Article: Using Earnouts to Facilitate a Business Sale


	Lynn Westergard

December 2007

Using earnouts to facilitate a business sale

An earnout gives the buyer a safety net and offers the seller incentive to help the company succeed after the sale is finalized

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. If the parties appear to have reached an impasse, an earnout may save the deal and benefit both sides.

An earnout is a contractual provision stating that the seller of a business is to obtain additional future compensation based on that business achieving certain future financial goals. The financial goals are usually stated as a percentage of gross sales or earnings.

Example. A business owner is asking $20 million for his company, based on projected earnings. He has a prospective buyer who is willing to pay only $17 million, based on the company’s historical performance. An earnout provision structures the deal so that the entrepreneur may receive more than the buyer's offer, if the business achieves a certain level of earnings. The exact numbers depend upon the business and the situation, but in this example a simplified provision might set the purchase price at $17 million plus 5% of gross sales over the next three years. The earnout thereby helps eliminate uncertainty for the buyer.

Another common feature of an earnout is that the buyer purchases a corporation’s assets but doesn’t pay a premium over book value in the purchase price. The advantage to the seller: He 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.

Meanwhile, 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 IRS considers them reasonable compensation.

Buyer considerations. Before deciding whether to use an earnout, a buyer needs to consider these questions:

Am I 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 my up-front exposure to risk and allow me to conserve cash?
Will the earnout attract IRS questions about unreasonable compensation?
Will I be able to motivate the seller-manager after the earnout period is over? Will the seller continue to be involved?

Seller considerations. To make sure an earnout will be beneficial, a seller needs to ask:

Am I willing to continue in the business?
How will I deal with trying to run a company that I no longer control?
Will I earn more from an earnout than from a straight sale?
How much confidence do I have in the buyer’s ability to manage the business?

Clearly, both parties must be more or less of one mind on two other questions:

Are the business’s prospects strong enough to achieve the earnout?
To what measures – e.g., sales, net profits, performance improvements – will the earnout be tied?

Many experts recommend using revenue targets instead of profit or growth targets, for the simple reason that it is harder for buyers to do things that will depress sales than to depress net income.

With a little willingness to compromise on both sides, and with advice from experienced professional advisors, an earnout can help the buyer and the seller negotiate an agreement that will achieve their goals.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.