What is an earnout?
If a company’s owners are negotiating a sale of their business, one facet of compensation the buyer may propose is an earnout, i.e., a contingent payment tied to a benchmark for the company’s performance post-sale.
An earnout is generally a tool of compromise between buyer and seller – if the parties cannot agree on a purchase price, using an earnout is a way to protect the buyer on the downside if the company does not perform as well as anticipated post-closing, while providing an upside in earnings for the seller if the agreed benchmark is met. The range of calculations for arriving at an earnout is infinite, but in general, the earnout will be some multiple of a financial metric or a fixed or variable number based on some measure of company performance. A seller, if confident about the company’s future, may view an earnout as a way to realize more money on the sale of the business than settling for a fixed number that is lower than what seller is willing to accept.
With all that being said, there is always a degree of risk involved in agreeing to contingent compensation which may or may not be realized, so most sellers are not inclined to agree to an earnout that will comprise too substantial a portion of the overall purchase price (with exceptions, as with all things). Another potential drawback to using an earnout is that it can result in less favorable tax treatment. If the transaction documents provide that the entirety of the earnout constitutes ordinary income to the seller receiving the payment, then seller will be taxed at an ordinary income tax rate, rather than at the preferred capital gains rate that could otherwise be available to seller.
Restructuring The Earnout Benefits
In light of this, it is important for a selling owner of a company to consider structuring the earnout so that the preferred capital gains rate can be attained on as much of the post-closing proceeds as is allowable under applicable law. A common method by which a buyer and seller do so is by agreeing on a separate payment that will constitute reasonable compensation to the individual for his or her post-closing services, and will thus be taxed at an ordinary income rate. Then the earnout monies that are separate from such reasonable compensation amount will be categorized in the deal documents as “deferred purchase price” being paid for the company’s equity or assets, and thus will be taxed at the same rate for the initial payment at closing. Taxation for a sale of equity will be at the capital gains rate, and for a sale of assets, as the facts allow and when structured correctly, the capital gains rate will predominate as well. Thus, the selling party will attain a preferred tax rate on the post-closing compensation that is separate from the set ordinary income.
As with most facets of a large-scale M&A transaction, the legal considerations in structuring the earnout terms correctly are far too varied and involved to cover in depth here, but there is great benefit in knowing beforehand that the structure of the earnout can result in vastly different tax treatment, and that advance planning and utilizing proper terms can help a seller achieve a much better position with regard to after-tax proceeds on a sale.