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How to Convert Earn Out Agreement to Excel

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In discussions of mergers and acquisitions, the price often presented can be misleading, as it may not be a fixed amount. An earn-out is a type of contingent payout included in some deals, allowing sellers, typically shareholders of the target company, to receive additional compensation based on the company's future financial performance. For instance, if Company A is acquiring Company B for $10 million, the agreement may stipulate that if Company B achieves a net income of at least $2 million in the following year, Company A will pay an additional $500,000. This means the total payout could exceed the initial $10 million, depending on Company B's financial success.

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How do you structure an earnout agreement?

Earnout structures involve seven key elements: (1) the total/headline purchase price, (2) the % of total purchase price paid up front, (3) the contingent payment, (4) the earnout period, (5) the performance metrics, targets, and thresholds, (6) the measurement and payment methodology, and (7) the target/threshold and

How is fair value calculated for Earnouts?

Simply stated, earnout value is equal to the probability of success, or of each possible outcome, multiplied by the amount to be paid given the outcome. Usually, the company assesses the probabilities and then applies a discount based on the time value of money and the probability that the company is unable to pay.

Are Earnouts taxed as capital gains?

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.

How do you account for earnout payments?

The earnout is measured by present valuing the expected payment. The present value is recorded as either equity or as a liability. If the earnout is for a fixed dollar value, then the present value is recorded as a liability and measured at fair value going forward.

What is a typical earn out percentage?

The typical term of an earnout is one to three years at approximately 10% to 25% of the purchase price. Earnouts are popular with private equity groups that do not always have the expertise to run a business and want to keep the owner incentivized following the closing.

What is an example of an earnout clause?

If an entrepreneur seeking to sell a business is asking for a price more than a buyer is willing to pay, an earnout provision can be utilized. In a simplified example, there could be a purchase price of $1 million plus 5% of gross sales over the next three years.

What are the different types of earnout structures?

Typically, the two types of earnout compensation are a right to fixed payments (guaranteed) and contingent payments (subject to achieving financial milestones).

Does an earnout go on the balance sheet?

How the treatment is classified is key, as generally accepted accounting principles (GAAP) requires a liability for the earnout to be recorded on the balance sheet.

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Convert Earn Out Agreement to Excel