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”.
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.
The basis of the preparation of the deferred consideration statement typically has a priority as follows:
- specific accounting policies
- historical accounts
- relevant local GAAP
To minimise disputes it is recommended that a proforma is provided by the Buyer and agreed before Completion of the sale. We always suggest that the Buyer and Sellers work through some illustrative examples and potentially even include these illustrative examples in the purchase agreement.
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.
Deferred consideration can be based on profit or the technical term EBITDA (Earnings before interest, taxation, depreciation and amortisation). If the deferred consideration is to be linked to this profit measure it is important for the Sellers to limit the following in the Earn-Out period:
- increases in costs, particularly salaries of employees
- what capital expenditure the Buyer can make
- any migration of the Sellers’ business into the larger Buyer group
The Sellers should also consider carefully the synergies with the Buyer’s business and how that will impact on the bottom line.
The management charges of a large organisation for HR, IT and accounting functions can make a difference to the profitability of a business and therefore it is important for the Sellers to set clear charging structures for this work after Completion. One drafting solution is that if there is any increase in expenditure over the charges for the previous 12-months this won’t be taken into account when determining EBITDA.
As another tip: if there is a period of months between Completion and the commencement of the Earn-Out period this should allow the settling in of a business into the new corporate structure and hopefully maximise the Earn-Out.
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. It is therefore very important that the following factors are reflected:
- that the sale agreement shows valuable consideration for the shares
- that the remuneration for any shareholders remaining in the business after Completion is reasonable (not too low)
- that the shareholders who are remaining in the business receive the same price per share as any individuals who are not remaining in the business
- that the Earn-Out is not conditional on the individual staying in the business.
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.
Because the CGT may be payable before all of the Earn-Out has been received the Sellers may not have received some or all the deferred consideration at that point (or may receive more in the future if the Earn-Out is not capped). If this is the case and the Seller receives more than the anticipated purchase price there will be additional CGT to pay. If the Seller receives less they can utilise a capital loss.
For this reason determining whether to overestimate or underestimate the purchase price is often tied to the availability of BADR. It is often better to overestimate the consideration (as if it is under estimated it will be necessary to pay interest and penalties add the late payment will not qualify for BADR).
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.