Rieck and Crotty, P.C. | Chicago's Business Lawyers

Look Out For Earn-Outs July-Aug-04

With the recent increase in corporate sale activity, we are seeing more use of earn-out provisions and agreements in business sales transactions. An earn-out is often proposed where a business seller and buyer have different expectations regarding a company’s prospects and, therefore, the value of the business, resulting in different pricing expectations. When negotiations reach an impasse because of pricing, each side can “have its cake and eat it too” by hedging against value changes that are inconsistent with expectations.

A seller, for example, may attribute substantial value to a newly developed product or account, resulting in a purchase price which exceeds the amount the buyer considers to be a fair value. The buyer, who assumes the risk of overpaying in the event that the seller’s valuation is not realized, will resist agreeing to pay the seller’s price. This may result in the termination of negotiations and a lost opportunity for both the seller and buyer. However, including an earn-out provision into the negotiations, which requires the buyer to pay a price above that which it otherwise considers reasonable only in the event that the seller’s expectation (and valuation) proves correct, may allow the parties to salvage the transaction.

Use of an earn-out results in less risk for the buyer and generally does not create issues too complex to work around from the buyer’s perspective. On the other hand, although an earn-out may provide the seller a chance to realize a higher price, it also presents complex tax issues which may create unexpected and costly results, unless extreme care is exercised in structuring the transaction. These issues include the following:

· Because of the earn-out, the transaction will be treated as an installment sale for tax purposes, which may result in application of complex basis rules resulting in “front- end” recognition of gain for the seller.

· If the transaction results in a substantial deferral of taxes, the seller may be required to pay interest on the taxes so deferred.

· If deferred payments are not subject to a stated rate of interest, the IRS may impute interest on the deferred payments, thereby converting to ordinary income part of the sales proceeds for which the seller might otherwise have expected to receive capital gain treatment.

· A pledge or transfer of the deferred portion of the purchase price represented by the earn-out may result in the acceleration of taxes.

In addition to tax considerations, the parties must also consider whether they are comfortable with the earn-out formula and the provisions setting forth the bookkeeping, accounting, inspection and reporting requirements, and other post-closing obligations that will be used to ensure the formula and provisions are applied correctly and accurately. This becomes a crucial matter if the seller is no longer involved in the business, since the buyer will be in control of the operations and information regarding the business. Consequently, earn-outs may be most viable only where the seller remains in management or on the board of directors or where the seller and buyer have some familial or other relationship that engenders full disclosure and complete trust.

Please contact us if you desire more information regarding earn-outs or other tools to enable transaction structuring that permit parties to move negotiations forward to a successful conclusion.

Rieck and Crotty, P.C. | Chicago's Business Lawyers

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