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Germaine Curtin
Transaction Attorney
Earn-Outs and how they impact the
sale of a business
Matt Slappey CBI, BCI
Certified Business Intermediary
Mergers and Acquisitions (M&A) Advisor
Not to be distributed without
written permission
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Earn-Out
Definition according to Google:
a provision written into some financial transactions
whereby the seller of a business will receive additional
payments based on the future performance of the business
sold
Wikipedia defines it as:
Earn out refers to a pricing structure in mergers and
acquisitions where the sellers must "earn" part of the
purchase price based on the performance of the business
following the acquisition. In an earn out, part of the
purchase price is paid after closing based on the target
company achieving certain financial goals
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Reality of an Earn-out
• An earn-out is used in most cases to bridge what a
seller thinks his/her company is worth to the price
that a buyer is putting on that same business.
• When a business is full of “potential” that the owner
has never actually realized (some of this is real and
some is smoke)
• Keeps negotiations alive when the parties seem far
apart.
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Scenario
• You have a listing/engagement with a client.
• The client has $500K per year in cash flow.
• The market will tell you that a buyer’s offer of 3 x
cash flow is not unreasonable.
• The seller wants $2,000,000+ or a 4x+ multiple
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Things to understand
• Why does the seller think the company is worth more
than the market rate?
• Is there a valid reason that the company is worth more?
• Is there true “unrealized potential”?
• Is the company about to land a large contract or
opportunity?
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Examples of companies that
lean toward an “earn out”
Consulting companies
No sales reps other than the owner
No management other than the owner
Family members involved in the business
Professional practices
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SBA Deal?
• If you are going to seek financing via an SBA
loan for your deal, do not pursue an earn-out
because the SBA does not allow the use of
earn-outs. They require a defined purchase
price.
• This is not the SBA lenders in the room making
the rule, it is the SBA.
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Earn-Out Structure
• Create an earn-out that is the most simple and
effective way to measure company or owner
performance.
• Complicated earn-outs must be clearly
understood by all parties and all parties must be
able to verify all the information required to
create the payouts.
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Types of Structures
• Revenue Goal
• Gross Profit Goal
• EBITDA or SDE Goal
• Retention of current clients
• Acquisition of new clients
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Tax Implications
• Most earn-outs are treated as an “Installment
Payment” which allows taxation in the year it is
actually received.
• Can use this technique to keep taxation of sales
of smaller businesses under the top tax rates.
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Tax Implications
Tax Rates-Single Person
Annual Income
25%
36,251-87,850
28%
87,851-183,250
33%
183,251-398,350
35%
398-351-400,000
39.6%
400,001+
Instead of $500,000 today, what if a seller gets $87,850
this year and for the next 5 years? Tax savings of
$73,000 that seller gets to keep because of the tax
structure of the payments! (14.6% x $500,000)
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Tax Note
It should also be noted that there may be
situations in which a seller would choose to
recognize the sale of a business currently and
forego deferral treatment, such as when a
business is sold at a loss, or when it is known or
expected that tax rates will increase in the future.
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Taking care of employees
It is possible for an owner to expense a portion of
his earn out payments that are then paid to
employees for retention or performance that leads
to the seller receiving an earn-out payment.
Scenarios change as to how to legally do this
based on differences in an asset or stock deal, so
consult a qualified attorney and/or tax advisor.
This can really motivate employees to achieve the
earn out goals, thus earning it for the seller!
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Summary
Earn outs are a powerful tool to bridge the gap in business
values.
Both sides can benefit from using them effectively.
There are tax implications and advantages of earn outs.
Knowing how to navigate earn-outs can help you close
more transactions.
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Thank You For Your Time!
Questions?
Matt Slappey
404-486-0350
[email protected]
www.murphybusiness.com/decatur
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