The Ins and Outs of Earn-Outs
John F. Thompson, CPWA?, CIMA?
As a Private Wealth Advisor, I help highly successful Business Owners, Professionals and their Families work towards making "work" optional so they can focus on their life of meaning
Key Takeaways
When selling your business, it might make sense to include an earn-out provision. But you’ve got to plan carefully and tread cautiously if you take this route.
With an earn-out, you essentially defer some of the purchase price and make receiving it dependent on the performance of the company for a period of time after you sell. If the business hits or beats certain performance targets, you get the rest of your money—and can potentially earn even more from the sale than the initial price, depending on the terms. A buyer might like to add an earn-out provision because it could protect him or her from overpaying for your business if it doesn’t perform as well as you predict.
Earn-outs are often an effective way to reconcile the differences in perceived value between buyers and sellers. With an earn-out in place, the buyer is essentially saying, “If the company’s actual future income meets the seller’s projections, then the seller should get the asking price.” Meanwhile, the seller is essentially saying, “If my projections are on the money, I deserve an even greater amount for the company for taking on additional risk because of the earn-out.”?
The issues of control and timing
As important as an earn-out can be, we find that a significant percentage of business owners don’t pay as much attention to their earn-out agreements as they should, according to attorneys who work with these clients (see Exhibit 1).?
One key aspect of an earn-out to focus on is control over decision-making. An earn-out provision will contractually obligate you to remain with the business after you sell for a defined period of time. For the earn-out to work well for you, you have to maintain a level of control over major business decisions that you feel is necessary and appropriate. If the buyer fully takes the reins from you and you give up all control, the business’s income—and your earn-out—is at the mercy of his or her decisions.
Another major concern is the timing of the earn-out. The transition period of an earn-out tends to be relatively short. Ideally you want it to be no longer than the amount of time needed to maximize your earn-out payments. Typically, though, former business owners add in a bit of slack. For example, if you think you can achieve the earn-out-maximizing objectives in two years, you might negotiate to make the measurement period be three years or less.
Timing is important because of the impact that decisions about the business can have in the near term. If, after the sale, the buyers decide to set up a research and development group or significantly increase marketing efforts, profits could be lower in the short term. That could translate into a lower earn-out, even though it might produce greater longer-term benefits.?
Legal protections
While you’ll want to retain a considerable amount of managerial control over the business after you sell, you will probably no longer have any legal control. You will therefore need to put legal protections in place to ensure you can collect what you are owed. Such protections can take a number of forms, including:
Keep in mind that anything that increases costs has the potential to decrease the earn-out. So, for example, you do not want to be forced to hire new employees or expand the business.?
Important: That doesn’t mean you should seek to stop the company from growing, of course. The critical issue is who will pay for any expansion: you (through your earn-out) or the buyer? If the money for growth comes from the buyer, then expansion is something you may want to pursue. However, any business moves that are a financial drain on the company may very well lower your earn-out. If, for instance, loans are obtained to finance growth, the interest payments may end up working against your payouts.
Also, all business dealings between the company and any affiliated companies of the buyer have to be arm’s-length transactions. Otherwise, the company might end up selling or buying from the affiliates at prices that are not profitable. The pricing might even result in losses for the business.?
Another consideration is maintaining the company’s existing general and administrative costs as well as its overhead costs, rather than using the cost structure that a buyer who owns other companies already has in place (which may be greater, potentially cutting into your payment).?
领英推荐
Litigation concerns
Earn-outs can be quite complex. Litigation involving earn-outs is common in our experience—and such litigation can get expensive fast. What’s more, buyers will often have deeper pockets than you have. They can use litigation to bludgeon you into submission so you settle for less.
Therefore, it’s wise to consider adding a clause in any earn-out agreement that deals with the cost of litigation. Such a clause should require the buyer to pay the owner’s legal fees if the owner is successful in litigation—and vice versa.?
Addressing imputed interest?
Sellers are often unaware that a portion of each earn-out payment is imputed interest, which is taxed at higher ordinary income rates instead of at the lower capital gains rate. There are a number of ways to avoid a higher-than-necessary tax bill, such as having the buyer pay the interest or by increasing the size of the earn-out payment to compensate.?
What is important to recognize here is that it will cost you more to do earn-out payments than if you simply sold your company outright with no earn-out agreement at all. Therefore, you have to take steps to get the optimal value from the sale of your company, including addressing the tax differential between ordinary income and capital gains.
Getting help
The complexities around earn-outs are just some of the reasons we believe you should seek expert guidance when negotiating the sale of your business. Without a knowledgeable navigator, for example, you can end up becoming too optimistic about the likelihood that an earn-out will generate a massive payday for you. Putting too many of your eggs in an earn-out basket can be a mistake.
Armed with a team of people who can help, you can potentially put yourself in the best possible position to maximize the amount of wealth you have when you finally walk away from your business for the last time.
VFO Inner Circle Special Report?
By Russ Alan Prince and John J. Bowen Jr.
? Copyright 2021 by AES Nation, LLC. All rights reserved.
No part of this publication may be reproduced or retransmitted in any form or by any means, including, but not limited to, electronic, mechanical, photocopying, recording or any information storage retrieval system, without the prior written permission of the publisher. Unauthorized copying may subject violators to criminal penalties as well as liabilities for substantial monetary damages up to $100,000 per infringement, costs and attorneys’ fees.
This publication should not be utilized as a substitute for professional advice in specific situations. If legal, medical, accounting, financial, consulting, coaching or other professional advice is required, the services of the appropriate professional should be sought. Neither the authors nor the publisher may be held liable in any way for any interpretation or use of the information in this publication.
The authors will make recommendations for solutions for you to explore that are not our own. Any recommendation is always based on the authors’ research and experience.?
The information contained herein is accurate to the best of the publisher’s and authors’ knowledge; however, the publisher and authors can accept no responsibility for the accuracy or completeness of such information or for loss or damage caused by any use thereof.
Unless otherwise noted, the source for all data cited regarding financial advisors in this report is CEG Worldwide, LLC. The source for all data cited regarding business owners and other professionals is AES Nation, LLC.?
Securities offered through LPL Financial. Member FINRA / SIPC. Investment advisory services offered through NewEdge Advisors, LLC, a registered investment adviser. NewEdge Advisors, LLC and Congruent Wealth, LLC are separate entities from LPL Financial.