Cancel date in the Earn Out Agreement

Aug 6th, 2022
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How to cancel date in the Earn Out Agreement

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[Music] so welcome back nick in our m a d constructed series where we are unpicking step by step the process of selling a company yep todays discussion is over something that i think is going to be really of interest to sellers and that is how you get paid um its very important in m a speak we use a term called consideration so most other sellers will think of price and but the question is how does that get delivered in other words when i when i sell a business what do i get at the end and of course most people think in terms of cash i simply sell my business for 10 million and at the end of the process i signed the page at the checker rise i got 10 million pounds um but of course in reality it doesnt often go that way there are forces at work if you like in the sale process that sometimes mean that it gets structured in a different way so um i think if i just briefly talk about the cash element thats easy so ill take the easy topic so typically a seller will want 100 cash on comp

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What is an earnout? Earnouts are a type of purchase agreement where an element of the price is contingent upon the performance of the business after the sale. They are often linked to a post-deal EBITDA target, but can also be driven by revenue or other KPIs, depending on the circumstances.
If the contingent earn-out is considered to be additional purchase price, the fair value of the contingent earn-out is recorded as a liability (or asset in select cases) or equity (if equity instruments are to be issued) at the acquisition date and the fair value is considered part of the consideration paid, thus
If an earnout is compensation, the seller must pay all taxes on a deal in the year of the sale. However, if the earnout is part of the purchase price, the seller can defer part of its tax liability under the installment sale method.
Depending upon how the sale of business agreement is structured, the earn-out is either considered to be part of the purchase price, thereby taxed at a capital gains rate, or considered to be compensation income to the seller as an employee, thereby taxed at the ordinary income rate.
Tax: Purchase Price or Compensation Expense? Generally, an earn-out will be treated for tax purposes as part of the purchase price. However, if the selling shareholder will continue to provide services to the company, it is possible that the amount will be considered compensation for services.
The earnout eliminates uncertainty for the buyer, as they only pay a portion of the sale price upfront and the remainder based on future performance. The seller receives the benefits of future growth. Key contractual considerations include earnout recipients, accounting assumptions used, and an agreed-upon time period.
Accounting treatment of the earnout. From an auditors perspective, payments associated with a specific post-deal period of employment of the seller will be treated as compensation. On the other hand, if payments are made regardless of the sellers employment, it could be recognized as additional purchase price.
Reverse Earnout Structure. Reverse earnouts differ from traditional earnouts in that the buyer pays the entire purchase price on closing, including the so-called earnout amount. In this scenario, the earnout amount is usually paid in the form of an adjustable promissory note or held in escrow.

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