How Earnouts Impact Business Valuations
Earnout clauses are an increasingly common feature in business acquisition purchase agreements. These are typically contractual provisions stating that the seller of a business must earn part of the purchase price based on the business achieving certain financial goals.
This effectively helps to align the interests of the seller with buyer, reducing the buyer’s risk, and providing the seller an opportunity to receive a higher price for their company.
As such, there are numerous considerations, before, during the sale process, and afterward to ensure a smooth business valuation process.
Earnout Pre-Deal Considerations
The terms of the earnout ultimately determine how much the buyer pays the seller and under what circumstances. Therefore, each party has an interest in understanding strategic elements of the various earnout structures as it relates to their position.
A strategic analysis of the size and timing of an earnout’s payoffs would help inform the buyer or the seller in their negotiations.
Earnout Post-Deal Considerations
After the deal closes, there are potential reporting requirements associated with the earnout for both the buyer and the seller. Though there are established guidelines for valuing earnouts there remains significant room for an appraiser’s professional judgement in selecting a model and the key inputs.
On the buy side, there may be reporting requirements as part of US generally accepted accounting principles (GAAP) business combination accounting under ASC 805. And on the sell side there are tax consequences and thus reporting requirements to the IRS.
In general, installment sale rules allow a seller to defer taxes on earnouts until the payments are received. While this can be a good thing, since the tax liability isn’t paid until the cash comes in, there are traps to watch out for.
Potential Earnout Traps
One trap, depending on the terms, is the requirement to spread out the tax basis to match the projected payments, the period of the earnout, or over 15 years. For example, spreading out the tax basis could result in a capital loss, which may be difficult to realize, if the seller ends up being paid less than expected.
Another trap is an interest charge on the deferred tax liability to the extent that the potential maximum earnout is greater than $5 million. In situations where the earnout is highly uncertain, the seller may pay the IRS nonrefundable interest for the privilege of using the installment method.
In these sorts of situations, it may make sense to elect out of the installment method. However, to do so may require a valuation of the earnout.
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For more details on business valuations for your company, contact your Moss Adams professional.