A Guide to Earn-Outs on Business Sales: Silver Bullet or Poisoned Chalice?

An earn-out is a commonly used pricing mechanism by which the sale price of a business is directly linked to its future growth and success. The buyer and seller agree certain targets which, if achieved, will result in further payments being made to the seller.

Earn-outs are a useful way of bringing the parties together where there is a difference of opinion on valuation, particularly where the seller believes that the future profitability of the business should be reflected in the sale price. They can also be very attractive to a buyer as earn-outs effectively allow a percentage of the purchase price to be paid from the future profits of the business.

For example, where the seller thinks the business is worth £10m but the buyer is only prepared to pay £7.5m, the seller might be prepared to accept an up-front payment of £7.5m and further payments of up to £2.5m dependent upon the business achieving certain growth targets.

Earn-outs have the potential to be win/win for all parties, delivering the fairest apportionment of risk and the most accurate calculation of price. However, they are not suitable for every transaction, can sometimes lead to disputes and care needs to be taken to ensure the desired tax treatment is available.

Professional advice should therefore always be taken when considering the suitability of an earn-out, and the sale and purchase agreement will need to include detailed and well-considered terms setting out how the earn-out is to be calculated and what protections will be given to each of the parties.

In this introductory guide to earn-outs we’ll consider the advantages and risks associated with earn-outs (for both buyers and sellers), look at some of the commercial and tax issues that need to be considered, and consider some alternative approaches that may be more suitable for certain transactions.

Earn-Outs: Advantages for Sellers

A seller will usually be attracted to an earn-out because it has the potential to increase significantly the overall sale price of a business. This is usually relevant because the seller thinks the business is worth more than the buyer is prepared to pay, or because both parties acknowledge that the business may be poised to become very profitable but nobody can accurately predict what value this will ultimately deliver.

In addition to capturing the full value of a high-growth company, there are several other reasons why an earn-out might be attractive to a seller, including:

• Potential benefits to be obtained from being part of a larger group, including business synergies, reduced overheads, better credit terms etc. (although note that a well-advised buyer will often try and exclude from the earn-out calculations the impact of benefits which arise solely from its ownership of the business).
• An earn-out can be an exciting incentive for sellers who know that they will be continuing to work in the business – far outweighing the usual remuneration of an employee. This is particularly relevant where a buyer’s ownership will help accelerate the growth of the business, enabling a seller to de-risk their personal position by capitalising on the value of the business whilst continuing to benefit from its future growth and success. The pain of failing to achieve an earn-out will be lessened where the seller is satisfied with the purchase price paid at completion and sees any earn-out payment as a bonus, not an entitlement; we always advise sellers to look at earn outs in this way as there is no certainty in life.
• The prospect of becoming an employee, on a full market-rate salary and with associated benefits, may be attractive to some entrepreneurs who have forfeited income for a sustained period in order to generate capital value in the target business. The seller may also be faced with restrictive covenants under the sale agreement (which restrict their ability to work in a competitive role or start a new business) but needs or wants to continue working.

Earn-Outs: Advantages for Buyers

It is generally felt that earn-outs are more advantageous to buyers than sellers. This is because they enable a buyer to defer and de-risk what may be a significant proportion of the purchase price.

However, there are various other reasons why a buyer might want to include an earn-out as part of the payment structure, including:

• Achieving a deal where the buyer is unwilling to meet the seller’s initial valuation of the business. Even if the buyer is highly dubious that the seller’s projections (and therefore the earn-out targets) will ever occur, the payment of the earn-out will only occur if future performance is better than the buyer expects.
• Incentivising and retaining key management (i.e. the sellers) for a pre-agreed period of time. It is not unusual for sellers to remain employees of a business following a sale, but where the buyer feels that the growth and value of the business are intrinsically linked to the ongoing involvement of a seller then an earn-out provides a clear timeframe for this and deters the seller from leaving.
• A better apportionment of risk, particularly if the target business is achieving high but uncertain growth, sits in a volatile marketplace or faces strong competition.

Earn-Outs: Risks for Sellers

Much of the risk associated with achieving payment of the earn-out sits with the seller. There are various ways that this risk can be reduced and mitigated against, but it is important to understand that some of the risks and pitfalls are inherent and cannot be offset.

• The greatest and most obvious risk is that the business does not perform as forecast, resulting in a failure to achieve the earn-out. The time and energy divested by management in completing a disposal often take a seller by surprise, and typically impacts the target company’s performance in the period following completion. The seller may also need to spend significant time and energy adjusting to a new role and integrating with the buyer’s group.
• A common frustration of sellers is that they are given insufficient control over the operation of the target business, preventing them (in their eyes) from achieving their earn-out targets.
• For many independently-minded entrepreneurs, the cultural clash associated with becoming an employee of the buyer may be unpalatable. The potentially underwhelming prospect of 2 or 3 years spent working for a corporate outfit – in the very business that the seller established – can be reason enough for some sellers to avoid signing up to an earn-out at all.
• Under an earn-out the seller may have to wait for a sustained period of time before they get their hands on their cash (assuming of course that the earn-out is achieved) – and so it may be better to agree a smaller, unconditional sum at completion of the deal in lieu of an earn-out. The counter-argument to this is that some sellers will be unable to deploy their sale proceeds until the expiry of an agreed warranty period, which may not be much (if any) shorter than the earn-out period.
• There is a danger that key management (who are not entitled to share in the earn-out) decide to leave the target business when the sale completes, reducing the target business’ ability to hit the earn-out targets.
• There is always a possibility that disputes will arise between buyer and seller as to whether earn-out targets have been achieved or not. This can result in an impasse where:
• There is genuine uncertainty as to whether targets have been achieved, for example where reporting/accounting processes have changed or it is difficult to quantify the savings associated with being part of the Buyer’s group; and/or
• Revenues which the seller believes belong to the target company are attributed to another company within the buyer’s group, or costs which the seller considers should be charged to the buyer’s group have been put through the target company.
• A seller will want to avoid the scenario that they no longer wish to be employed by the target business – but are effectively forced to stay in the role rather than leaving and forfeiting some or all of the earn-out. A seller will also want to ensure that they are protected against the Buyer dismissing them during their earn-out period.
• Sometimes a buyer will choose to manage the target business in such a way that protects its value but thwarts the earn-out targets being achieved, perhaps by incurring increased marketing or R & D costs.
• What happens if the buyer chooses to sell the target business during the earn-out period (assuming it is allowed to do so under the terms of the earn-out) or if the buyer itself is acquired by a third party?

Most of the issues set out above can be avoided or mitigated by a well negotiated and drafted sale and purchase agreement. There may be resistance from a buyer, particularly where the acquisition is leveraged on the assets of the target company, but some buyers will understand and try to accommodate reasonable requests made by the seller.

Earn-Outs: Risks for Buyers

Whilst earn-outs are generally considered to carry less risk for buyers, there are still various issues to be aware of:

• The buyer is unlikely to be able to fully integrate and manage the target business on day 1, and may need to give the seller a measure of control (albeit by way of veto) over the business during the earn-out period.
• In circumstances where the buyer might normally choose to dismiss the seller, it may not be able to do so because of the earn-out protections given to the seller.
• Poorly negotiated earn-out targets could result in the seller being paid out for hitting certain targets, even if the overall health of the target business is not as strong as it should be. There is a particular risk that a seller will focus exclusively on hitting the earn-out targets (i.e. maximising short-term profitability) at the expense of longer-term growth.
• Whilst in theory an earn-out aligns the interests of the buyer and the seller, because both want the target business to succeed, other areas of conflict may still arise. For example, the buyer might be disinclined to bring a warranty claim on the basis that it doesn’t want to upset the seller and prejudice the future growth of the business.
• Where an earn-out is subject to a cap, stamp duty of 0.5% may be payable at completion on the maximum possible amount payable, even though there is no guarantee that the maximum amount will ever be paid. This can result in a greater payment of stamp duty than would otherwise have been required.

How to Define and Document an Earn Out

Much of the potential for disagreement between the parties can be reduced by carefully negotiating and documenting the terms of the earn-out during the sale process. Whilst this can be time-consuming it is invariably better to set clear parameters at the outset than to fall into disagreement several years down the line. The earn-out provisions of the sale agreement should be objectively clear and sufficiently straightforward that a third-party can understand and implement them in the event that the parties cannot agree the earn-out between themselves.

Whilst the detail will always depend upon the commercial strength of the parties and the exact nature of the deal, there are several key principles that will underpin a successful earn-out:

1. Look for genuinely win/win metrics

A successful earn-out should always generate significant additional value for the Buyer and handsomely reward the Seller for creating this growth. As soon as there is an imbalance in the earn-out then one of the parties will be incentivised to manipulate the position to their advantage, leading to tensions and potentially disputes.

1. Consider a blend of financial and non-financial metrics

Whilst many earn-outs are calculated with reference to the turnover, EBITDA or net profit of the target business over an agreed period, there are various benefits to combining financial targets with operational ones. The complexity of calculating earn-out targets (and the scope for one or both parties to attempt to manipulate them) can mean that alternative metrics are preferable.

Possible targets could include winning a certain number of new customers, renewing certain key contracts or achieving a minimum number of product sales. Whilst less sophisticated, these targets will be harder to argue over.

1. Try to avoid cliff edges

It can be tempting to agree earn-out targets and rewards such as “£250k if year 1 EBITDA exceeds £1m”, but what happens if year 1 EBITDA is £950k and this represents an excellent result for the target business (and by extension the buyer)? If the seller doesn’t see a penny for their hard work – and there are also earn-out targets for years 2 and 3 – there is a chance that they will walk rather than stick around and risk narrowly avoiding subsequent targets, which may be a really bad result for the buyer.

Cliff edge targets also increase the likelihood of disputes arising, because in the example above the seller might start looking for ways in which EBITDA of £1m could be calculated (or that the buyer has manipulated the accounts to arrive at the figure of £950k).

Instead, it is often better for targets to include sliding scales or thresholds so that a seller is rewarded for excellent results, even if they don’t necessarily achieve the ‘headline’ targets.

1. Consider reasonable and practicable restrictions (both positive and negative) for both parties

For the protection of all involved, it is always wise to agree clear parameters about what each party can and cannot do in relation to the operation of the target business.

For example, how will financial reporting be implemented (i.e. to what extent can the buyer integrate its existing systems and policies)? How much autonomy will the Seller have to continue running the target business unfettered? What protections should the Seller have against being removed from their position, and should good or bad leaver provisions be included?

Tax Issues with Earn-Outs

The taxation of earn outs is not a straightforward issue but broadly speaking, earn-outs can lead to two potential tax issues.

The first is that that a seller may receive less advantageous capital tax treatment on earn-out payments than completion and deferred payments. This is because Entrepreneurs’ Relief is generally only available on completion and deferred payments, not sums subsequently received under the earn-out. The right to receive an earn out is not an asset that attracts Entrepreneurs’ Relief irrespective of any shares that might be retained by a seller.

A potentially greater issue is the danger that deferred payments will be treated by HMRC as income, rather than capital, with significant consequences for the seller (who will be liable to pay a much higher rate of tax – of up to 45% plus employees’ national insurance at 2%) and the target company/buyer (who may be liable for employer’s national insurance contributions at 13.8%). The basis for this is that HMRC may argue that earn-out payments are effectively bonuses linked to ongoing employment, rather than part of the purchase price paid for the business. There are what are called safe harbour provisions agreed with HMRC but falling within these provisions can cause tensions between the buyer and the seller and/or the sellers as a group.

There may be structures that can improve the tax treatment of earn outs and for these reasons tax advice should always be sought as part of the negotiation of an earn-out.

What are the Alternatives to an Earn-Out?

Whilst many parties will nevertheless conclude that earn-outs are the best way for them to structure their deal and create the right win/win dynamic for all parties, it is important to remember that there are other approaches that can achieve some of the benefits of an earn out:

1. Seller to be issued shares in the buyer

By issuing the seller with shares in the buyer as part of the purchase price, many of the risks associated with calculating and agreeing an earn-out can be avoided. The buyer is free to run the target business unfettered from day 1, and the seller stands to gain from owning a proportion of the buyer’s larger group.

These could be set up as ‘growth shares’ which only carry any rights in the event that the buyer achieves a certain level of growth (to which the seller effectively contributes through ongoing service). This is particularly appropriate where the seller is taking up a wider executive role in the buyer’s group.

From the seller’s perspective, care should be taken to ensure that they receive sufficient protections against the value of their shares being diminished, normally in the form of a shareholders’ agreement, but it is unrealistic to expect much control (if any) over the operation of the buyer’s business.

1. Agree ‘overage’ provisions in the sale agreement

A less conventional, but sometimes useful approach is for the parties to agree an ‘overage’ or ‘anti-embarrassment’ formula. This means that where the buyer sells the target business for a profit, the seller will be entitled to share in the proceeds.

Alternatively this could be structured so that additional payments are triggered by certain financial goals being achieved – irrespective of whether the seller remains involved in the target business (which may be attractive for one or both parties).

1. Consider a time-based approach

An alternative to using financial targets is a time-based approach, with the seller being rewarded for remaining in the target business for a period of time.

This might sound unattractive to a buyer, but the rationale behind this approach is that the seller has created the value in the target business in the first place, and if they are happy to remain in their current or earmarked role (noting that many entrepreneurs would not be content to be part of a larger corporate entity for a sustained period of time) then they are likely to generate further value for the Buyer.

This approach removes the cost and complication of agreeing an earn-out and reduces much of the potential for friction to arise further down the line.

Is an Earn-Out the Answer?

We have identified many potential risks associated with earn-outs, which might be enough to persuade a potential seller to avoid an earn-out at all costs. It might be that an earn-out is simply not an appropriate solution for you.

However, that might not be the case. Earn-outs are an incredibly useful and flexible tool, which when approached in the right way (and when coupled with the right professional advice) can create a powerful win/win solution to difficult negotiations.

For more information or to discuss the best way to approach your potential transaction, please contact us and we will be happy to assist you.

This article is for general information only and does not, and is not intended to, amount to legal advice and should not be relied upon as such. If you have any questions relating to your particular circumstances, you should seek independent legal advice.

Author

Stephen Morse