What is an earnout in an M&A deal?

An earnout is a post-closing purchase price payment that is contingent on the acquired business satisfying negotiated performance goals after closing. Earnouts can be a useful tool for buyers and sellers with different views on the value of the business, allowing them to avoid difficult purchase price negotiations.

What is an earnout on debt?

What Does Earnout Mean? An earnout is a financing arrangement for the purchase of a business in which the seller finances a portion of the purchase price, and payment of this amount is contingent on achieving a predetermined level of future earnings. An earnout is often used to bridge a valuation gap.

How does an earnout work?

An earnout is a contractual arrangement between a buyer and seller in which a portion or all of the purchase price is paid out contingent upon the target firm achieving predefined financial and/or operating milestones post transaction-close.

How does the earnout affect the buyer and seller?

The differing expectations of a business between a seller and a buyer are usually resolved through an earnout. The earnout eliminates uncertainty for the buyer, as they only pay a portion of the sale price upfront and the remainder based on future performance. The seller receives the benefits of future growth.

Are earnout payments expensed?

If payments are made no matter what the employment status of the seller is, this is a strong indicator that the payments represent additional purchase price. When contingent payments are determined to be additional compensation, the payments made under this agreement are expensed as they are incurred to the seller.

How do you account for earnout payments?

The earnout is measured by present valuing the expected payment. The present value is recorded as either equity or as a liability. If the earnout is for a fixed dollar value, then the present value is recorded as a liability and measured at fair value going forward.

Is earnout included in purchase price?

Generally, an earn-out will be treated for tax purposes as part of the purchase price. However, if the selling shareholder will continue to provide services to the company, it is possible that the amount will be considered compensation for services.

Is earnout included in enterprise value?

An earn-out (whether tied to a specific event or some performance metric) can also bridge a valuation gap where buyer and seller disagree on the enterprise value of the business as of the closing.

How are earnout shares taxed?

Earnout payments are taxed generally as ordinary income or as purchase price consideration (i.e., capital gain).

How are contingent payments taxed?

When the buyer takes contingent payments into consideration for tax purposes, a portion of each payment must usually be treated as interest, which can often be deducted on the purchaser’s federal income tax return.