First, a couple of thoughts on earnouts when you sell your business. While an earnouts is often seen as a mechanism to defer payment of the purchase price; if used correctly, it should in fact be consideration to the seller of a company over and above full cash paid at closing. Earnouts should not be considered part of the purchase price if/until they materialize and are paid to the seller, but why not set additional opportunities to increase the purchase price paid, over and above the full cash price paid? If “x” is the maximum that a buyer will pay for a company in cash at closing, it is still possible to negotiate “x” at closing, plus an additional 25-50% or more after closing. As with most things in life and business, it is not the tool that is at fault, it is the way that it can be misused and misunderstood.
Even in a deal where a seller requires all cash at closing for the company, there is still an opportunity to negotiate additional amounts based on future performance, typically for the following three years. When you have negotiated the maximum cash at closing, you can negotiate additional compensation contingent on achievement of future metrics that are determined and described when negotiating the letter of intent and subsequent purchase agreement with the seller.
Another misconception of earnouts is that they have to be all or nothing, i.e. you only receive “x” earnout if you fully achieve “y”. It would often be more favorable to the seller to negotiate proportional earnout based on proportional performance towards forecasted financial performance. Furthermore, earnout can be based upon much more than revenue or EBITDA; in fact there can be any number of other performance milestones, operating benchmarks, customer retention, new customer gains, contract wins, or any other metric that may better suit a specific and unique company that is being acquired.
Tax Treatment of an Earnout
In terms of tax treatment, if an earnout is contingent on continued employment of the seller by the buyer, then the IRS may see earnout as ordinary income if it is an alternative way of providing incentive compensation, rather than a capital gain as part of the purchase price.
According to an article by CFO.com, the timing of the recognition of the gain on the sale is also affected by the earnout. CFO.com states the following:
“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.”
In summary, as with any other tax issue, we would recommend that you talk to a tax professional to plan the deal structure that works best for your particular tax situation.
Your advisor or investment banker’s task would then be to negotiate the deal structure that best represents your ideal outcome, without compromising price and terms with the buyer. Easier said than done, but there are countless ways to creatively structure a deal.