What’s the difference between an earnout and an installment payment?
If you are NOT going to receive the entire purchase price in Cash at closing (less the amount of escrow, typically 10 percent held for 12 months) you may see the following types of payments in the LOI or Term Sheet from the Buyer(s):
Installment payments secured notes. Can defer capital gain taxes. There are some limitations to the deferral of taxes, depending on the amount of the note. Most of our sellers who have agreed to take a note do so with a secured note that is not subordinate to the bank or other lender’s position.
Retained equity allows the seller to use part of the purchase price to buy an equity position in the business at closing (in landscaping, usually a position in the new business entity that is being created). Especially good when the seller is going to remain involved in building the company.
Earn out. A payment that is contingent on meeting certain targets tied to the income statement, like sales or earnings. It could be tied to other factors like retaining large customers. Often used by buyers to hit a higher price if they are worried the business is too owner dependent. It can be difficult to measure, especially since the owner will no longer have control over external events that could impact the earnout.
If the earn out is a deferred payment for purchasing the business it may be taxed at capital gains rate. If it is tied to employment, it will be taxed at ordinary income rates.
It is the seller’s tax advisor/CPA/attorney that will make sure that the legal documents represent the parties’ intended tax result. These will be outlined in the Letter of Intent along with other terms including the working capital requirement, including accounts receivable and inventory.
If you’d like to have a discussion about where to start, please reach out to me at 224-688-8838 or email me at [email protected].
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