Selling Your Business Using Installment Sales and Earnouts

If you are planning on selling your business, you have more options than ever before. One increasingly popular option is to sell the business using installments. In this situation, the buyer will typically pay a down payment, and then the seller will finance the rest of the deal. The buyer will pay in installments over a period of time, determined in the sales agreement, and will pay an interest rate in line with that of borrowing from a traditional lender.

As a seller, there are many benefits to installment sales. They will generally bring a higher price than bank-financed sales, and the taxes can be reported over time as you receive payments. This allows you to defer tax on capital gains as long as you receive at least one payment after the year in which the sale takes place.

But not all asset sales can be reported in this way. For example, your inventory or accounts receivable are not eligible for installment accounting. These are tangible items on which you will have to pay tax within the year of making the sale, whether you have already received payment or not. Assets that have depreciated beyond their original purchase price, such as real estate, are eligible for installment sales, as are intangibles (such as goodwill) that are established during the course of the business. Sit down with your accountant to determine what is and what is not eligible under installment sales guidelines.

An earnout sale may allow you to get a higher price for your business than you might get though a traditional sale. In an earnout sale, the buyer pays less money at the time of the sale but makes additional payments based on the future success of the business. An earnout sale is not unlike royalties received by an author. The seller (the author) receives royalty payments from the buyer (the publishing company) based on the success of the business (the book).

In a down economy, you can use an earnout to get a value closer to what the business is worth in a better economic climate. Earnouts can be used in negotiations as a contingent element, which help the two parties reach a mutually agreeable value of the business.

An earnout can be set up in any manner that is agreeable to both parties. For example, they may only include products or services that were part of the business when the sale took place. The earnout may only be applicable to the sales revenue from one division of the business, or it may only be paid after the business surpasses a specified sales total. They can also be based on units sold (such as is the case with books) or, for online businesses, they may be based on a benchmark number like traffic. An attorney familiar with setting up earnout deals should be involved in establishing the parameters, including the timeframe in which the earnout will be in place.

As with any business arrangement, there are some inherent risks in an earnout. Research the company with whom you are preparing to make a deal very carefully prior to entering such an agreement. You need to carefully calculate the earnout amount and be able to verify the numbers that the buyer submits once he or she has taken over the business.

You must also make sure that the buyer does not manipulate the sales of a particular product in order to avoid paying the earnout. Consider the scenario wherein the new buyer decides to merge with, or sell to, another business, which will affect the earnout. All of these, and other scenarios, need to be accounted for in the agreement.

Both installment sales and earnouts are complicated and can take time to set up, but both can be very beneficial to a seller looking for a fair price.