The Ins and Outs of Earnouts

The Ins and Outs of Earnouts

Buying or Selling a Michigan Small Business.

What is an Earnout?For Lease  Commercial Space

An earnout is a portion of the purchase price that is held back by the buyer or placed in escrow contingent upon the business remaining successful after the acquisition.   A buyer will typically hold anywhere from 10-30% of the purchase price back under an earnout agreement, and sometimes the holdback can be as much as 50% if the risks to the buyer are significant.

Why use an Earnout in the Sale of a Michigan Business

Increasingly, Michigan small business acquisitions are including an earnout provision in the purchase agreements.  Buyers of Michigan businesses are using earnouts more prevalent when acquiring businesses where success or failure is based on customer relationships or when the company is growing quickly or has cutting edge products without an established or steady market.  Some Michigan business sellers are demanding earnouts simply because of a down economy or in years with lower sales, hoping to gain greater value if sales return to the levels preceding the drop in sales.

How does an Earnout function in a Michigan Small Business Acquisition?

Typically, the earnout portion of the purchase price is equal to a percentage of the gross or net income of the business over a period of time after the closing of the business sale.  This rewards the seller only if the performance in the future matches the current expectations of future performance of the business.

The source of funds for earnout payments is typically the future revenue of the business, but sometimes all or a part of the earnout amount is held in escrow.  Escrows are used when the net income of the business is not expected to be enough to make the escrow payments.  For example, if the net income of a business is 10%, then that income would not support a 20% earnout payment in any given year, and would probably not event support a 5% earnout payment.

When Are Earnout Provisions Not The Answer?

Earnouts are not the answer primarily when it does not fit the transaction or the parties.  Some buyers of struggling Michigan businesses may take advantage of the situation and manipulate the earnout payment provisions to disadvantage the business seller.  This may unacceptably increase the Seller’s risk.

An earnout is also not the answer if the buyer is resistant to structures that give some security for the buyer collecting what is due or put the necessary time and investment into structuring a fair agreement between the parties.  Earnouts are often secured by liens on the assets, personal guaranties of the buyers and other methods, but these can mean little if the agreements are ambiguous or do not contain provisions to allow for attorney fees and costs of collection.

Tax treatment of the earnout becomes an issue for Sellers of a Michigan business if it results in a capital gain being treated as ordinary income or some other unfavorable tax treatment.  Also, the gain recognized in the year of recognition, so if tax rates or brackets increase for the seller, the earnout funds may be worth less than a lower immediate payment in the current year.   The installment method of reporting the earnout portion of the gain on the business sale may have other negative tax consequences as well.

If the buyer makes long-term decisions that negatively deflate performance, these will also reduce the earnout payment.   The business buyer most often will make immediate changes to ensure long-term viability, such as repositioning to new markets or accelerating investments in future productivity.  While this will be good for the long-term sustainability of the business buyer and employees, the business seller could unwittingly bankroll these investments through the reduced earnout.

Lastly, many earnouts require at least some involvement of the seller. The business buyer may need a period of transition where the previous owner is involved to ensure a smooth transition of the business relationships.  This may be great for preserving customer and vendor relationships, but it may not be conducive to the seller’s future plans or may exacerbate financial instability caused by unexpected health issues.

Experienced Michigan Small Business Attorney

Earnouts are a powerful tool in maximizing value for sellers and minimizing risk for buyers of Michigan businesses.  However, careful consideration and planning is required to ensure the earnout fits your transaction and future goals.  If you have questions about using an earnout or any other issues related to your Michigan business sale or acquisition, please call or email me, West Michigan Small Business Attorney Shawn Eyestone, to schedule a free initial consultation.

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