Even where a deal has been agreed, with or without an Earn Out agreed, the issue often gets raised again as the transaction proceeds and lawyers are commonly required to assist in negotiations as well as the drafting. We are very experienced at dealing with earn Out arguments and negotiations from both the buyer and seller side.
What is an Earn-Out?
Where the purchase price for a business is made up partly of the payment on the date of sale (completion) and partly of a contingent payment or payments to be determined at a future point in time the later payment is referred to as an “Earn-Out”.
If you are selling a business or buying a business and earn out is already part of the negotiations, please read on. You will see that we have the experience and know how to assist you in the buy or sell transaction. Please do call us.
The most common reasons behind Earn-Outs are:
- the future is unpredictable so the Sellers and Buyer share the risk of future success of the business
- the Earn-Out incentivises Sellers into staying and making the business a success
- the Buyer may need to defer payments in order to raise funds to satisfy the purchase price
Earn-Outs are also one of the largest areas of dispute, both during the sales process and after.
For obvious reasons sellers don’t like earn outs and want all the money on completion. Buyers think otherwise.
Earn-Outs are typically based on financial performance and that is notoriously easy to impact upwards or downwards. To minimise future arguments the drafting around calculating Earn-Outs needs to be very clear and properly understood by the Buyer and Sellers (not just their advisers).
Structuring an Earn Out
If the principle of earn out is agreed between buyer and seller the next question is the structure. There are many options including the length of the earn out period, proportion of the sale price which depends on the earn out provisions, key staff staying on for how long and there may also be tax considerations. Each situation is different. We have wide ranging experience in structuring earn outs.
Deferred consideration statement
To determine the Earn-Out at time of payment the most usual approach is for a Buyer to prepare a deferred consideration statement which suggests the level of the Earn-Out to be paid to the Sellers. Up to three stages then follow:
- the Sellers have a period of time (usually around 20 business days) to review this statement. It is important that during this time the Sellers are provided with full access to the accounts and personnel of the Buyer.
- there is then a period set to negotiate any difference of opinion in the detail of the deferred consideration statement. This is typically up to around another month.
- if there is still no agreement between the Buyer and Seller regarding the deferred consideration statement there is usually a procedure set out to have the deferred consideration statement determined by an independent expert.
The independent expert is typically an accountant. If the parties cannot agree on the identity of an accountant the ICAEW has a facility to appoint the expert but parties should be aware of the high costs involved in this process.
Basis for determining Earn Out
The basis for determining Earn Out is typically centred around:
- new customers; or
- active customers
To the extent any determination of the Earn-Out is not within the Sellers control it will be seen as unfair. Particularly if the aim of the Earn-Out is to incentivise Sellers into staying in the business, this can act as a disincentive.
Tax on Earn Out
Sellers typically wish to structure sales such that they benefit from capital tax (CGT) on the entire sale price. Many individuals also wish to qualify for Business Assets Disposal Relief (BADR). It is important to structure the Earn-Outs correctly to maximise the chances of getting this tax treatment. We can assist in ensuring the drafting does this.
There is a risk of the Earn-Out being treated as employment income. We can also advise on mitigating this.
There is stamp duty payable at half a percent on the entire purchase price. This is usually paid by the Buyer however this means the Buyer has to determine how much the Earn-Out will be (to quantify stamp duty payable).
For CGT purposes, the Sellers often have an additional matter to consider where the Earn-Out is unascertainable. To qualify for CGT generally the Sellers have to value the deferred consideration at the time of sale. Accordingly the gain to be subject to CGT crystallises at Completion. The tax is due on the 31st of January following the end of the tax year in which Completion takes place.
Helen is a partner and heads up the corporate team, advising start-ups, SME companies, partnerships, entrepreneurs, investors and shareholders. Dual-qualified in the UK and USA and a qualified solicitor since 1998 you couldn't ask for more experience.