The Ins and Outs of Earnouts

A contingent pricing mechanism for mergers and acquisitions, the method requires sharp tax analysis.
Gary Q. MichelJuly 12, 2011

There’s plenty of equity money in the marketplace seeking operating companies to buy.  Such buyers are the usual suspects — wealthy individuals, established companies, and private equity funds. Some may be very motivated because the time period for them to draw upon their investors’ capital commitments may be near expiration.

The sellers who want to sell to those buyers, however, may not want to sell – especially if the price is based on operating performance they believe is only temporarily depressed in the wake of the financial meltdown. Or they may be hesitant to sell based solely on historical performance when their businesses are in high-growth industries.

Buyers, however, want to buy on proven performance and not speculative future performance.  This presents a classic situation: a buyer wanting to buy for less negotiating with a seller wanting to sell for more.  When buyers and sellers cannot agree on the valuation, a way to bridge this gap is through an earnout.

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An earnout is a contingent pricing mechanism. In an earnout, a portion of the purchase price is calculated by using the performance of the selling company over a period of time after the closing of the sales transaction.  It rewards the seller only if the future performance actually matches the current projections of future performance.

Further, it allows a seller to exit its current investment without forfeiting the ability to share in its future growth.  It also protects the buyer from overpaying if a seller’s projections are overly optimistic.  In many ways, the earnout aligns the financial incentives of both the buyer and the seller.

The contingency of the earnout can be measured using any number of factors, such as achieving certain sales volumes, EBITDA levels, or other operating benchmarks. It could even be measured according to transaction-specific milestones, like the target company obtaining a large contract.

The parties can also decide that the additional purchase price is earned only if the targeted performance levels are achieved.  Or they can decide that it can be earned in part based on a sliding scale of operations relative to a target level.  The parties must determine over what period of time performance is measured and when the additional payments are made.  They also need to consider such “what if” scenarios as a later sale by the buyer of the newly purchased business – or even a sale of the buyer itself.

The use of an earnout may always be well-intended. Still, there are many instances in which the deployment of an earnout creates friction between the buyer and seller.  A buyer doesn’t want any limitations placed on its ability to integrate the newly purchased business and achieve the economies of scale and other synergies that motivated its purchase. For its part, the seller wants to maintain separate and distinct operations to make achievement of the performance targets more likely.  Operating control and capital funding issues must be dealt with to make sure that each party’s expectations are met.

Taxing Issues

The tax treatment of the earnout to the seller requires sharp analysis.  Is the earnout contingent upon the seller’s continued employment by the buyer?  If so, is the earnout really additional purchase price (capital gain) or another way of providing incentive compensation (ordinary income)?

The timing of the recognition of gain on the sale is also affected by the earnout.  The installment method of reporting the gain on the sale, in which the tax liability is deferred until cash is received, is allowed. But that gain will necessarily be accelerated, either because all contingent future payments of the earnout are included in the gain calculation or because the basis of the shares sold is allocated ratably over the earnout period.

If the operating results are not achieved so that additional earnout payments are not made, the capital loss then generated may be of limited utility to the seller.  Moreover, the gain recognized is subject to the tax rates in effect in the year of recognition.

If, as many believe, tax rates will be higher in the future, your post-closing earnout payments will come with a higher tax cost.  Finally, some part of the earnout payments will be treated as ordinary interest income.

To solve or lessen the impact of these problems, many sellers have opted to opt out of the installment method of reporting the gain on the sale.  To do so, however, sellers must report and pay tax on the present value of the earnout payments. The seller’s valuation for tax purposes should be compared with the buyer’s valuation of the earnout which the buyer must undertake in order to properly account for the purchase.

Earnouts can bridge the valuation gap in the negotiation between buyers and sellers.  However, they create their own unique problems and carry their own costs.  It takes a significant amount of time to negotiate an earnout and have it properly analyzed and documented.

That additional time translates into additional professional costs.  Moreover, an earnout keeps the seller involved in the business even though, in many instances, the seller is moving on to other priorities.

From the buyer’s perspective, the seller is looking over the buyer’s shoulder to make sure the business is being operated in order to maximize the earnout payment and not necessarily what is good in the long-term for the buyer.

Notwithstanding these shortcomings, earnouts do ensure that the competing objectives of the buyer and seller are met – the buyers pays for actual performance and not speculative conjecture, while the sellers get paid for the value they always knew was there.

Gary Q. Michel is a partner in the law firm of Ervin Cohen & Jessup, in Beverly Hills, California, where he chairs the firm’s tax law practice.