Language is Key in Earn-Outs: PART 2

Don Sihota
Articles

In my last article, I discussed the concept of the earn-out.  I mentioned that an earn-out is simply the method by which a purchaser seeks to reduce the risk it is taking on when purchasing a business.  Of course, when a purchaser reduces its risk, the effect is that the seller takes on more risk. Earn-outs can be a good way to bridge the gap of price expectations between buyers and sellers.

Earn-out provisions actually come in two forms: (1) the standard earn-out and (2) the reverse earn-out or “earn in”. The standard earn-out provision defines a base payment and then goes on to state the final price will be the base amount plus the earn-out amount, which will be based on a formula. The reverse earn-out starts at fixed price which will be reduced based on how the business does after the sale. These are two different ways of getting to the same place but the key point for the parties is to understand the tax impact of each type of earn-out. Therefore, if an earn-out is contemplated as part of a transaction, it is important to obtain tax advice to determine what type of earn-out should be used.

Most earn-out provisions will operate over a three to five year period which begins on the closing of the transaction. The form of the earn-out will be subject to the negotiation and, since every situation is different, every earn-out is different. In the case of a standard earn-out, you might see the seller receiving additional payments if certain sales thresholds are met or certain profits are achieved. Whatever measure for payment is used, a seller will want to ensure that there is no room for manipulation. That is why sellers want earn-outs based on top line figures on the financial statements, such as sales or gross sales, rather than bottom line figures such as net earnings or profits. Of course purchasers want earn-outs based on more bottom line figures, such as net income. This allows them more flexibility on whether or not the milestones were achieved.  If there is an earn-out, the seller should try to control the business activity after the sale to ensure the buyer can’t do things to reduce the likelihood of achieving the earn-out.  Of course, the buyer will resist this.  Having worked on many transactions with earn-outs, I have language to include in any deal that addresses these concerns.

There is much more to earn-outs than I can deal with here. The key is for you to obtain the advice of an experienced lawyer and accountant/tax advisor so that the best result is obtained for you.

Language is Key in Earn-Outs: PART 1