A More Cautious Approach
Compared to the torrid pace of M&A transactions last year,[i] the current year seems rather pedestrian. That is not to say businesses are not being sold; they are. The purchase and sale of a business is one of the natural alternative paths in the evolution of the business.[ii]
However, the environment in which buyers and sellers are now considering their options and the manner in which they are approaching one another seem to have changed; one might say they are generally being more cautious, notwithstanding that the economy apparently remains strong by many measures.
There are several factors to which this change in attitude may be attributed, including the high rate of inflation, the rising cost of energy, the Fed’s move to raise interest rates, labor shortages, supply chain snarls, the unstable geopolitical scene, and the continued dysfunction within the Federal government.
How is this more “cautious” attitude manifesting itself in M&A transactions? Based upon several deals I have been asked to review this year I would point to what may be described as an increased preference on the part of many buyers to utilize earnouts to determine the purchase price for a target business.
Earnouts – In General
An earnout is a form of contingent, deferred consideration that is often utilized to reconcile a difference of opinions between the buyer and the seller regarding the fair market value of the target business as of the date of the closing.
For example, the purchase and sale agreement for a business will set forth a base value (the parties’ common ground for value) as the purchase price at closing,[iii] while the earnout will provide for an upward adjustment to this figure based on a formula using the actual earnings[iv] performance of the acquired business during a set number of years[v] following the sale of the business. The amount determined under the formula – i.e., the amount of the positive adjustment to the purchase price – would only be payable upon the target’s achievement of the agreed-upon performance goals.[vi]
Thus, the earnout assures the buyer they are not overpaying for the target business; they are paying value for value.[vii] It also affords the seller the opportunity to demonstrate that the business was worth more than the base amount payable at closing.[viii]
Seller’s Tax Treatment – In General
As stated above, the earnout is a form of contingent consideration that relates back to the date of the sale of the business; it represents the “corrected” purchase price as derived from the post-closing performance of the business. Thus, the nature of the gain attributable to the earnout is determined as of the closing date and is dependent upon the nature of the assets sold on such date.
Character of Gain
If the sale of the business was effectuated as a sale by the shareholders of all the outstanding shares of stock of the target corporation, then the earnout would be treated as additional purchase price for the stock, and the gain attributable to the earnout would be treated as long-term capital gain.[ix]
If the disposition of the business was structured as a sale of assets, then the increase in purchase price must be allocated among the assets sold using the residual method.[x] Given the purpose and nature of the earnout (determining the value of the business as a going concern based upon earnings performance), the additional purchase price will likely be allocated to goodwill and going concern value,[xi] and the resulting gain will be treated as long-term capital gain.[xii]
As for determining when the gain attributable to the earnout is to be recognized by the seller, the installment method requires that it be included in gross income in the year the earnout is actually or constructively received by the seller.[xiii] In other words, the recognition of gain is deferred.
Because the earnout payment is deferred, the imputed interest rules would apply to recharacterize a portion of the payment as interest income – which is taxable as ordinary income – instead of purchase price,[xiv] unless the earnout payment is made with adequate stated interest.[xv]
The Owner(s) and the Earnout
Assume the owner of a business has sold their stock, or has caused their corporation to sell its assets, to a buyer for a purchase price that includes a fixed amount payable at closing plus an earnout payable only when the business satisfies certain negotiated performance targets over a three-year period.
If the owner is key to the success of the business, the buyer will probably try to keep them employed in the business for some transition period in exchange for a compensation package commensurate with the value of the owner’s services. In that case, it is more likely the earnings target will be met, in which case the buyer will presumably – but not necessarily[xvi] – have acquired a more valuable asset than originally thought and will pay the earnout accordingly.
If the former owner does not remain with the business after the sale, or if they agree to remain with the business but are terminated, resign, become disabled, or die during the earnout period, the business may not reach the earnings target, in which case the buyer will not have to pay the earnout.[xvii] In the interim, they will have paid reasonable compensation to the former owner for services rendered through the time of their departure.
Alternatively, the business may succeed notwithstanding the owner’s absence or departure – evidence that its value resides within the business, its customers, its workforce, its other intangible assets (not in the owner) – and the earnout would be paid to the former owner or to their estate.
If the owner’s continued presence is not essential to the well-being of the business,[xviii] then the buyer’s obligation to pay the earnout will depend entirely upon the ability of the acquired business to reach the agreed-upon earnings goal.
Purchase Price or Compensation?
Where the continued presence of the former owner will be a key element in the post-closing success of the business, one may wonder whether the attainment of the earnout goal is attributable to the value inherent in the business or to the owner’s efforts.
Stated differently, does the earnout payment represent additional consideration for the sale of the business or is it more properly characterized as “bonus” compensation for the post-sale services of the former owner?[xix]
The questions to ask are: what did the parties intend at the time of the closing, and how was this intent manifested in the purchase and sale agreement and other related documents?[xx]
The answers will depend upon the unique facts and circumstances of the parties’ transaction.
Favor Purchase Price
Is the matter settled where the former owner enters into an employment agreement with the buyer pursuant to which the buyer pays the former owner reasonable compensation for the services rendered?[xxi] Does this necessarily indicate that the earnout represents additional purchase price?[xxii]
If we start from the premise that unrelated parties will only treat with one another on an arm’s length basis,[xxiii] it should follow that one such party will not overpay the other in exchange for property, the use of property, or services. Thus, if the compensation paid[xxiv] is reasonable for the services rendered,[xxv] and if the amount of the earnout payment brings the total purchase price within a reasonable range of value for comparable businesses, the earnout payment should be treated as additional consideration for the business.
If the former owner departs the business for any reason during the earnout period and the earnout target is satisfied nevertheless, will the earnout still be payable to the owner? If the answer is yes, then the payment should be treated as purchase price.
Where there are two or more shareholders in the target business, is the earnout payable to them in proportion to their ownership interests in the target? What if only one of the former owners is employed by the buyer post-closing but all of them participate in the earnout payment in proportion to their former equity interests?
What if the former owner’s compensation is relatively low? May some portion of the earnout represent additional compensation? What if the term of employment covers the entire earnout period? What if the other former owners are excluded from the earnout?
What if the purpose of the earnout is not necessarily to resolve a disagreement between the parties over the valuation of the business but, rather, as a means of “ensuring” the continued employment of the former owner for purposes of smoothing the transition of the business?[xxvi] It is reasonable to assume that the proverbial carrot, sweetened with the possibility of capital gain treatment, should align the interest of the former owner with that of the buyer?
The foregoing analysis is intuitive for the most part. However, there is one term or condition included in the earnout provisions of the transactions to which I referred above that is counterintuitive and, in fact, is inconsistent with the position that the earnout represents additional purchase price. What’s more, where the target is owned by only one individual, this condition makes it very difficult for the earnout to escape treatment as compensation.
According to the term in question, the earnout will only be paid to the former owner if they remain employed by the buyer throughout the earnout period, including the time of payment. In other words, the payment is conditioned on the continued services of the former owner notwithstanding the satisfaction of the earnout target. Moreover, the reason for the former owner’s failure to remain is irrelevant; their resignation or termination is on the same plane as their disability.
Does that sound sort of familiar? It should. Such a requirement is often included in nonqualified deferred compensation arrangements offered by employers to a key employee.[xxvii] If the employee fails to satisfy the condition they perform substantial future services, they will forfeit whatever compensation may have been “offered” by the employer in respect of such services.[xxviii]
How can this requirement be reconciled with the notion that the earnout is additional purchase price for the sale of the business? After all, the buyer has already acquired the business. The only “loose end,” if you will, is the final purchase price. If the business is, in fact, worth more (based upon the results of the earnout) than what the buyer agreed to pay as of the closing date, why should this amount be withheld from or forfeited by the seller because the former owner ceased working for the business.
Stated differently, is the attainment of an earnout target intended as empirical proof of the “true” value of the target business as of the closing date, or is it more like compensation for the key employee’s post-closing performance as reflected in the attainment of such earnout target?
Although it may be desirable for the buyer to incentivize the former owner of the target business to remain with the business for some period after the closing to assist with transitioning the client base, it seems incongruous to do so by conditioning the payment of some portion of the purchase price to the former owner’s continued employment.
Indeed, it may be even worse if the intention is to retain the former owner by offering them an “opportunity” to be taxed at the federal long-term capital gain rate for what in substance is compensation for services.
Assuming we are entering a period in which buyers will become more circumspect in their approach to pricing transactions, it is likely we will see a greater reliance on earnouts as a means of establishing or “proving” the value of a target business post-closing.
At the same time, many buyers will undoubtedly utilize provisions similar to those described above in an effort to retain former owners who were also key employees of the target business.
However, if the intention of the parties is to treat the earnout as additional purchase price for the business – certainly the seller’s preference – it would behoove them to avoid creating any nexus between the payment of the earnout and the continued employment of those former owners who were key employees of the business.
Instead, the buyer should consider offering employment agreements that provide reasonable compensation for these key people, and perhaps a performance bonus to incentivize and retain them.[xxix] In the event such a former owner resigned or retired prior to the payment of the bonus, the agreement may provide for the forfeiture thereof, but not of the earnout. A non-competition agreement would also be prudent to facilitate the transfer of the goodwill to the buyer.
Of course, the possibility of an earnout payment should, in itself, provide the former owner-employees an additional economic incentive to attain the agreed-upon earnings target. With their continued involvement, the acquired business should have a better chance of reaching the earnout target.[xxx]
If this target is met, the earnout amount should be payable to all the former owners, regardless of their employment status with the buyer, in accordance with their pro rata share of the target business. In addition, the earnout amount should be payable to their estates or representatives in the event of a former owner’s death or disability; this is consistent with its status as an existing property right as opposed to compensation to be earned.
As always, the best time to ensure that the parties’ intention may easily be inferred from their facts and circumstances is before concluding the transaction.
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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] Fueled in no small part by the plentiful supply of dry powder that had been held in reserve during the first year of the pandemic, the very low interest rate environment, the threat of a significant increase in the federal long-term capital gain rate, and the willingness of many sellers to get out of the rat race while they were still well enough and sufficiently well-off to enjoy the proverbial fruits of their labor.
[ii] However, one of these paths – the transfer of a business to members of the owner’s family – is becoming less likely every year.
[iii] Say, the buyer’s position on the value of the business. This would include the value of tangible assets, such as inventory and equipment, with respect to which there is unlikely to be much disagreement.
[iv] Or some other measure, such as sales.
[v] In general, one to three years; after all, the value determined under the earnout relates back to the date of the closing – attaining the earnout target “proves” the value of the business as of the earlier date. When the earnout period extends beyond this relatively short period, the nexus between the value of the business as of the closing date and the value of the business as of the earnout date becomes more tenuous.
[vi] The fact that the seller agreed to the base value and to the performance goals set forth in the purchase and sale agreement indicates that the seller believed these were reasonable in light of the seller’s opinion of the value of the business. It also indicates that the buyer’s and the seller’s respective positions on the value of the business were not so far apart as to render the earnout unattainable and, thus, meaningless.
[vii] If the earnings target is not satisfied, the buyer is not required to pay any additional consideration to the seller for the acquisition of the seller’s business. Sometimes, the buyer will try to cap the additional amount they would be required to pay if the earnings target was met; for example, $1 for every $X over the target earnings figure, but in no event more than $Y in total.
[viii] In the case of a relatively “young” business without a lot of operating history, an earnout may be the only way to ensure the payment of a fair price.
[ix] We are assuming all the shareholders satisfy the holding period requirement for all their shares. We are also assuming there is no election to treat the stock sale as a sale of assets under IRC Sec. 338(h)(10) or Sec. 336(e).
[x] IRC Sec. 1060; Reg. Sec. 1.1060-1(e)(1)(ii)(B). A supplemental asset acquisition statement will have to be filed on IRS Form 8594.
[xi] The buyer will amortize this amount over a 15-year period. IRC Sec. 197.
[xii] Class VII assets.
[xiii] IRC Sec. 453; Reg. Sec. 15A.453-1(c). Under the installment sale rules, a portion of every payment of “principal” is treated as a recovery of basis while the balance is treated as gain.
The regulations prescribe rules for allocating the seller’s basis to payments received and to be received in a contingent payment sale. These rules distinguish, for example, between situations in which a maximum selling price is determinable and those in which the term of payment is known but the maximum price is not determinable.
N.B. if the potential earnout payment exceeds $5 million, IRC Sec. 453A imposes an interest charge on the deferred tax liability attributable to the earnout that effectively defeats the benefit of deferral.
[xiv] The maximum Federal rate for ordinary income is 37% whereas the maximum rate on capital gain is 20%.
[xv] IRC Sec. 1271, et seq. (the original issue discount, or OID, rules) or IRC Sec. 483 (unstated interest). The OID rules impute interest which the seller accrues and reports as income currently over the term of the “debt” obligation pursuant to which the earnout is payable. The Sec. 483 rules apply where the OID rules do not; they impute interest when the earnout payment is received.
Adequate interest is determined by reference to the applicable federal rate (AFR) under IRC Sec. 1274. For sales occurring this month (June 2022), the annual short-term rate (for amounts payable up to 3 years after the sale), based on monthly compounding, is 2.19%. Rev. Rul. 2022-10.
[xvi] The proof will be in the performance of the business after the former owner is no longer involved in the business, which will depend in turn upon how effective the transition was and upon the strengths of the owner’s successor(s).
[xvii] They will pay only for what they acquired.
[xviii] Certainly, no personal goodwill, but there may be key employees.
[xix] Additional purchase price would be taxed at a Federal capital gain rate of 20% and may be subject to the Federal surtax on net investment income under IRC Sec. 1411. Compensation would be taxed as ordinary income at a maximum Federal income tax rate of 37% and would also be subject to employment taxes; it also has to contend with IRC Sec. 409A.
[xx] Such as noncompete and employment or consulting agreements.
[xxi] Meaning the amount that would ordinarily be paid for like services by like organizations in like circumstances. IRC Sec. 162; Reg. Sec. 1.162-7(b)(3).
[xxii] Is this position bolstered if, before the sale of the business, the soon-to-be former owner formally contributed their “personal goodwill” to the target? Would the execution of a non-compete agreement assuring that any such personal goodwill was effectively transferred with the business support the position that the earnout was properly allocable to the goodwill of the business?
[xxiii] I’m ignoring the possibility of a bad deal or fraud. I’m also assuming that the buyer is not paying a premium, although there are circumstances in which this may be advisable from the buyer’s perspective; for example, a competing bid or the elimination of a competitor.
[xxiv] Perhaps including a year-end performance-based bonus.
[xxv] There may be situations involving unrelated parties in which the compensation exceeds what is reasonable. In that case, the excess portion may be treated as having been paid by the buyer in exchange for a noncompete from the seller. This amount would be amortized by the buyer on a straight-line basis over a 15-year period rather than deducted in the year of payment. IRC Sec. 197.
[xxvi] After all, it’s not always easy to transition clients or customers to a new owner.
[xxvii] For example, the deferred compensation will be paid at a prescribed time after the vesting requirements are satisfied, provided the employee is still employed by the employer on the payment date.
[xxviii] IRC Sec. 409A. See also IRC Sec. 83 and Reg. Sec. 1.83-3.
In Lane Processing Trust v U.S., the 8th Circuit held that payments made by an employee-owned corporation to its employees represented compensation (subject to employment taxes) rather than distributions in respect of the shares of stock held in trust for them. “The Trust’s contention that the distributions were the fruits of ownership is not persuasive” where the employees would be eligible for such distributions only if they were employed by the business when the corporation’s stock was sold. “The distributions,” the Court stated, “were conditioned not only on prior service, but also on continuing employment at the time of the sale,” regardless of the reason for the employee’s departure. 25 F.3d 662 (1994).
[xxix] One that complies with IRC 409A.
[xxx] Of course, they will have to ensure that the buyer does not interfere or otherwise make it difficult for them to operate or contribute to the business post-closing.