Blueprint for Wealth
Wayne M. Zell, Esq.
Properly Structuring Earn-Outs Save Headaches Down the Road
Many of you are trying to sell your business while tax rates remain low and as the economy struggles to recover. In structuring the sale, you may have to consider using an “earn-out”, or payment in the future based upon certain events occurring or targets being met, to get a buyer to the closing table. Typically, earn-outs are used where the buyer wants to bridge the valuation gap in what he is willing to pay the seller and what the seller wants. This gap might arise where the seller has new and unproven products or services. The seller may view the prospects for the new products and services with rose-colored glasses, while the buyer may not see things quite as optimistically. Or, the seller may view prospects for the business or economy to be excellent, while the buyer sees obstacles ahead. Alternatively, the buyer may want the seller involved in the business to ensure its continued success. Whatever the reason, the earn-out structure likely will affect the parties’ ability to achieve their business goals following closing. Here are some important considerations in structuring your earn-out.
Earn-outs are most frequently based upon financial measurements. Common measurements include sales revenues for the purchased business, net profits, and earnings before interest, taxes, depreciation and amortization (EBITDA). If you must remain involved in the business after closing, then try to structure the earn-out to retain control over your ability to achieve the desired result. The buyer may want you involved as well, but may not be as willing to relinquish control of the newly acquired business. If the buyer takes any action that causes you to lose control, then the agreement may cause the earn-out to accelerate the earn-out and be payable in a lump-sum, whether or not the milestones have been met.
Financial earn-outs based solely on revenues may be easier to achieve and verify than earn-outs based upon profits. For example, the buyer may try to load up the seller’s business with new expenses, such as the buyer’s overhead, reducing seller’s profits. Revenues may be harder to manipulate, but still may create problems in measurement.
The seller also will want the right to verify the buyer’s calculations by demanding back-up information and having an accountant inspect the buyer’s books and records. The buyer will want to limit seller’s access to buyer’s records. If the inspection reveals significant errors in buyer’s numbers, then the buyer should pay for the inspection cost, as well as the additional earn-out. If the audit reveals no errors, the seller should bear the inspection cost.
Buyers generally insist that the seller meet certain thresholds before paying the earn-out and impose annual caps or an overall maximum amount on the earn-out payable. The thresholds usually are set above seller’s projections, so that the seller must exceed expectations to receive the earn-out payments. Similarly, placing a ceiling on the earn-out ensures that the buyer does not pay too much for the seller’s business. At the same time, the seller will want the ability to carry over or carry back superior performance in one year to offset sub-par performance in another year. Usually, earn-outs have a fixed term, so that the seller’s ability to achieve the maximum earn-out price expires after a specific number of years or months.
Earn-out payments usually are made in cash. In some cases, the buyer may offer its stock in payment of the earn-out. The seller should be careful in structuring an earn-out paid in stock. In a volatile stock market, the seller takes a risk that the stock value may decline after closing. Also, the seller may not want stock, unless the stock can be sold in time to pay income taxes generated on its issuance. The seller will want to have the ability to time the sale of the stock, which may only be available if the buyer is publicly traded on a national securities exchange with a ready market for its shares. So, the seller may demand rights to register the buyer’s stock for resale; receiving unregistered stock in a publicly traded company limits the seller’s ability to generate liquidity to pay taxes on the value of the stock received. Tax and other factors also should be considered in deciding on whether and how to structure earn-out payments in the sale of a business.