Selling Your Business With an Earnout Clause

Earnout Verification Tips

Ensuring the seller’s interests are protected under an earnout clause, especially when additional payments are tied to EBITDA milestones, requires clear auditing rights and transparency measures. Maintaining a professional and collaborative tone is essential. Below are practical strategies to help ensure fairness and accountability:

Specify Audit Rights

• Include language that allows the seller or their representative to audit financial records of the sold division for the earnout period.

• Ensure access to detailed expense records, particularly expenses allocated to the division.

• Clarify the frequency of audits (e.g., annually or quarterly) and outline the scope to avoid conflict.

Set Clear Rules for Expense Allocation

• The purchase agreement should define how expenses are allocated between divisions. For example:
• Shared costs (e.g., administrative, IT, or management expenses) should be allocated based on pre-agreed formulas such as percentage of revenue or headcount.
• Expenses that are clearly non-recurring or unrelated to the sold business should not be allocated to the division.
• Include a requirement for the buyer to provide periodic cost allocation reports.

Require Financial Transparency

• Request periodic (e.g., quarterly) division-level financial statements that show:
• ?? Revenue
• Costs of goods sold (COGS)
• Overhead allocations
• ? Any intercompany charges or unusual expenses
• ? These reports can be reviewed by the seller’s CPA or financial advisor.

Engage in Friendly Communication

• Establish a cooperative working relationship with the buyer by setting up regular review meetings (e.g., quarterly) to discuss:

o?? Division performance

o?? Major expense trends or reallocations

o?? Milestones for the earnout payments

• Frame these meetings as a way to support the buyer’s success and the growth of the business, not just a check on compliance.

Introduce Objective Benchmarks

• Compare division EBITDA with historical benchmarks or projections pre-sale. Sudden deviations may suggest expense shifting or unusual allocations.
• Use industry benchmarks or similar businesses for additional comparisons.

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Third-Party Review Option

• Consider including the option to engage a neutral third-party forensic accountant to review the financials if disputes arise.
• This clause can add a layer of protection without requiring legal escalation.

Escrow or Holdback Option

• If there’s any uncertainty about earnout payments, you could negotiate an escrow account or holdback provision.
• Payments can be made in tranches based on verified milestones, with the seller having the right to review documentation.

Friendly Tone and Framing

When requesting information or audits, frame the discussions as a collaborative effort:

• “We’d like to stay aligned and ensure the business continues to grow successfully under your ownership. To that end, let’s establish some clear processes for reviewing expenses and performance.”

• “We’re confident in the success of the business, and these periodic reviews will help keep everything transparent for both parties.”

Example Audit Request

“We appreciate the continued effort in growing the division and maintaining EBITDA milestones. To help us verify the earnout progress, we’d like to review the detailed financial reports, particularly the allocation of shared expenses, which will ensure fairness for both parties and align with our mutual goals.”

Summary

By implementing these measures, you can ensure fair accounting of EBITDA for the earnout while maintaining trust and professionalism with the buyer.

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IRS Form 8594

2. Both Parties Must Match

The big deal is that both parties have to file matching IRS form 8594 and ensure that the allocation method on Schedule 3 follows the Residual Method applicable to regulations §1.1060-1 and §1.338-6 (defined below).

?Assets are classified into seven classes, and the purchase price is allocated in the following order:

?1.????? Class I: Cash and cash equivalents.

2.????? Class II: Actively traded personal property (e.g., stocks and bonds).

3.????? Class III: Accounts receivable and other assets that will convert to cash.

4.????? Class IV: Inventory.

5.????? Class V: Tangible assets like real estate, equipment, and machinery.

6.????? Class VI: Intangible assets other than goodwill (e.g., patents, trademarks).

7.????? Class VII: Goodwill and going concern value.

*???? Remaining purchase price, after allocations to the higher-priority classes, is attributed to Class VII (goodwill and going concern value

Section 1.338-6 (Overview)

26 U.S. Code Section 1.338-6

3.2 Contract Transferability

Assuming the target company has contracts that cannot be easily transferred to the buyer in an acquisition, the buyer and seller may want to make a 338(h)(10) election. With this election, the buyer purchases the target company’s stock, which allows the target to maintain non-transferrable assets (e.g., contracts) and remain a separate entity from a legal standpoint.

Tax - with 338(h)(10) Election

From a tax perspective, the transaction is treated as an asset purchase, enabling the buyer to achieve a stepped-up basis in the target’s assets for depreciation and amortization purposes, which provides the benefits of an asset sale while avoiding the legal and logistical challenges of transferring specific assets.

Tax - without 338(h)(10) Election

If the target’s stock is valued at $1.5 million but the tax basis in its assets is only $500,000, a traditional stock sale would limit the buyer’s basis in the assets to $500,000. Additionally, stock cannot be depreciated or amortized for tax purposes.

However, in an asset purchase, the buyer’s tax basis in the acquired assets is stepped up to their fair market value of $1.5 million, allowing for depreciation and amortization deductions on the increased basis.

Section 1.338-6 (Key Concepts)

Under 26 CFR § 1.338-6, the terms ADSP (Adjusted Deemed Sales Price) and AGUB (Adjusted Grossed-Up Basis) are key concepts used in a Section 338 election, which treats a qualified stock purchase of a corporation as an asset acquisition for tax purposes. Here is a detailed explanation of each term and their allocation:

Adjusted Deemed Sales Price (ADSP)

Definition: ADSP is the deemed sales price of the target corporation’s assets when the target is treated as having sold all its assets. It applies when a Section 338(h)(10) election is made, and the seller’s gain or loss is calculated as if the target sold its assets to the buyer at fair market value.

?How ADSP is Determined:

• ADSP equals the sum of:

o?? The grossed-up amount realized on the sale of stock.

o?? The target corporation’s liabilities as of the acquisition date.

• Formula:

o?? ADSP=Grossed-up?Purchase?Price?of?Stock+Target?Liabilities

• ADSP represents the hypothetical sale price of the target’s assets in a deemed asset sale.

Adjusted Grossed-Up Basis (AGUB)

Definition: AGUB is the deemed purchase price of the target corporation’s assets from the buyer’s perspective. It represents the buyer’s cost basis in the acquired assets after making a Section 338 election.

?How AGUB is Determined:

AGUB equals the sum of:

• The purchase price of the target stock.
• The target’s liabilities as of the acquisition date.
• Other relevant costs incurred by the buyer (e.g., transaction costs).

Formula:

GUB=Purchase?Price?of?Stock+Target?Liabilities+Other?Costs

·?????? AGUB reflects the total amount the buyer is deemed to have paid for the assets.

Allocation of ADSP and AGUB

Once ADSP and AGUB are determined, the amounts must be allocated to the target corporation’s assets using the residual method under Treasury Regulations § 1.338-6 and § 1.338-7. This allocation mirrors the rules under Section 1060 for asset sales.

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Steps for Allocation:

1.???? Classify Assets into Seven Classes:

·?????? Class I: Cash and cash equivalents.

·?????? Class II: Actively traded securities.

·?????? Class III: Accounts receivable.

·?????? Class IV: Inventory.

·?????? Class V: Tangible property (e.g., real estate, machinery).

·?????? Class VI: Intangible assets (e.g., patents, trademarks, copyrights).

·?????? Class VII: Goodwill and going concern value.

?2.???? Allocate in Order of Priority:

• ADSP (for the seller) and AGUB (for the buyer) are allocated in priority order, starting with Class I and ending with Class VII (goodwill).
• Any remaining purchase price after allocating to tangible and identifiable intangible assets is assigned to goodwill (Class VII).

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3.???? Fair Market Value:

• Assets are assigned their fair market value within each class. If ADSP or AGUB exceeds the sum of the fair market values of the other classes, the remainder is allocated to goodwill.

Practical Significance:

For Sellers: ADSP determines the gain or loss on the deemed sale of assets.

For Buyers: AGUB determines the buyer’s basis in the acquired assets, which impacts future depreciation, amortization, or cost recovery deductions.

?The allocation is critical because it directly affects the tax consequences for both parties:

• Ordinary income (e.g., depreciation recapture) versus capital gains for sellers;
• The step-up in basis for buyers, which impacts their deductions;

By following § 1.338-6, both ADSP and AGUB ensure consistent and fair allocation of the purchase price across the acquired assets.

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