When a business is changing hands, there may be a big gap between the seller’s opinion of its value and what the buyer is willing to pay. Creative purchase agreements can bridge that gap.
Betting on future performance
One option is called an “earnout,” in which a portion of the sales price is held in an escrow account or paid from future operating income — but only if certain predetermined financial benchmarks are achieved. An earnout allows an optimistic seller to negotiate a higher price by bearing some risk that the business will perform as expected. From the buyer’s perspective, an earnout lowers its risk of overpaying for a company.
There are some disadvantages to earnouts, however. When the earnout is due, the parties may disagree about how to verify financial performance — making it critical to write specific metrics into the purchase agreement. Earnouts also bring complicated tax issues to the negotiating table. For instance, will earnout payments be considered compensation for services or additional sales proceeds? The buyer and seller have competing interests on this matter.
If earnout payments are treated as compensation, the seller reports them as ordinary income, which is taxed at a higher rate than capital gains. The seller also owes employment (or self-employment) taxes on the income. At the same time, the buyer gets a deduction for any amount treated as compensation or consulting fees, and will also be responsible for the payroll taxes associated with such payments.
In contrast, if earnouts are treated as additional sales proceeds, the seller may qualify for capital gains tax treatment, which is lower than income tax rates. But the buyer receives only an increased tax basis in his or her investment.
Complex tax rules could apply if the earnout payment isn’t made before year end. The rules differ depending on whether there’s a determinable maximum selling price and/or a fixed payment period.
The installment plan
Under the installment method, sellers of certain eligible property can recognize the tax gains or profits from installment sales proportionately over time. The installment method also gives the buyer a fully stepped-up basis in the acquired property. So the buyer can take depreciation deductions based on the purchase price, even though the full amount wasn’t exchanged at closing.
Installment sales can help get a deal done when the buyer has limited access to bank financing. In effect, the seller finances the sale and bears some default risk.
Installment sales can also save tax for the seller if tax rates fall in future years. Conversely, they can be costly if tax rates increase. Another tax consideration for sellers is that depreciation recapture must be reported as gain in the year of the sale — even if it exceeds the installment payment the seller receives that year.
Not all transactions are eligible for the installment method. For example, inventory sales and transactions involving related parties are ineligible.
After the sale
In order to ease the managgement change, the seller can serve as an employee or consultant after closing. That continued involvement can reduce turnover, minimize disruptions, and build trust with long-term employees, suppliers and customers.
On the flip side, the seller could use his or her business contacts and specialized knowledge to start a competing business. If that is a risk, the buyer should consider adding restrictive covenants — such as noncompete or nonsolicitation provisions — to the purchase agreement that prevent the seller from: 1) diverting business opportunities from the company, 2) working for any competitors within a negotiated distance of the business, or 3) soliciting the company’s employees to leave the business to work for the seller or any affiliated entity.
The parties should negotiate in advance how much of the purchase price to allocate to consulting agreements and noncompete provisions. These allocations will have tax and financial reporting consequences, so it’s important to get them right.
Get help making the deal
Negotiating the optimal deal takes time, patience and financial know-how. Weaver’s transaction and valuation professionals can guide you through the options and their implications. For help, visit our Transaction Advisory Services webpage or contact us for a complimentary consultation.
Another consideration: What are you selling?
Whether you structure the transaction as an asset sale or a stock sale has important tax and legal implications:
Asset sales. Buyers often prefer asset sales, because they can select specific assets to acquire. This option usually protects buyers from inheriting contingent liabilities, such as product claims and employee-related lawsuits. However, intangibles such as intellectual property, contracts, leases and goodwill may be difficult to assign or transfer.
From a tax standpoint, the buyer benefits from a stepped-up basis for any depreciable assets acquired. However, the seller typically owes more tax in an asset sale.
Stock sales. Here, the buyer acquires an equity interest in the company, requiring the seller to divest any unwanted assets and liabilities before closing. Any hard-to-assign assets automatically transfer to the buyer, along with contingent liabilities.
Sellers generally prefer stock sales for tax purposes, because stock sales usually result in a lower tax bill on the sale. A potential disadvantage for the buyer, however, is that the transaction doesn’t create a new basis for the company’s depreciable assets; instead, the existing depreciation schedule still applies.