Increased Interest in Earnouts

One frequently used form of compensation in the sale of a business is an earnout -- where a portion of the selling price is contingent upon the future performance of the business.

I've seen increased interest in earnouts over the past few months, because they can bridge differences in opinion between the buyer and seller regarding the value of a business with future growth potential.

For example, I recently met with an owner of a mid-sized construction company with an interest in acquiring a specific smaller firm. The smaller company is in a green-industry niche, and has been growing despite the economy. However, given the smaller company's projected growth, the seller is looking for a valuation which the buyer feels is unrealistic given the uncertainty in the economy. An earnout may help both sides reach an agreement.

It goes without saying that sellers prefer to receive all their compensation at closing. However, an earnout can help a seller capture future upside potential, and can provide a financial incentive when the seller remains with the business. Buyers are generally comfortable with earnouts because they won't have to pay for future growth unless targets are achieved.

However, problems do occur with earnouts, and there are important issues to consider:

1. Determine Goals

A first challenge is to determine the goals to be met for the earnout to be paid. For sellers, basing the earnout on future revenue is more attractive than using future income, as the buyer may be in a position to control expenses and impact income. Earnouts can be based on a sliding scale, with payments based on a percentage of the milestones achieved, rather than an "all or nothing" goal. Earnouts can also contain caps, limiting future expense for the buyer, but also limiting the upside potential for the seller. It's also important to identify the method and timing to be used to report and measure whether the goal is achieved. Accounting standards may need to be clarified, to avoid issues such as timing of revenue recognition and depreciation methods.

2. Be Careful What You Wish For

Sellers may have an optimistic view of the future performance of the business they are selling. However, one important reason to ensure that projections shared with a buyer regarding future performance are realistic is that a buyer may incorporate the seller's projections into an earnout proposal. Sellers can find themselves in an awkward position if they won't agree to compensation based on the future performance that they assured a buyer the business could easily deliver

3. Penalties for Non-Payment

It's important to consider actions and penalties if the buyer does not or cannot pay the earnout when due. An agreement should also address what happens if the buyer sells or exits the business before the end of the earnout period.

4. Taxes

There are tax considerations to the seller and buyer that arise when a portion of the transaction price is based on an earnout. Questions arise as to whether earounts are taxable as capital gains or ordinary income, which should be addressed by a CPA or tax attorney.

As a takeaway, earnouts are a useful tool to help sellers and buyers reach agreement regarding the sale of a business. However, it's important for both sides to carefully think through future scenarios, and of course to work with an experienced attorney when drafting any agreements.