An Earnout is an arrangement in which a buyer agrees to pay a seller additional consideration after an acquisition if the business reaches specified targets. It is a form of contingent consideration because some of the final purchase price depends on future events rather than being fixed at closing.
An Earnout in M&A may be tied to revenue, gross income, net operating income or specific operational milestones. For example, a portion of the purchase price might become payable if the acquired company reaches an agreed revenue target during the two years following closing. This approach can help bridge differences over valuation.
Buyers and sellers may use earnouts for several reasons in Mergers and Acquisition transactions. One motivation is avoiding third-party financing, allowing buyers to reduce the amount of outside funding needed to complete the transaction. Earnouts can also help when the parties disagree about the business’s value, with future performance providing a basis for determining additional consideration. For a closely-held business that continues to employ the owner(s) following the sale, an earnout can encourage the seller to support the company’s performance during the transition. Other motivations include bridging valuation differences, reducing upfront payment requirements, and aligning the parties’ interests after closing.
The parties first determine what will trigger payment. Common financial measures include revenue, gross income and net operating income. Agreements may also use non-financial milestones such as regulatory approval, patent issuance or a product launch.
The parties must then establish the measurement period, calculation method, payment deadline and accounting standards. Earnout periods commonly last one to three years, with calculations often delivered 60 to 90 days after each measurement period.
Payments may be binary, tiered or scaled. Agreements may also establish maximum payments, minimum thresholds and rules governing cash, stock, promissory notes or other forms of consideration.
Earnout tax treatment depends heavily on whether the payments are treated as additional purchase price or compensation for services.
When treated as purchase price, payments may generate capital gain for the seller, subject to applicable basis, recapture and installment-sale rules. For the buyer, amounts generally become part of the basis of acquired stock or assets and may be depreciated or amortized when applicable.
If payments are treated as compensation, the seller generally recognizes ordinary income and payroll taxes may apply. The buyer may receive a deduction. This distinction becomes especially important when the seller continues working for the business after closing.
Earnout disputes often begin with different interpretations of how performance should be calculated. Problems can arise when buyers change accounting methods, allocate additional overhead, increase spending, integrate operations or otherwise make decisions that affect the agreed performance metric.
For that reason, agreements often specify accounting standards, access to records, operating requirements and procedures for challenging calculations.
A typical process gives the seller time to review the buyer’s calculation and raise specific objections. The parties may then negotiate before submitting unresolved accounting issues to an independent accounting firm. Thorough Financial Due Diligence before closing can also help identify assumptions that should be addressed in the agreement.
Can an Earnout be structured to reduce seller’s tax burden?
Potentially. When an Earnout qualifies as additional purchase price rather than compensation, the seller may be able to receive capital-gain treatment and, depending on the structure, defer recognition through installment-sale rules. The applicable treatment depends on the transaction’s facts and documentation.
What happens to an Earnout if the buyer sells the business?
That depends on the agreement. Sellers may negotiate an acceleration provision requiring some or all of the remaining Earnout to become payable if the buyer sells the acquired business during the Earnout period or makes continued measurement impossible.
How long does an Earnout period typically last?
Earnout periods commonly run from one to three years after closing. The agreement should specify when measurement begins, how frequently performance is calculated and how long the buyer has after each measurement period to deliver its calculation.
Can an Earnout be tied to non-financial performance metrics?
Yes. Earnouts can depend on milestones such as regulatory approval, issuance of a patent or launch of a new product. The agreement should precisely define the milestone, the deadline and the buyer’s obligations to support or cooperate with achieving it.
For more than four decades, Bennett Thrasher has provided businesses and individuals with strategic business guidance and solutions through professional tax, audit, advisory, and business process outsourcing services. Contact Bennett Thrasher’s Mergers & Acquisitions Transaction Advisory practice, or call us at 770.396.2200.
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