experienced advisors.
For example, it’s common for CPAs to kill deals by offering their unsolicited opinion on a business’s value. They may attempt to use logic that only applies to publicly traded companies, or use valuation methods, such as DCF, that don’t apply to small to mid-sized companies. I have heard CPAs claim that an appropriate multiple for a business was seven to nine times EBITDA when, in reality, multiples were in the range of three to four times. Such opinions are common among CPAs. If a CPA or other advisor opines on your company’s value, respond by asking how many transactions they have personally been involved in.
Selling a business involves numerous tradeoffs. Price is always relative to the ratio between risk and reward. If the perceived risk is high, then either a buyer will offer a lower purchase price or seek to mitigate the risk through transaction structuring, such as earnouts or stronger reps and warranties. It’s critical that your advisor understands your business from an operational standpoint so they can see how the deal mechanisms a buyer proposes fit into the overall deal structure.
Your advisors should understand the risks inherent in your business, particularly the risks that a buyer will perceive in your business. A buyer’s perception of risks will vary from buyer to buyer. Understanding this will enable your advisor to understand how a buyer’s proposals relate to the overall deal structure and their perception of risk. Your advisor will then be able to propose alternative deal structures that meet both parties’ needs.
The best advisors have deep, relevant experience. They understand their client’s business and industry and are willing to be flexible to meet the needs of both parties. Negotiating the deal involves making numerous tradeoffs. Both you and your advisor must be prepared to be flexible and make concessions if you want to get a deal done. By the same token, your advisor should have the experience necessary to know when a buyer is unreasonable and when it is sensible to advise you to stand your ground.
This understanding is required if they are going to offer their opinion on the transaction structure, as opposed to simply accommodating your requests. The most valuable advisors play a technical role and have the requisite experience to add more value than that for which they were retained. This is particularly important when a transaction structure involves an earnout, one of the most complicated deal mechanisms to design. Don’t pay your advisor to learn on the job — ensure you have retained advisors who have significant relevant experience drafting and negotiating earnouts. As a business owner, you likely have no practical experience negotiating an earnout. You must, therefore, solely rely on the advice of professionals. Close collaboration with your deal team will be essential to creating a deal structure that minimizes your risks and maximizes your purchase price.
One of the primary advantages of hiring an M&A advisor lies in their role as an intermediary. Retaining an intermediary to negotiate on your behalf enables you to maintain goodwill and minimize conflicts with the other party. This is valuable when the buyer and seller will maintain an ongoing relationship post-closing. Negotiations regarding price can become contentious. An experienced M&A advisor can keep their cool during these negotiations and insulate you from the stress of negotiating. This can help you focus on your business and minimize interpersonal conflicts with the buyer. This is especially important if your transaction includes an earnout.
An investment banker can also be instrumental in providing a preliminary range of value for your company and preliminary transaction structuring. This could include estimating the possibility and degree of an earnout that may be included in offers from buyers. They can also assess your business and identify risk factors a buyer is likely to perceive, then outline a strategy for mitigating those factors. Ideally, you should build a relationship with your M&A advisor several years in advance so they can strategically advise you on actions you can take to maximize the value of your business.
When working with M&A advisors, it’s also important to understand when your advisors expect to be compensated based on the earnout. Most advisors don’t expect to be paid until you receive the money. However, some advisors are willing to work with you to estimate the amount of the earnout and negotiate an early payment to minimize the administrative complexities of ongoing monitoring.
When selling your business, retaining an attorney to represent you is required unless your business is small — less than one million dollars in the purchase price. If your transaction includes an earnout, it’s paramount that your attorney has real-world experience negotiating earnouts relevant to the size of your business.
Your attorney should work closely with your accountant in evaluating and negotiating the earnout. Earnouts have legal and accounting implications, and your attorney and accountant must actively work together as a team to ensure your earnout is properly drafted.
It’s also important to bear in mind that no contract can provide complete protection for both parties. There are too many variables to anticipate and address. As a result, it’s critical that your attorney remain flexible and that you trust the buyer.
Litigation is common in earnouts due to their inherent complexity. Your attorney should be well-versed in common and potential issues in earnouts.
Here is a list of questions and possible concerns for a seller to address:
- Who pays attorney’s fees if there is a dispute and one party is successful?
- Is mediation, arbitration, or litigation the preferred method of resolving disputes?
- What is the role of third parties in resolving disputes? Is their decision binding?
- Can earnout payments be clawed back under other terms of the purchase agreement?
- In what form is the earnout being made? How is the price being allocated for federal and state income tax purposes?
- What is the impact of a change of control after the closing? Does the earnout agreement terminate, is it assigned to the buyer, or is there a termination fee? About half of earnouts accelerate upon a change of control.
- Does the buyer have a right of offset against the earnout for indemnification claims or other breaches in the purchase agreement? Or would there be a right of offset against future earnout payments?
- Will earnout payments be escrowed?
- Will the buyer make representations and warranties regarding their ability to operate the business if they will be in control of the business?
Accounting Considerations for the Buyer and the Seller
An accountant will play a key role in drafting an earnout agreement due to the potential tax and accounting implications.
According to generally accepted accounting principles (GAAP), a buyer must estimate an earnout’s fair value and record it as a liability on the opening balance sheet. The liability estimates the amount the buyer will likely owe the seller based on the earnout agreement. The liability remains on the balance sheet until it is paid off and must be re-estimated periodically based on what will likely be paid to the seller.
It’s due to the complicated accounting rules that earnouts are not common with publicly traded firms. An increase in the earnout amount would be recorded as a loss on the buyer’s income statement and would decrease earnings and earnings per share (EPS). In lieu of earnouts, public companies will often pay the seller in stock in the merged entity to motivate the management team post-closing. Accounting for equity is much easier than accounting for an earnout and does not affect the income statement, or EPS.
Tax Considerations for the Buyer and the Seller
The tax treatment of earnouts is a major consideration for both buyer and seller. The primary question for the seller is if payments will be treated as capital gains or as ordinary income. For the buyer, the major concern is if the earnout payment is deductible. Unfortunately, the answer is ‘it depends,’ and case law is mixed on the issue of taxation. Regardless, it’s critical that both parties involve their tax advisors as early as possible in the process.
Generally speaking, installment payments are recognized as capital gains income as part of the purchase price. Most forms of individual compensation, such as a consulting agreement, will be taxed at ordinary income tax rates. If the payment is deductible by the buyer, it will almost always be treated as ordinary income by the seller. Therefore, the parties are at odds with one another — the buyer prefers that the payments are deductible while the seller prefers earnouts are treated at ordinary income tax rates. The potential tax situation of both parties can be taken into account. For example, the seller’s marginal tax bracket should be compared with the buyer’s likely taxation to minimize the total amount of taxes paid — regardless of who pays them. In other words, with proper tax planning, the pie can be made bigger by allocating the earnout payments to the party with the most favorable tax position and then splitting the tax advantage between the parties.
It’s also possible that the tax implications will change over time, especially with a change in the presidential administration. An accountant or CPA should examine whether the tax rates are based on current rates or the tax rates when the business was sold.
Summary of Tax Implications and Considerations of Earnouts
- Allocation: For buyers, earnouts are normally treated as ‘excess purchase price.’ The earnout is allocated either to assets acquired or to goodwill (amortized over 15 years) and is then either expensed or capitalized (depreciated) based on the rules for that asset class. It’s important that the parties include an estimate of the value of the earnout in the allocation that is agreed to by the buyer and seller.
- Deductibility by Buyer: If the earnout is structured as some form of compensation income, it is deductible by the buyer — or expensed on the buyer’s P&L — and is treated by the seller as ordinary income. If it’s deductible by the buyer, it’s almost always treated as ordinary income by the seller. Characterizing the earnout as an element of the purchase price supports the notion that the earnout will be treated as a capital gain by the seller and, therefore, not deductible by the buyer.
- Spread Out Income: Earnouts can also be spread out as income for the seller and help mitigate taxes in situations where the seller may be pushed into higher marginal tax rates. Generally speaking, the higher the income, the higher the taxes as a percentage of income. By receiving the payments over several years, the seller may smooth out their income and avoid spikes in income in certain years, thus helping them stay in lower marginal tax rates.
- Compensation Income: If the earnout payment is dependent on the seller remaining with the business, the earnout payment is treated as a form of compensation and is expensed on the buyer’s income statement. It is treated as ordinary income by the seller. For an earnout to be treated as an earnout from a tax perspective, it cannot be contingent on the seller’s continued employment. It must also treat all shareholders equally — it cannot treat shareholders who remain with the business differently than those who do not.
- Imputed Interest: A portion of each earnout payment is subject to ‘imputed interest rules’ if the seller does not charge the buyer interest on the estimated amount of the earnout. In essence, the IRS views an earnout as a loan from the seller to the buyer and requires that interest be paid on the loan. If interest is not charged, the IRS requires the parties to ‘impute interest,’ and the parties will be treated as if interest had been charged, from a tax perspective. As a result, a portion of the earnout payments will be taxed at ordinary income tax rates. This is true even if the earnout payments are made in stock (normally taxed at capital gains rates), instead of cash. The only way to avoid ‘imputed interest’ is for the seller to charge the buyer a minimum interest on the estimated amount of the earnout. While the actual taxes due to imputed rates may be low, such rules can complicate your accounting. Careful records should be maintained to ensure you are in compliance.
- Deferred Payments: If a deferred note includes contingency elements, such as those often seen in earnouts, the note will likely be treated as a capital gain for the seller. Deferred payments that do not bear interest will be treated partially as interest income (taxed as ordinary income) and partially as sale proceeds (taxed at capital gains rates).