Earnouts and Seller Financing

Contents

1. Where the gap comes from
2. What an earnout is
3. What the contract has to define
4. Seller financing and the promissory note
5. Collateral and recourse
6. How the installment method taxes it
7. The farm version and the related buyer
8. Staying on after closing
9. When the payments stop

Brent O’Mara works with business owners and multigenerational families, and the question of how a business sale is structured is one that work reaches past the portfolio to answer. The answer usually settles in a fixed order. A buyer and a seller agree that a company should change hands, discover they disagree about its worth, and then negotiate not the number but the timing: how much is paid at closing, how much later, and what has to happen for the later money to arrive. The contract recording those terms, and the tax treatment that follows, are the subject of this entry.

Where the gap comes from

An Inc. guide opens with the observation that the value of a business depends on whom one asks, and that cautious buyers in a slow market rarely meet a seller’s expectations; an earnout clause in the purchase contract is one way to narrow that divide.¹ A business broker writing in the New York Times puts the buyer’s side as a common saying, that buyers pay only what the company is worth today, so payment for future growth is likely to be contingent.²

What an earnout is

The same broker defines an earnout as a contingent payment based on the future performance of the business, and reports that most are structured as payments tied to milestones such as gross sales, gross profit or net income, with a typical term of one to five years.² Her example is a software consulting firm sold in 2004 whose owners tied the earnout to gross consulting revenue rather than the buyer’s bottom line, so the buyer’s overhead could not shrink their payments, and were paid every six months for five years.² The Inc. guide adds that the original owners are usually obliged to stay through a transition period, and that for the buyer the clause is a hedge against paying in full for a company that fails to grow as its founders expected.¹

What the contract has to define

A second Inc. article lists what the purchase and sale agreement must state: when earnout payments fall due, how they are calculated, and any minimum and maximum, with most agreements requiring an independent certified public accountant acceptable to both sides to do the arithmetic.⁴ The New York Times broker names the seller’s risks: delayed payment in full, reliance on the buyer’s skill, and disagreements over how the clause is read.²

Figure

Earnout payments against a seller financed note

	Earnout	Seller financed note
What the buyer owes	Part of the price, paid only if the business hits stated milestones after closing	A fixed loan balance with interest, repaid on a schedule whatever the business does
What the contract defines	When payments fall due, how they are calculated, and any minimum or maximum	The repayment promise, the loan terms, the collateral and any personal pledge
What the seller gains	A negotiating chip that often holds the price up, and income spread over several years	A larger pool of buyers, a faster closing and, on average, a higher price
What the seller risks	Payments shrink or stop if the new owner cannot sustain the business	Default, and collateral that may be worth less by the time it is seized

Seller financing and the promissory note

The older arrangement is simpler: the seller lends the buyer part of the price. The Wall Street Journal reported that after the 2008 downturn buyers often could not borrow the whole cost of a company, which pushed owners toward seller financing, an old setup in which the seller is paid over time and bets on the buyer keeping the business strong.⁷ The Inc. financing article describes the paperwork, a promissory note setting out the repayment promise and terms, and the trade a seller makes by accepting it: more buyers, a faster closing, proceeds spread over several tax years and, on average, a higher price.⁴

Collateral and recourse

A secured note gives the seller a claim on named assets if the payments stop. The Inc. article warns against collateral in which the seller stands second in line and against the business’s own assets as security, since they can lose value before they are seized, and notes that a personal pledge from the buyer lets the seller pursue personal assets.⁴ Kiplinger’s account of sales to key employees describes the standard form there, a note held by the departing owner, paid over a set period with interest and secured by the business’s assets and stock along with the buyers’ own collateral; employees rarely have the liquidity for a lump sum, which often means a lower price.⁶ The purchase by a management team is covered under management buyouts.

How the installment method taxes it

The Internal Revenue Service defines an installment sale as a sale in which at least one payment arrives after the tax year of the sale, and requires the gain to be reported under the installment method unless the seller elects out by the due date of that year’s tax return. Under the method only the gain portion of each payment is income; the part that gives back the seller’s basis is not. Two exceptions matter to business sellers: any gain that is ordinary income under the depreciation recapture rules is reported in the year of sale regardless of the schedule, and the method cannot be used for inventory or for securities traded on an established market.⁵ Interest on the note is ordinary income, and a contract with too little stated interest has part of its principal recharacterized as interest at the applicable federal rate.⁵

Figure

How the installment method reports a deferred sale

1. 01
   Default ruleGain is reported as payments arrive, unless the seller elects out by the due date of the year of sale
2. 02
   Year oneAny depreciation recapture that counts as ordinary income is reported in the year of sale, whatever the payment schedule
3. 03
   Each paymentOnly the gain portion is income; the part that gives back the seller's basis is not
4. 04
   InterestStated interest is ordinary income, and too little stated interest is recharacterized at the applicable federal rate

The farm version and the related buyer

Iowa State University Extension treats the installment sale as one of five ways to move farm machinery to the next operator, with an outright sale, a gradual sale, a lease followed by a sale, and a gift. Payments can be timed to the income the assets produce, once a year when the crops are sold, and below market family interest must be recalculated at the federal rate for tax reporting.⁸ It cautions that when buyer and seller are closely related, all of the capital gain may be taxable in the year of sale rather than as payments arrive.⁸ Whether the deal is written as a sale of assets or of shares changes the tax picture again, the subject of asset sale or stock sale.

Staying on after closing

Deferred payment ties the seller to the company; the Wall Street Journal found that owners who finance the deal often stay involved long after it is sealed, to help the buyers succeed and so protect the payments.⁷ Kiplinger adds that employee buyers who know the seller may ask for lenience if the business struggles, and that reworking the terms is sometimes in everyone’s interest.⁶

When the payments stop

A second New York Times column tells what happens otherwise. A seller took about a third of a $1.4 million price in cash and held the rest as a seller’s note. The buyer changed the business, a key employee’s noncompete agreement was never transferred, that employee left with most of the staff and clients, the buyer went bankrupt, and the seller lost more than half the price with no remedy.³ The columnist’s conclusion is that sellers who accept a note or an earnout have agreed to act as the buyer’s bank, and should treat the smallest clauses accordingly.³

What remains unsettled is the base rate. None of the sources above reports how often earnouts pay in full or seller notes default; the broker who built a successful earnout calls it a larger payout than any cash offer she could have had, and the columnist who watched a note fail says he is no fan of the device.² The shape of a sale is tax and legal work, the province of qualified professionals, because the right answer depends on individual circumstances; the decisions it feeds, including the buy sell agreement that may have fixed the price years earlier, sit in the wider work of business succession planning.