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Earnouts in a Business Sale

3 minute read

Earnout provisions can introduce significant issues into business sale negotiations. An earnout is a term of sale that bases the final purchase price payable to the business vendor in part on how the business performs post-closing after the vendor has sold it. This type of sale term is used when the vendor and purchaser cannot agree on a final purchase price at the time of closing, most often because the business has not proven to the purchaser's satisfaction that the level of earnings on which the vendor wants the valuation to be based is sustainable. This could, for example, be because the business is in its early stages and does not have a sufficiently long track record or because the business has only recently been turned around and has not established that the turnaround is maintainable or on an upward trajectory.

Use of an earnout in these circumstances amounts to the purchaser saying: I'll pay you what you're asking if you can prove the earnings you are basing the valuation on are actually achievable.

The mechanics of using an earnout needs to be carefully addressed. At the most basic level, when earnings from the business being sold need to be calculated for post-closing periods, those earnings need to be calculated on an apples to apples basis with earnings pre-closing. This means that the entity in which the business was carried on pre-closing needs to be identical to, or at least identifiable as, the entity in which the business is being carried on post-closing, for purposes of calculating revenues and expenses attributable to that business. If the business has to be carried on by the purchaser post-closing in a different entity for some reason, then that business still needs to be accounted for as a separate business, comparable to the pre-closing business.

One of the reasons for the purchase transaction is usually to take advantage of cost saving synergies or revenue enhancement possibilities between the purchaser's existing business and the business being purchased from the vendor. The impact of these items on earnings of the business being sold will need to be negotiated since the vendor will want them to be fully reflected in earnings for purposes of the earnout calculation whereas the purchaser may regard some of these earnings improvements as resulting from the combination of the two businesses rather than as being attributable to the business being purchased for purposes of finalizing the purchase price. Usually this negotiation results in a splitting of the baby, i.e. allocating a negotiated portion of the cost synergies and revenue enhancements to the earnout calculation.

Another additional issue is the management of the business during the post-closing earnout period. Understandably, the vendor (who typically stays on as an employee of the business during at least the earnout period) will want to continue to have control over management of the business during that period, both as to his own involvement and the involvement of other key personnel that he is familiar with. This objective will have to be assessed against the purchaser's intentions towards management. For instance, what control does the purchaser want to have over management post-closing; is the purchaser willing to have the vendor in charge of day to day operations of the business and, if so, what overall budgetary and other constraints will the purchaser want to have over the vendor's management. Is the purchaser willing to permit the vendor to retain key personnel from the pre-closing period who would now be employed at the purchaser's expense?

Another issue which comes into play is the tax treatment of earnouts. Agreements need to be carefully structured if the earnout proceeds are to be treated for tax purposes as sale proceeds, taxable at lower capital gains rates, rather than as ordinary income.

Overall, given the potential issues and uncertainties with earnout provisions, it is preferable for the parties, if possible, to agree on the final purchase price at closing, even if a portion of the purchase price is paid post-closing. In some cases that will not be feasible, typically for the reasons noted above. In these cases, it will be necessary to address and negotiate the sometimes-difficult issues described above.

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Greg Hatt

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