In the world of mergers and acquisitions, earnouts (also formally known as a contingent consideration) can be a useful tool to help bridge the valuation gap between a buyer and seller in the negotiation phase of a transaction. With supply chain issues, labor shortages and rising costs continuing to impact the current market, many M&A advisors are turning to earnouts to help close a deal. Although they can help salvage a transaction, accounting for earnouts can raise some frustration for both the buyer and seller if not clearly defined in the purchase agreement.

Exploring Earnouts

In an earnout, a buyer will make an initial purchase payment for a target business with potential additional payments made over time based on achievement of specific performance metrics, as outlined in the purchase agreement. These performance metrics may include operational and/or financial metrics, and are most commonly based on revenues or profits. For sellers, revenue-based metrics are preferred due to its straightforwardness, while buyers lean toward profit-based metrics, such as earnings before interest, taxes, depreciation, and amortization (EBITDA), to protect themselves from potentially overpaying, especially when there is uncertainty related to revenue performance. Regardless of the financial metrics being used, there are several accounting factors to consider as it could have a significant impact on both parties as the earnout takes place. For example, the seller will have to recognize they no longer have financial or operational control of the business, so if a buyer changes how the company expenses are handled or makes significant purchase while the earnout measurement period is taking place, it could directly impact the company’s profitability. This a common scenario, which is why the purchase agreement and earnout should clearly define how accounting matters will be handled.

Accounting Considerations

There are several accounting factors to consider, including:

• Accounting treatment of the earnout. Will it be treated as additional purchase price or seller compensation? From an auditor’s perspective, payments associated with a specific post-deal period of employment of the seller will be treated as compensation. On the other hand, if payments are made regardless of the seller’s employment, it could be recognized as additional purchase price.
  • How the treatment is classified is key, as generally accepted accounting principles (GAAP) requires a liability for the earnout to be recorded on the balance sheet. Under GAAP, compensation is recognized as an expense and is therefore recorded in equity, while an additional purchase is recognized at fair value in the income statement and must be adjusted appropriately based on the type of business.
• Cash payments of the earnout. The buyer will need to consider the valuation of the earnout and its impact on the balance sheet, particularly its impact on any financial covenants. In addition, the buyer needs to understand the timing of payment for any potential earnouts. If the company expects to be in growth mode with limited working capital available when an earnout payment is due, this could cause undue stress to be put on the company to meet this obligation.
• Tax impact. If the earnout is treated as an additional purchase price, the buyer may not be able to deduct this as they would with compensation payments. In a stock purchase, the payment of purchase price goes toward the buyer’s basis in the company stock whereas a compensation payment would result in a tax deduction for the buyer. The tax treatment of earnouts can be very complex and should be evaluated by both the buyer’s and seller’s CPAs to ensure they are maximizing a favorable tax position as payments are distributed.

While earnouts can help buyers and sellers come to a mutual agreement in a transaction, it can be a complex process. Whether you’re a buyer or seller, having the right team is key to your transaction and overall accounting liability. To obtain assistance with navigating your earnout, contact us today.