As buyers and sellers engage in negotiations for the sale of a business, often there may be disagreements as to the value and expected growth of that business. One party might currently value the business higher than the other party does, or there may be economic uncertainty regarding the future performance of the business. These differing expectations are usually resolved through an earnout. An earnout is a contractual arrangement that allows the buyer to pay the seller a portion of the purchase price at a later date, contingent upon the target business achieving certain performance goals. In other words, the seller must "earn" the remainder of the purchase price, based upon the healthy financial performance of the target business.
Earnouts are a helpful way to both bridge a valuation gap and incentivize the seller to increase the business' value post-closing. Typical earnouts take place over a 3-5-year period, with 10%-50% of the purchase price being deferred over that time period and paid if and when the business meets certain thresholds. The thresholds can be financial, such as revenue, net profit, EBITDA, EBIT, or gross margins; or non-financial, such as market acceptance, technical achievements, or regulatory approvals. The seller's goal is to receive as much cash as possible up front, because there's always the possibility that the business does not meet the thresholds and thus the buyer won't have to pay the remaining purchase price. In contrast, the buyer would prefer to pay as little upfront as possible because of its skepticism of the seller's valuation of the business, the business' future performance, or both.
Tax Treatment
Tax implications of earnouts are numerous, but one that is particularly pertinent is how earnout payments the seller receives are taxed. Earnout payments generally are taxed as either ordinary income or at a capital gains rate, all depending on how the transaction is structured. If an earnout is deemed to be part of the compensation paid to the seller as an employee, then it generally will be taxed as ordinary compensation income. If an earnout is considered to be part of the purchase price, then it will be taxed at a capital gains rate.[1] The difference is important because the capital gains tax rate is much lower than the top marginal income tax rate. Thus, sellers would want their earnout payments to be treated as part of the purchase price, whereas buyers prefer the earnout payments be treated as compensation income, because then the buyer would be entitled to a tax deduction for the earnout payment. The IRS considers multiple factors in determining whether an earnout is considered compensation or part of the purchase price. The factors that more heavily favor ordinary income tax treatment are (i) whether the earnout is conditioned, in whole or in part, on future services; and (ii) whether the seller's employment term is aligned to the earnout period. The factors that more heavily favor capital gains tax treatment are (i) whether the seller's post-closing employment compensation is close to market; (ii) the proportionality of earnouts (for example, if all sellers receive the earnout based on their proportionate equity interests, but the earnout is tied to the performance of services by a minority set of owners, then that more heavily favors capital gains treatment); and (iii) the buyer's earnout obligation if seller's employment is terminated (if the buyer is obligated to make payments notwithstanding a termination, then that more heavily favors capital gains treatment).
In conclusion, earnouts act as a middle ground for resolving valuation disagreements between sellers and buyers regarding a target company. However, the taxation of these earnouts is where the significant divergences in opinion truly emerge.
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[1] Note that any portion of the payment treated as interest would be subject to tax at ordinary income rates.