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By David Baer and Gary C. Bubb
As lawyers, we know that earn-outs are often an element of the purchase price in the sale of a business. This means both good and bad news for our client sellers.
A seller risks the possibility that despite the credit-worthiness of a buyer, the full expectancy of the purchase price will not be realized.
On the other hand, a seller can expect to receive the full amount of an earn-out in a merger and acquisition transaction if there is careful negotiation and drafting of the agreement. As attorneys representing sellers, that is up to us.
An earn-out, which is a contingent portion of the purchase price paid after the closing of the sale of a business, is typically based on the performance of some measure of the business after the closing.
Usually payable over a term of one to three years, earn-outs are negotiated in various circumstances. For example, if the buyer and seller disagree on the value of the business because it is experiencing rapid growth or is expected to grow in the future, an earn-out may be negotiated to bridge this difference.
Another example would be if management changes have been made because a business's recent performance is weak. An earn-out may be an appropriate way to bridge the difference between the financial statement value of the business and the seller's confidence in the future business performance.
In other circumstances, an earn-out may be negotiated if the value of the business is based on retaining or expanding the seller's existing customer base, revenue stream or profit stream.
When the seller or seller's existing management remains active in the business after the closing, an earn-out may be sought by the buyer to align management's performance with the buyer's business strategy for the acquired business.
Occasionally, the buyer's pre-acquisition due diligence may raise a risk from the buyer's perspective that affects its formulation of the purchase price. For example, the buyer may have a concern that a key customer will not continue with the business after the sale or that the current growth curve of the business will not continue after the sale.
Measuring earn-outs
Earn-out consideration is typically determined based on a key metric of the performance of the business after the sale. It can be as simple as a formula based on the percentage of the business revenues after the sale, e.g. increases in revenue, from the business as a whole or to specific customers or business segments.
Also, earn-outs can be measured by the gross profits or net profits of the business or based on more exotic measures, such as the compounded annual growth rate of profits or revenues.
In order to avoid issues of interpretation or allocation, a seller should negotiate for a raw top-line metric to form the basis of the earn-out formula that is easy to measure and harder to manipulate or disagree over. In this regard, an earn-out formula that is based on measures such as gross revenues or units sold are more favorable to sellers as opposed to measures based on profits or earnings. If the earn-out metric is based on a derived figure in the financial, such as net income or net profit, the parties should, at a minimum, require that GAAP be used in arriving at that figure.
Often, the seller has specific concerns about successfully attaining his earn-out expectations. This uneasiness is related to the conduct of the business and the amount of control and autonomy the seller can keep with respect to the business after the closing.
It is not typical for a seller to remain involved in a business after it is sold. However, if a significant portion of the purchase price is determined after the business has been sold, the seller will want to make sure the buyer's control over the business does not frustrate the seller's ability to maximize earn-out consideration.
Earn-outs are often used where the seller's owner or existing management remains with the business after the closing. In these circumstances, the seller should negotiate to preserve the autonomy and control of the business subsequent to the closing, so that the buyer is restrained from instituting changes that will adversely affect the business's performance and frustrate the earn-out.
This is done through negotiation of covenants in the acquisition agreement that specify the level of control the seller or its management will have, on the one hand; or the lack of interference by the buyer in the operation of the business after the closing, on the other hand.
As representatives of the seller, lawyers should be certain that assurances in the acquisition agreement regarding conduct of the business after the closing are highly negotiated and tailored based on factors such as: relative bargaining strength of the parties, the business culture of the acquirer, and how meaningful the prospect and amount of additional earn-out consideration is to the seller.
Transaction covenants
In our experience we have seen brief, general restrictions that have resulted in the seller fully accelerating an earn-out. Language can be as simple as:
"The buyer agrees not to impose any reporting structure with respect to the Company or otherwise establish any requirements which will unreasonably interfere with the conduct of the Company's business or be directed to restrain the ability of the sellers to earn the additional consideration …"
In a different situation where the seller's management was going to remain with the business, the buyer, via post-closing covenants, exerted control over the business going forward, requiring the buyer's approval of the annual budget and major actions. The seller's ownership and management were legitimately concerned that they would not have the autonomy and control they needed to achieve the additional earn-out consideration.
A more generalized covenant regarding the intent of the parties was negotiated as follows:
"During the Earn-Out Period, the Purchaser agrees that (i) it will not take any action affecting the division, the purpose and intent of which is to materially adversely affect the division's ability to maximize the amount of the Earn-Out and (ii) it will not impose any material requirements on the division which prevent the seller's ability to maximize the amount of the Earn-Out."
In this transaction, the purchaser further agreed that, during the earn-out period, it would not reduce the division's working capital via inter-divisional transfers or sell any of the operating assets without the approval of the seller.
Moreover, the purchaser agreed that it would not reassign any of seller's management to other divisions during the earn-out period. These covenants allowed the sellers to maximize their earn-out.
Other transaction covenants have been much more detailed in terms of the earn-out protections. The acquisition agreement should be clear that once any earn-out covenants are breached, the purchaser is in default and the earn-out payments are due. A provision such as the following may suffice:
"If a final order is issued that establishes that purchaser has materially breached any of the Earn-Out protections set forth in this Agreement, the purchaser shall pay the full Earn-Out amount as provided herein within 10 business days of receiving such final order."
In this regard, the parties should negotiate a default earn-out amount if the buyer breaches the earn-out covenants.
Tax issues to consider
Finally, sellers need to consider tax issues with respect to earn-outs.
Generally, taxable earn-out payments have the same character (capital gain or ordinary income) as the payments made at the closing.
For example, if the transaction is structured as a stock purchase, earn-out payments will receive capital gain treatment even if the payment benchmarks are based on revenues or profits.
If the transaction is structured as an asset purchase, the character of earn-out payments made to the selling business should be the same as the character of the consideration that was paid at the closing.
Earn-out payments made after the year of sale generally will be taxed on the installment method (each earn-out payment will have three components: (i) tax-free recovery of basis, (ii) taxable gain and (iii) an amount treated as interest).
The amount of each earn-out payment that will constitute recovery of basis will depend on whether or not there is a stated maximum earn-out amount and the number of earn-out payments that will be made.
Owners of sold businesses who remain employed by the buyer after the sale run a risk that earn-out payments will be taxed as compensation (ordinary income) rather than as purchase price (generally capital gain).
Whether earn-out payments are treated as compensation depends on the facts and circumstances of each case, but there are two factors that generally indicate that earn-out payments are compensatory: (i) if the former owner's right to payments will be forfeited if employment terminates, and (ii) if the former owner's right to payments is not proportional to his ownership interest in the business that was sold (meaning that former owners who remain employed in the business receive a larger portion of earn-out payments than they would receive if such payments were strictly based on pre-closing ownership interests).
If the sale transaction is structured as a tax-free reorganization (in which the buyer's stock is used as a significant component of the purchase price), there are restrictions on the amount of money and other property that may be received by the sellers.
Earn-out payments must comply with these restrictions (which vary based on the type of reorganization that is being employed) in order to preserve the "tax-free" receipt of stock from the buyer.
David Baer is a shareholder and chairman of the mergers and acquisitions group at Ruberto, Israel & Weiner in Boston. Gary C. Bubb is also a shareholder at the firm.
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© 2007 Lawyers Weekly Inc., All Rights Reserved.
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March 12, 2007
