Draws versus Salaries

In an S-Corp, the shareholders are required to take salaries, not draws.  If an S corp shareholder takes out salary of $20,000, she will still pick up that $20,000 as W-2 income.  Taxes would have to be withheld, and shareholders would receive a W-2 at the end of the year.

In an LLC, members take “draws” rather than salaries, and taxes are not withheld on those draws.  A draw means an owner is just taking money out of the bank against the balance sheet account called partner draw (liability).  Instead, if an owner takes out $20,000 in an LLC, it doesn’t affect her ownership income, and she’ll receive a K-1 at the end of the year showing that $20,000 in income.

Unlike salaries in an S corp, LLC ownership draws do not reduce the company’s income.  A draw is not an expense, so although cash is decreased by the amount taken out as a draw, the payout of the draw does not constitute an expense that would lower net income of the company.  A salary is an expense account on the income statement that reduces your net income and your cash account.

Profits and Losses of the Company

In either case, shareholders or members will receive a K-1 from the company at the end of the year.  If the business has net income for the year (including deduction for salaries paid but excluding deduction for any draws) then that income will pass through to the owners on a K-1.

Therefore, while a company’s owners could reduce taxable income through salary payments in an S corp, they’re going to recognize the same total 1040 income through the combination of salaries and profit distributions via K-1.  Self-employment taxes (discussed below) will effectively cost them the same, and the only possible variable will be varying effects of marginal tax rates and capital gains treatment of profits versus salary.  (More on that last point under a separate posting coming soon.)

Self employment (SE) taxes

In an S-Corp, a shareholder is still (effectively) going to pay the full SE tax.  A shareholder cannot avoid SE taxes by taking salary rather than a draw, because while the company would indeed pay half of the SE tax, since the shareholder is essentially the company, the shareholder is effectively paying all of it.  And that would then be the same as if an LLC owner received all of here income on via owner draws.

It also has obvious risks, particularly to a seller.  Commonly, the earnout involves a seller who will continue to participate in the business after the sale under some sort of employment or consulting arrangement with the new owners.  This theoretically gives a seller an ability to have some control over the post-closing success of the business, while giving the purchaser a way to incentivize (and control) the seller’s employment or consulting performance.

Almost by definition and necessity, the seller will have less control over the success of the business post-closing, even a seller given real management control over the purchased business.  Management, staffing, budget, infrastructure, sales and marketing capabilities and other resources will in varying respects be subject to the input, discretion and control of the new owners.  Further, the very existence, corporate structure and ownership of the business are matters now beyond the control of the seller, who might see the new owners turn around and re-sell the business to an entirely new owner.  That new owner may or may not be bound by the earnout, although that concern can be addressed.  What cannot so easily be addressed is that the seller’s still-unpaid earnout is now subject to the ownership control of an entirely new set of players.

Put another way, whereas with a cash sale of a business there may be little interest or concern about who your purchaser is, an sale structured with earnout makes the sale of a business much more like a merger and partner-like investment in the business of the purchaser.  Understanding who you’re dealing with and your trust and expectations about their future would then be front and center concerns.

All of these factors need be considered when selling a business for a price that partly or largely consists of an earnout.  Or more broadly, all of these factors need be considered when selling a business and even considering a structure with an earnout.  Several immediate things come to mind:

1. Assuming the seller will be participating in the business post-closing, performance metrics for the earnout should be reasonably related to the job duties under the employment or consulting agreement.  While revenue growth of the business post-closing may be one obvious criteria for measuring success or failure, operational influence on that revenue growth will clearly affect its attainability.  A seller may sincerely believe that the business will continue to grow at a 20% annual clip, but the seller also probably assumes reasonable continuity in management in those forecasts.  On the other hand, from the perspective that this type of acquisition is more of a joint venture or other strategic partnership, rather than a simple exchange of asset for cash, the expected input by the purchaser of financial and other resources into the business certainly motivates the seller to sell.  A not unreasonable purchaser will seek to figure these inputs into the calculus for revenue growth, profitability, growth of customers and so forth.  This gets back to the question of why each party is doing the deal in the first place and the trust – and due diligence – in the other party’s promises about future performance.

2. Due diligence.  This may be challenging, because a seller may not easily have access to a purchaser’s financials books and records.  But due diligence relates not only to the management and financial stability of the purchaser, but also to the purchaser’s wherewithal to fund and operate the purchased business post-closing.  As noted above, both of these aspects of due diligence underlie a well-constructed earnout.  It is not so easy – and, really, can be quite difficult and costly – to “undo” an earnout that ends up being dishonored or, in fairness to both sides, disappointing to one side or the other.  Disappointment can arise from poorly conceived earnout metrics resulting in failure to achieve goals.  Causes for that failure may not be easily allocated between the parties, and in any event an earnout may not provide a mechanism for doing so.  With people you know, it can be difficult to say in advance that you will be able to trust your business partner in the event of a dispute.  Sometimes, acquisitions occur between parties that have worked together and known each other for long periods, making this aspect of an earnout less risky.  In the context when you have no actual history working with that business partner, however, earnouts place a premium on a seller’s ability to trust their new business partners to resolve potential business disputes amicably and fairly.

3. Accounting issues.  Bear in mind that accounting treatment may vary (and potentially wildly) between seller and purchaser concepts like revenue recognition; prepaid accounts such as subscriptions and prepaid rent; allocation of administrative and overhead charges and capitalization or amortization of asset costs.  So, a seller forecasting financial performance as a basis for evaluating and negotiating an earnout will want to take care in either (a) incorporating variances in accounting (for example: GAAP versus cash accounting) into his thinking or (b) negotiating careful terms about treatment of financial components such as those listed above.  Provision for apples-to-apples treatment comparing pre-sale to post-sale performance can be important.

4. Change of control.  A seller might consider seeking protection against a purchaser’s subsequent transfer of the business impacting an as-yet unfulfilled earnout.  A “change of control” clause in a sale agreements would trigger immediate payment or acceleration of unpaid (including not yet earned) earnout payments.  The real problem sellers try to address is the uncertainty thrown into the picture by the insertion of a new controlling ownership, which uncertainty itself creates difficulties in quantifying what should actually happen if a change of control occurs.  A purchaser might argue that nothing should happen, that all obligations remain in place and the company is still bound, etc. etc.  And there might be some merit to that argument, so that the flexibility of a seller to simply work under the new ownership might be desirable under certain circumstances.  The seller might respond that they signed up to do business only with one particular party, and they staked their financial future on that party.  That argument, too, might have merit, although the purchaser could still respond that re-transfers and changes of control are known risks in business and should have been calculated into the earnout payments in the first place.

Bottom line and lawyer’s perspective: The real crux with an earnout is the due diligence prong above, because ultimately, you don’t want to have a dispute.  If you sell yourself into a situation where you have to litigate in order to get your money, you’re not well off using an earnout.