Earn Outs

Earn Outs

March 31, 2011

Earn outs are common when companies with a number of wind, solar or other projects under development are sold.

An earn out is a right to an additional payment or share of project earnings in the future once certain milestones are reached.

A developer may not be able to agree with a potential buyer on how much the development pipeline is worth. An earn out is a way to bridge the gap. It may also be a way to keep key personnel at the company and focused on pushing projects across the finish line.

There is a risk that the payments may be treated as compensation to the seller rather than additional purchase price if the remaining payments are tied to additional work that must be done. This can affect the tax treatment to both the buyer and seller. Compensation must be reported as ordinary income rather than capital gain. The buyer can deduct compensation while a payment of purchase price would go into basis and be used to calculate Treasury cash grants, investment credits and depreciation on the projects.

One way to avoid confusion is to make sure employees are paid separately at market rates for ongoing services or offered retention bonuses. True earn out payments should be paid in proportion to the ownership interest of each seller, whether or not he performs additional services.

The amount should be fixed at sale. It can be subject to future events, like project completion, but not whether the seller remains with the company.

Keith Martin