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Not to be distributed without written permission 2 Earn-Outs and how they impact the sale of a business Matt Slappey CBI, BCI Certified Business Intermediary Mergers and Acquisitions (M&A) Advisor

Murphy Business & Financial Corporation 3 Earn-Out Definition according to Google: a provision written into some financial transactions whereby the seller of a business will receive additional payments based on the future performance of the business sold Wikipedia defines it as: Earn out refers to a pricing structure in mergers and acquisitions where the sellers must "earn" part of the purchase price based on the performance of the business following the acquisition. In an earn out, part of the purchase price is paid after closing based on the target company achieving certain financial goals

Murphy Business & Financial Corporation 4 Reality of an Earn-out An earn-out is used in most cases to bridge what a seller thinks his/her company is worth to the price that a buyer is putting on that same business. When a business is full of “potential” that the owner has never actually realized (some of this is real and some is smoke) Keeps negotiations alive when the parties seem far apart.

Scenario You have a listing/engagement with a client. The client has $500K per year in cash flow. The market will tell you that a buyer’s offer of 3 x cash flow is not unreasonable. The seller wants $2,000,000+ or a 4x+ multiple Murphy Business & Financial Corporation 5

Things to understand Why does the seller think the company is worth more than the market rate? Is there a valid reason that the company is worth more? Is there true “unrealized potential”? Is the company about to land a large contract or opportunity? Murphy Business & Financial Corporation 6

Examples of companies that lean toward an “earn out” Consulting companies No sales reps other than the owner No management other than the owner Family members involved in the business Professional practices Murphy Business & Financial Corporation 7

SBA Deal? If you are going to seek financing via an SBA loan for your deal, do not pursue an earn-out because the SBA does not allow the use of earn-outs. They require a defined purchase price. This is not the SBA lenders in the room making the rule, it is the SBA. Murphy Business & Financial Corporation 8

Earn-Out Structure Create an earn-out that is the most simple and effective way to measure company or owner performance. Complicated earn-outs must be clearly understood by all parties and all parties must be able to verify all the information required to create the payouts. Murphy Business & Financial Corporation 9

Types of Structures Revenue Goal Gross Profit Goal EBITDA or SDE Goal Retention of current clients Acquisition of new clients Murphy Business & Financial Corporation 10

Tax Implications Most earn-outs are treated as an “Installment Payment” which allows taxation in the year it is actually received. Can use this technique to keep taxation of sales of smaller businesses under the top tax rates. Murphy Business & Financial Corporation 11

Tax Implications Murphy Business & Financial Corporation 12 Instead of $500,000 today, what if a seller gets $87,850 this year and for the next 5 years? Tax savings of $73,000 that seller gets to keep because of the tax structure of the payments! (14.6% x $500,000) Tax Rates-Single PersonAnnual Income 25%36,251-87,850 28%87, ,250 33%183, ,350 35% , %400,001+

Tax Note It should also be noted that there may be situations in which a seller would choose to recognize the sale of a business currently and forego deferral treatment, such as when a business is sold at a loss, or when it is known or expected that tax rates will increase in the future. Murphy Business & Financial Corporation 13

Taking care of employees It is possible for an owner to expense a portion of his earn out payments that are then paid to employees for retention or performance that leads to the seller receiving an earn-out payment. Scenarios change as to how to legally do this based on differences in an asset or stock deal, so consult a qualified attorney and/or tax advisor. This can really motivate employees to achieve the earn out goals, thus earning it for the seller! Murphy Business & Financial Corporation 14

Summary Earn outs are a powerful tool to bridge the gap in business values. Both sides can benefit from using them effectively. There are tax implications and advantages of earn outs. Knowing how to navigate earn-outs can help you close more transactions. Murphy Business & Financial Corporation 15

Thank You For Your Time! Questions? Matt Slappey Murphy Business & Financial Corporation 16