Earn Out negotiations on business sales

What is an Earn-Out?

Where the purchase price for a business comprises an initial payment on completion and one or more contingent payments calculated or determined at a later date, the deferred element is known as an "earn-out."

If you are buying or selling a business and an earn-out is being negotiated, we can help you structure the arrangement, negotiate its terms and address the associated legal and tax issues.

Reasons for considering an Earn Out Arrangement

The most common reasons for using earn-outs are:

• sharing the risk where the business' future performance is uncertain;
• incentivising sellers to remain involved and help the business succeed after completion; and
• allowing the buyer to defer part of the purchase price, potentially easing funding requirements.

Sellers generally prefer to receive the full purchase price on completion, whereas buyers may favour an earn-out linked to future performance. As earn-outs often depend on financial measures that can be affected by business decisions, the calculation provisions must be clearly drafted and understood by both parties.

Earn-outs are also a common source of disputes during negotiations and after completion.

Structuring an Earn Out

Once the buyer and seller agree in principle to an earn-out, they must decide how it will operate. Key considerations include the duration of the earn-out period, the proportion of the purchase price that is contingent, the seller’s ongoing role and any relevant tax implications. Each transaction requires a structure suited to its circumstances. We have extensive experience advising on earn-out arrangements.

Deferred consideration statement

A common approach is for the buyer to prepare a deferred consideration statement setting out its calculation of the earn-out payable to the seller. The agreement may provide for the following process:

• The seller has a specified period, often around 20 business days, to review the statement. Appropriate access to relevant accounts, records and personnel is important to enable the seller to verify the calculation.
• The parties then have a further period, often around a month, to resolve any disagreements through negotiation.
• If agreement cannot be reached, the disputed matters may be referred to an independent expert for determination under the procedure set out in the agreement.

The independent expert is often an accountant with relevant expertise. The agreement should specify how the expert is appointed if the parties cannot agree, the scope of the expert’s authority and how the costs will be allocated. An appointment through the ICAEW may be available in appropriate circumstances, but the process and costs should be considered in advance.

Basis for determining Earn Out

Earn-outs are commonly linked to:

• turnover
• profit or EBITDA
• new customers; or
• active customers

The seller may have limited control over the factors determining the earn-out, particularly where the buyer controls the business after completion. If the earn-out is intended to incentivise the seller to remain involved, the parties should consider how business decisions, accounting policies and access to information may affect the outcome. Clear protections can help reduce the risk of disputes.

Tax on Earn Out

Sellers typically seek CGT treatment on the sale proceeds and may qualify for Business Asset Disposal Relief (BADR), subject to the relevant conditions. We can help structure earn-outs to support the intended tax treatment.

Where the seller remains employed by the business, care is needed to avoid the earn-out being treated as employment income.

Stamp Duty may be payable by the buyer on the purchase of shares, generally at 0.5% of the chargeable consideration. The treatment of contingent consideration should be considered when calculating the liability.

For CGT purposes, the treatment of deferred consideration depends on whether the amount can be determined at completion. Special rules may apply to unascertainable earn-outs, affecting when tax becomes payable.