The Earnout
Bridging the Gap Between Buyer and Seller
by
J. Kevin Crain
The Situation
It happens all the time.
The chemistry is good. Buyer and seller like each other, respect each other, and want a deal.
The money is there. The bank likes the minimal part they are willing to take, the buyer’s investors recognize there is profit to be made, and the seller is willing to finance a piece as retirement cash flow.
The company is clean. Every preliminary indication from the lawyers, the accountants, and the staff shows the company carries low risk in a tough environment.
But there is no agreement on the price. The buyer looks at the past, and adds up the value of the actual stuff he or she is getting. That number inevitably comes in low, especially in this economy. The seller envisions the future, and calculates the cushy salary and vigorous profits he or she must give up. That number inevitably comes in high, especially to an entrepreneurial mindset.
So how does the advisor bridge the gap between buyer and seller?
Of course there are a variety of techniques the wise advisor can offer the client. The use of noncompete arrangements and consulting agreements has been extremely valuable in this area. But today I want to focus on the earnout as a sometimes overlooked tool in the advisor’s arsenal.
What is it?
I define an earnout as an extra payment from buyer to seller, deferred to one or more later years, that is contingent on the performance of the company after the deal is closed. For example, buyer may agree to pay seller ten percent of company profits for five years following the closing. This simple example includes all three of the essential elements: (1) more money for the seller; (2) deferral to later years; and (3) a tie to company performance.
The earnout is called different names by different people. Some call it a workout, or a bonus arrangement, or a contingent payment sale. Whatever you call it, it offers five distinct advantages to the transaction:
Advantage # 1: It pays for itself.
The buyer ought to love the earnout, because it matches payments to the seller with the company’s cash flow. If the company does not cash flow well enough to meet the earnout goal, no payment is due to the seller. If the company cash flows well enough to meet the earnout goal, there is available cash to pay the seller. The earnout pays for itself.
Advantage # 2: It validates the seller.
The sellers ought to love the earnout, because it proves what the seller has been saying all along. The seller has an opportunity to participate in the bright future he or she envisions for the company. If the company does not perform, the seller should get less. But if the company performs as expected, the seller should rightfully claim a higher price. The earnout validates the seller.
Advantage # 3: It unifies buyer and seller.
In the final analysis, everyone has a vital interest in the success of the deal. The buyer wants a wise investment in a profitable company, and the seller wants a fair price for a company that will go the distance. The earnout exactly matches the interests of buyer and seller, because it gives the seller a stake in the buyer’s continuing success with the company. The earnout unifies buyer and seller.
Advantage # 4: It is completely flexible.
The terms of the earnout are limited only by the human imagination. The earnout can be linked to gross sales, gross profit, net profit, total salaries, cash flows, or the price of eggs in China. It can run for one year, five years, or 27 ½ months. The earnout can pay at 1%, 2%, 5%, 55%, or on a sliding scale. If buyer and seller can express it, the earnout can reflect it. The earnout is completely flexible.
Advantage # 5: Buyer and seller control the taxes.
Because the earnout itself is completely flexible, the tax regime has to be flexible also. The earnout can be treated as a performance bonus to the seller individually, resulting in a quick deduction for the buyer and ordinary income treatment for the seller. And the earnout can be treated as a contingent portion of the purchase price, resulting in deferred deductions for the buyer and a lower tax rate for the seller. If the wise advisor is brought in at the start of the transaction, buyer and seller can control the tax treatment of the deal.
Call Crain Law Firm, LLC
The earnout is not a magic bullet. It takes time to understand a proposed transaction and craft a flexible solution that meets the needs of buyer and seller. But that is exactly the kind of challenge I enjoy. The next time you get stuck in the middle of what ought to be a good deal for both parties, please give me a call.
J. Kevin Crain
CRAIN LAW FIRM, LLC 636-G Long Point Road #95 Mt. Pleasant, South Carolina 29464 Phone (843) 735-7602 Fax (843) 735-7002 Mobile (843) 327-7744 Email kevin@kevincrain.com