Buyers and sellers often use “earnouts” or “‘contingent price deals” to bridge valuation differences in merger and acquisition negotiations. An earnout is a payment made in the future by the buyer contingent upon the performance of the seller’s business after it is acquired. An earnout is based on revenue, gross profit, net income, future business value or some other measurement for a specific period after acquisition.
Sellers prefer retaining control of the business once sold to maximize their earnout. If sellers cannot retain control and, as a result, have no control over expenses affecting net income, they will prefer a revenue-based measurement instead. Buyers, however, are generally unwilling to let sellers retain control after funding the down payment of the total purchase price, which includes the earnout.
Earnouts are complex and tailored for each transaction. The seller’s employment could be a key part of earnout negotiations, but is contingent upon continued employment of the seller. Though the seller would prefer his or her compensation treated as capital gains because of lower tax rates, it is instead treated as ordinary income. Under generally accepted accounting principles (GAAP), buyers cannot capitalize seller’s earnout salary as part of the purchase price if the salary is tied to continued employment. A seller is continuously employed if the buyer deducts the earnout salary for tax purposes as part of the earnout negotiation. In which case, the earnout salary is expensed – and not capitalized – in the period incurred.
Other than in earnouts, valuations by a business valuation analyst are important in financial, tax and litigation matters.
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.