Earn-out and Installment Payments: Key to a Successful Online Business Sale Transaction

Selling an Online Business in Poland: A Complete Guide">Online Business Sale Agreement: Key Clauses for a Successful Deal">Selling a business, especially in the dynamic online world, is often one of the most significant decisions in an entrepreneur's career. It typically involves complex negotiations regarding value and payment methods. Two popular, yet often underestimated, methods for determining transaction price are earn-out and installment payments. Both mechanisms can significantly impact the transaction structure, its attractiveness to both parties, and the final profit. At Online M&A">Digimarket.info, we deeply understand these nuances and want to provide you with a practical guide on how to leverage them to your advantage.

What are Earn-out and Installment Payments in the Context of Online M&A?

Before delving into details, let's clarify the basic concepts:

Earn-out: This is a clause in a sale agreement that ties a portion of the purchase price to the acquired company achieving specific financial results (e.g., revenue, EBITDA, number of users) post-transaction, within a predefined period. It's a form of variable compensation designed to motivate the seller's continued involvement and ensure a smooth business transition. The earn-out period typically ranges from 12 to 36 months. For example, if a company generates 1 million Polish Zloty (PLN) annually in revenue, and the buyer wants to pay 3x revenue but perceives risk, they might propose 2.5 million PLN upfront and an additional 0.5 million PLN after achieving 1.2 million PLN in revenue in the first year post-acquisition.

Installment Payment (Deferred Payment): This is simply spreading the payment for the business over time. Unlike an earn-out, the installment amount is usually fixed and independent of the company's future results. Installments can be paid monthly, quarterly, or annually, according to a schedule specified in the agreement. It's often used when the buyer doesn't have sufficient funds upfront, or as security for the buyer in case of potential hidden legal or financial defects. A typical schedule is 20-30% of the price upfront, with the remainder spread over 12-24 installments.

Both mechanisms have their place in M&A transactions and can be used independently or in combination, depending on the business's specifics and the parties' expectations.

When to Consider an Earn-out? Seller's and Buyer's Perspective

For the Seller:

Value Maximization: The biggest advantage. If you believe in your business and its future growth potential, an earn-out allows you to achieve a higher price than with a one-time payment. If the initial valuation is 2.5 million PLN (approx. $625,000 USD), but the market is uncertain, an earn-out of 500,000 PLN (approx. $125,000 USD) for achieving specific targets can raise the transaction to 3 million PLN (approx. $750,000 USD).
Overcoming Valuation Gaps: When buyers and sellers have different views on future results, an earn-out can help bridge this gap by linking the price to actual achievements. For example, the seller values a startup at 10x EBITDA (0.5 million PLN = 5 million PLN), while the buyer values it at 6x EBITDA (3 million PLN). An earn-out could allow for an additional 2 million PLN if EBITDA grows to 0.7 million PLN within 2 years.
Maintaining Engagement: If the seller possesses key knowledge or contacts, an earn-out motivates them to remain with the company for a certain period, facilitating smooth integration.

Risks for the Seller:

Loss of Control: After the sale, the seller loses control over the company and, consequently, over the factors influencing the achievement of earn-out targets. The new owner's decisions could negatively impact results. For example, the buyer changes marketing strategy, which lowers conversion rates.
Complexity of Settlements: Earn-out formulas can be complicated and lead to disputes. It's crucial to precisely define metrics (e.g., net or gross revenue, whether returns are included).
Insolvency Risk: There's a risk that the buyer might not pay the earn-out due to financial problems.

For the Buyer:

Risk Reduction: An earn-out allows for spreading the risk associated with the business's uncertain future. The buyer pays the full price only if the company actually achieves the promised results. This is especially important with rapidly changing trends in e-commerce.
Alignment of Interests: The seller is naturally motivated to ensure the transaction's success post-acquisition, facilitating smooth integration.
Lower Upfront Payment: This reduces the capital burden at the start of the transaction. Instead of paying 100% of the price immediately, the buyer can pay 70-80% and the rest conditionally.

Risks for the Buyer:

Seller Resistance: The seller may be reluctant to make decisions that temporarily reduce profits but are strategically important for the new company's long-term growth (e.g., large marketing investments).
Monitoring Complexity: The need for accurate monitoring and reporting of company results during the earn-out period.
Potential Conflicts: Different interpretations of earn-out terms can lead to disputes. It's advisable to precisely define the method of calculating metrics and any potential dispute resolution mechanisms.

When to Use Installment Payments?

Installment payments are a more common solution than earn-outs, especially in smaller transactions.

For the Seller:

Access to a Wider Pool of Buyers: Installments can allow buyers with less financial liquidity to purchase a business, increasing the number of potential acquirers. Instead of looking for a buyer with 1 million PLN (approx. $250,000 USD) in cash, you might find someone who can pay 300,000 PLN (approx. $75,000 USD) upfront and then 30,000 PLN (approx. $7,500 USD) monthly for the next 2 years.
Stable Cash Flow: The seller receives regular payments after the sale, which can provide financial security for the future. For those retiring, this can be a steady income source.
Tax Benefits: In some cases, spreading payments over time may allow for capital gains tax to be recognized across several tax periods, which can be tax-efficient (e.g., avoiding entry into a higher tax bracket).

Risks for the Seller:

Insolvency Risk: Similar to earn-outs, there's a risk that the buyer may become insolvent. It's recommended to secure installment payments, for instance, through bank guarantees, promissory notes, pledges on shares, or mortgages.
Long-term Tie-in: The seller remains tied to the buyer for the entire repayment period, which can be psychologically burdensome.
Inflation: In cases of long repayment periods, inflation can reduce the real value of future payments. This can be mitigated by indexing installments to the inflation rate or establishing an interest rate.

For the Buyer:

Liquidity Management: Allows for purchasing a larger business without having to commit the entire amount upfront, which is crucial for small and medium-sized enterprises. Profits from the acquired business can be used to cover installments.
Time for Integration: Enables a smoother integration of the acquired company with the new owner, without immediate financial strain.
Security: If unforeseen business problems are discovered (e.g., hidden liabilities, unintended copyright infringements), the buyer may have grounds for renegotiation or withholding future payments (with appropriate contractual clauses).

Risks for the Buyer:

Financial Obligation: The buyer assumes a long-term obligation that can burden the company's future financial performance.
Need for Security: The seller will often require security, which can increase transaction costs (e.g., costs of establishing a bank guarantee).

Legal and Tax Aspects in Poland – What to Pay Attention To?

In Poland, both earn-out and installment payments have legal and tax implications that need to be thoroughly analyzed.

#### Taxes for the Seller:

Income Tax (PIT/CIT): The sale of shares or stock is usually taxed as capital gains:

Individuals (PIT): A 19% rate (the so-called "Belka tax") on income from the sale. In the case of installment payments, tax is generally paid upon receipt of individual installments (income is recognized on a cash basis). For earn-outs, tax is paid only after conditions are met and the additional payment is actually received.
Legal Entities (CIT): A 19% or 9% rate (for small taxpayers, up to a 2 million Euro revenue limit) on income. Similar to PIT, income is recognized on a cash basis.

Tax on Civil Law Transactions (PCC): The sale of shares/stock is subject to PCC at 1% of the market value of the shares/stock. The tax liability generally arises upon the conclusion of the sale agreement. In the case of an earn-out, the additional (variable) part of the price may also be subject to PCC if it is considered part of the price under tax regulations, however, this is often more complex and requires individual interpretation. If the transaction is subject to VAT (sale of the entire enterprise as an organized part of an enterprise - ZCP), PCC does not apply.

#### Taxes for the Buyer:

Amortization (Depreciation): Acquired shares/stock are generally not subject to depreciation. However, if, for example, an organized collection of tangible and intangible assets (ZCP) is purchased, individual assets can be depreciated, which is a deductible expense.
Financing Costs: Interest on loans or borrowings taken to purchase the business can be tax-deductible expenses (with limitations, e.g., thin capitalization rules).

#### Legal Aspects:

Precise Definition of Terms: This is an absolute must! In both earn-out and installment agreements, it's crucial to precisely define metrics, settlement periods, calculation mechanisms, and payment formulas. Lack of clarity is a recipe for legal disputes.
Protective Clauses:
For the Seller (for installment payments and earn-out): Blank promissory note, pledge on shares/stock of the acquired business, bank guarantee, surety, mortgage on the buyer's real estate. In cases of lack of control, the seller should negotiate clauses in the sale agreement limiting the buyer's ability to make significant operational changes to the company without the seller's consent if it would impact the earn-out payment.
For the Buyer (for installment payments): The ability to offset payments from installments for disclosed seller liabilities (e.g., resulting from previously undetected errors in tax settlements, unpaid penalties), or due to warranty liability. In the case of an earn-out, it's important for the buyer to specify, for example, maximum compensation costs for the seller during the earn-out period or the inability to sell key assets.
Dispute Resolution Mechanisms: Arbitration clauses or designation of the competent court for resolving potential disputes.
Seller's Responsibility: Clear definition of the scope and duration of the seller's liability for physical and legal defects of the business (warranty, guarantees). Installment payments often allow the buyer to more easily enforce claims.

Practical Case Study: E-commerce Sale

Imagine the owner of a popular online craft store, "Creative Hands," generated 800,000 PLN (approx. $200,000 USD) in revenue and 250,000 PLN (approx. $62,500 USD) in operating profit (EBITDA) last year. They want to sell the company, but the market is uncertain, and the buyer sees growth potential but with some risk.

Option 1: Transaction with Earn-out

Base price: 1,000,000 PLN (approx. $250,000 USD) (4x EBITDA), paid immediately.
Earn-out: An additional 300,000 PLN (approx. $75,000 USD) if the store achieves:
1,000,000 PLN (approx. $250,000 USD) in revenue within 12 months after the transaction AND
350,000 PLN (approx. $87,500 USD) in EBITDA within 12 months after the transaction.
Commentary: The seller believes in further growth and is willing to stay with the company for a year to achieve these goals. The buyer reduces risk by paying less upfront and motivating the seller. If targets are met, the seller will ultimately receive 1.3 million PLN (approx. $325,000 USD).

Option 2: Transaction with Installment Payment

Total price: 1,100,000 PLN (approx. $275,000 USD).
Payment:
300,000 PLN (approx. $75,000 USD) upfront (upon signing the agreement).
800,000 PLN (approx. $200,000 USD) in 24 monthly installments of 33,333 PLN (approx. $8,333 USD).
Security: Blank promissory note from the buyer, personal guarantee from the buyer's owner.
Commentary: The buyer has limited liquidity but steady income from other sources. Installment payments allow them to spread the burden. The seller receives stable, though staggered, income and some security.

Option 3: Combination of Earn-out and Installment Payment

Base price: 900,000 PLN (approx. $225,000 USD).
Payment for base price:
300,000 PLN (approx. $75,000 USD) upfront.
600,000 PLN (approx. $150,000 USD) over 12 months, in 12 installments of 50,000 PLN (approx. $12,500 USD).
Earn-out: An additional 250,000 PLN (approx. $62,500 USD) if the store achieves 950,000 PLN (approx. $237,500 USD) in revenue in the first year after the transaction.
Commentary: The maximum price is 1,150,000 PLN (approx. $287,500 USD). This option combines security for the buyer with potential upside for the seller, and also allows for flexible capital management.

The choice of the appropriate structure depends on the negotiating power of the parties, their expectations, financial liquidity, and the specifics of the industry and the business itself.

Negotiating and Documenting Terms – Key to Success

Regardless of the chosen structure, the key is precise and careful wording of all clauses in the sale agreement. Special attention should be paid to:

Definitions of metrics: What exactly does "revenue," "EBITDA," "user," etc., mean? Are there any exclusions? For example, is revenue from a one-time transaction with contractor X (who was the seller's contractor, not the buyer's) counted towards the earn-out?
Settlement period: What is the time horizon for the earn-out? When are installment payments due?
Calculation mechanism: How will the metrics be verified? Who is responsible for preparing the report? For example, "according to the audited financial statements for year X, prepared by an independent audit firm Y, at the buyer's expense."
Right to information and control: Does the seller have the right to inspect the company's books and documents during the earn-out period to monitor results? This is especially important when the seller no longer works for the company, but their compensation depends on its performance.
Security: What guarantees does the seller have that they will receive due payments? What security does the buyer have in case of defect disclosure?
Anti-manipulation clauses: For example, provisions obliging the buyer to conduct business with due diligence and in a manner that does not intentionally reduce the company's results during the earn-out period.

It is always advisable to use the services of experienced legal and tax advisors specializing in M&A transactions. Their knowledge and experience are invaluable in the process of structuring and negotiating such agreements. The average cost of comprehensive legal services for an online M&A transaction worth 1-3 million PLN (approx. $250,000 - $750,000 USD) ranges from 25,000 PLN to 70,000 PLN (approx. $6,250 - $17,500 USD), but this is an investment that can save millions of Polish Zloty and many problems.

Frequently Asked Questions (FAQ)

Is an earn-out always profitable for the seller?

Not always. An earn-out is profitable when the seller strongly believes in the future growth of the business and its potential, and is able to negotiate favorable and precise terms. The risk of loss of control and complex settlements can make a fixed, lower price a safer option.

What are the main securities for the seller in an installment payment plan?

The most effective securities are blank promissory notes from the buyer, a registered pledge on the shares/stock of the acquired business itself, bank guarantees, or a mortgage on the buyer's real estate. It is also worth considering personal guarantees from the owners of the buying company, if it is a corporate entity.

Can I combine an earn-out with an installment payment?

Yes, this is a common practice. A portion of the fixed price can be spread into installments, while an additional part of the price (the earn-out) is dependent on future results. This allows for greater flexibility and adaptation to the needs of both parties.

Do I pay tax on an earn-out immediately, or after receiving it?

Tax on an earn-out is generally paid upon actual receipt of the payment. Tax regulations consider income realized when it is at the taxpayer's disposal, which, in the case of an earn-out, occurs after the conditions are met and funds are disbursed.

What happens if the company under the new owner fails to meet earn-out targets due to the buyer's fault?

A well-structured agreement should include clauses protecting the seller from such a situation, e.g., by obliging the buyer to conduct business with due diligence and in a manner that does not intentionally diminish the company's results. In case of disputes, the matter may go to arbitration or court.

Is an installment payment plan tax-efficient?

An installment payment plan can be tax-efficient for the seller because it allows income to be spread over several tax years. This can help avoid entering a higher tax bracket or optimize annual tax liabilities, if regulations allow and the transaction is not recognized as a source of income where the entire sale price is recognized at the time of the transaction.

How can Digimarket.info help with transactions involving earn-outs or installment payments?

Digimarket.info can connect you with suitable buyers or sellers, and through our network of experts (lawyers, M&A advisors), you can receive support in structuring transactions, including earn-outs and installment payments. We provide tools for business valuation and an escrow mechanism that further secures your transactions.

Ready to Sell or Buy an Online Business?

Earn-out and installment payments are powerful tools that can determine the success of M&A transactions. Their proper application requires in-depth analysis, professional advice, and precise documentation. We hope this guide has provided you with valuable information. If you are considering selling your business or looking for investment opportunities, Digimarket.info is where your plans become a reality.

Sell your business today!

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Earn-out & Installment Payments: Optimizing Online Business Deals