It is not uncommon for purchasers and sellers to disagree on the price of a business. This is especially true today in the face of economic uncertainty resulting from the COVID-19 pandemic. In cases where the parties cannot come to an agreement, an earnout or reverse earnout provision may be utilized to bridge the valuation gap between the purchaser and the seller.
In a “classic earnout”, the purchase price will be adjusted upwards after the closing date if the performance of the business exceeds the agreed upon benchmark(s) (e.g. net profits, EBITDA, revenue). For example, the parties may agree to a base purchase price of $500,000 with an earnout provision that stipulates that the purchase price will be increased by 20% if the business increases its revenues by 15% over the two-year period after the closing date. An earnout allows the parties to proceed with the transaction while addressing the purchaser’s concern of overvaluing the business and the seller’s concern of undervaluing the business. It should be noted that in the case of a share transaction, the base purchase price will be taxed as a capital gain but any amounts payable under the earnout will be taxed as regular income.
In a reverse earnout situation, the parties agree to a maximum purchase price that the purchaser will pay on the closing date. However, if the performance of the business does not meet the agreed upon benchmark(s), the purchase price will be decreased and the seller will have to re-pay a portion of the purchase price back to the purchaser. Unlike the classic earnout, the full amount of the purchase price paid under a reverse earnout situation in a share transaction will be treated as a capital gain as long as there was a reasonable expectation at the time of the sale that the performance benchmark(s) would be met. If the performance thresholds are not met, it would result in a capital loss for the seller which could be used to offset a capital gain.
– Felix NG, Associate Lawyer
Felix’s practice is focused exclusively on corporate-commercial law, including the purchase and sale of businesses, secured lending transactions, commercial leasing and commercial contracts. Felix graduated from Western Law in 2016. While studying law, Felix volunteered for the Family Law Project through Pro Bono Students Canada and at a legal clinic in St. Thomas, Ontario. Felix is a lawyer licensed to practice law by the Law Society of Ontario and is a member of the Canadian Bar Association.
© Kalfa Law 2021
The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.