Exploring Earnouts
In an earnout , a buyer will make an initial purchase payment for a target business with potential additional payments made over time based on achievement of specific performance metrics , as outlined in the purchase agreement . These performance metrics may include operational and / or financial metrics , and are most commonly based on revenues or profits .
For sellers , revenue-based metrics are preferred due to its straightforwardness , while buyers lean toward profit-based metrics , such as earnings before interest , taxes , depreciation and amortization ( EBITDA ), to protect themselves from possibly overpaying , especially when there is uncertainty related to revenue performance . Regardless of the financial metrics being used , there are several accounting factors to consider as it could have a significant impact on both parties as the earnout takes place .
For example , the seller will have to recognize they no longer have financial or operational control of the business , so if a buyer changes how the company expenses are handled or makes a significant purchase while the earnout is taking place , it could directly impact the company ’ s profitability . This is a common scenario , which is why the purchase agreement and earnout should clearly define how accounting matters will be handled .
Accounting Considerations
There are several accounting factors to consider , including :
• Accounting treatment of the earnout . Will it be treated as an additional purchase price or seller compensation ? From an auditor ’ s 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 seller ’ s employment , it could be recognized as an additional purchase price .
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 . Under GAAP , compensation is recognized as an expense and is therefore recorded in equity , while an additional purchase is recognized at fair value in the income statement and must be adjusted appropriately based on the type of business .
• Cash payments of the earnout . The buyer will need to consider the valuation of the earnout and its impact on the balance sheet , particularly its impact on any financial covenants . In addition , the buyer needs to understand the timing of payment for any potential earnouts . If the company expects to be in growth mode with limited working capital available when an earnout payment is due , this could cause undue stress to be put on the company to meet this obligation .
• Tax impact . If the earnout is treated as an additional purchase price , the buyer may not be able to deduct this as they would with compensation payments . In a stock purchase , the payment of purchase price goes toward the buyer ’ s basis in the company stock whereas a compensation payment would result in a tax deduction for the buyer . The tax treatment of earnouts can be very complex and should be evaluated by both the buyer ’ s and seller ’ s CPAs to ensure they are maximizing a favorable tax position as payments are distributed .
While earnouts can help buyers and sellers come to a mutual agreement in a transaction , it can be a complex process . Whether you ’ re a buyer or seller , having the right team is key to your transaction and overall accounting liability . To obtain assistance with navigating your earnout , contact us today . ■
Issue 1 | 2021 VIEWpoint 7