Use Earnouts to Facilitate a Business Sale
October 1, 2010
What happens when a buyer and a seller can’t agree on the business’s value? This question is critically important in a business acquisition. When a buyer and a seller can’t agree on an equitable price for the business, an earnout may offer a solution that benefits both sides – and that could even save the deal.
What Is an Earnout?
The buyer purchases a company’s assets but doesn’t pay a premium over book value in the purchase price. As a result, the seller doesn’t pay taxes on a large gain and incur double taxation. Instead, the premium is included as an earnout, contingent on the future performance of the company. The buyer avoids the risk of paying a price based on an overly optimistic estimate of future earnings. The buyer also can reduce its taxable income because earnouts, when included in an employment agreement, are deductible, as long as the Internal Revenue Service (IRS) considers them reasonable compensation.
An earnout is a bonus paid to the seller for staying actively involved in the business and is pegged to future earnings performance. For example, the agreement may specify that the seller will receive 25% of the next four years’ profits.
What a Buyer Needs To Determine
• Is he or she willing to commit part of future company earnings to the seller, based on higher prospects?
• Is the size of the earnout reasonable?
• Will the earnout reduce up-front exposure to risk and allow the buyer to conserve cash?
• Will the earnout attract IRS questions about unreasonable compensation if deducted from the company’s income?
• Will the buyer be able to motivate the seller-manager when the earnout period is over? Will the seller continue to be involved?
What a Seller Needs To Determine
• Is he or she willing to continue in the business?
• Will he or she earn more from an earnout than from a simple purchase?
• Are the business’s prospects strong enough to achieve the earnout?
• Will the earnout be linked to net profits, sales, performance improvements or other measures?
• Is he or she confident of the buyer’s ability to manage the business?
Strategy for Success
With a little willingness to compromise on both sides and advice from a competent valuation consultant, the buyer and the seller can negotiate an agreement that will achieve their goals. We can help you structure an earnout that will benefit both sides and avoid negative tax consequences. Please give us a call with any questions you may have on earnouts or any other valuation issue.