When entrepreneurs sell their business, they might be faced with an earnout provision. I remember listening to a software entrepreneur talk about his experience when he sold his company. (Spoiler alert: It was not good). Without going into detail, he simply said there was a major disagreement between him and the purchasing company over the earnout provision. He said that it was probably going to end up in litigation. You don’t want to end up in that situation.
What is an earnout?
Basically, when you sell your company, the purchasing company will make an up-front payment. The final purchase price, however, depends on your sticking around and running your business to hit certain targets. In theory, if you hit your targets, you will “earnout” a higher purchase price which means, among other things, potentially money in your pocket.
The earnout formula
The earnout formula is ultimately based on the negotiations between you and the purchasing company. Aside from negotiating the formula, your lawyer can be helpful in a couple of additional ways: (1) the lawyer can bring up certain key nuances that might not have been obvious to you initially and (2) the lawyer’s job, obviously, is to draft good contractual language.
If the targets are met, you should be entitled to the full amount of the earnout. But what if the targets are not met? Should you, as seller, get a pro rata amount? And what if the targets are exceeded? Should you get more than the earnout? These scenarios should be handled in the negotiations.
Ordinary Income Tax
As the seller, you might have to pay ordinary income tax on a percentage of the contingent purchase based on a formula that takes into account the number of years the payment is deferred. I’m no tax expert. Talk to a tax lawyer about the best way to minimize your taxes. In fact, it’s a good idea to get a tax lawyer involved for virtually any deal.
As part of the negotiations, you should take care, along with your lawyer, to define earnings in a way that is in line with what they would have been if there was no acquisition at all. You don’t want to be blindsided by, for example, being charged for overhead of the home office of the purchasing company.
Who’s the Boss?
There will inevitably be issues related to the business operations of the two companies. You, as the seller, might want to pursue a strategy that will rub the management of the purchasing company the wrong way. Or the purchasing company might fail to take action that would have helped you meet your earnout targets, such as a failing to expand in a certain market.
Careful negotiations might help create an atmosphere that minimizes these conflicts. For example, as the seller, you might negotiate for the ability to hire and fire certain personnel without the consent of the purchasing company. You might negotiate to get assurances from the purchasing company that it will keep you, as the newly-acquired subsidiary, properly capitalized. The points on which you can negotiate to maintain control are numerous. You can get creative here.
Good Faith by the Buyer
The purchasing company most likely has a duty to manage the purchased business in a reasonable manner and in good faith. This is good news for you as the seller. Of course, if the purchasing company has to react to circumstances outside of its control in a way that will hurt the your chances of meeting his earnout target, then you may not have recourse. For example, say that as part of the acquisition agreement, the purchasing company promised to support the seller by spending a certain amount on marketing. If spending target is not met, then the purchaser is to return the assets to the seller. Say then that the purchaser company is suffering a PR nightmare and class action suits because of consumer outrage that its products do not work as advertised. If the purchasing company doesn’t spend on marketing and instead puts its efforts towards quelling the public furor, then the seller probably can’t say the buyer violated the terms of the earnout. The seller will get his assets back and that’ll be the end of it. This is what happened to Squid Soap when it was purchased by Airborne.
The earnout is an opportunity for a lot of creative negotiation. And it also has the potential for unexpected results. Keep in mind that once the purchase agreement is signed, you’re an employee of a larger corporation and under a fair amount of obligations (under any employment agreements and the earnout provision). Make sure you’re ready for both.
(photo courtesy of: http://flic.kr/p/6Jw1J)