Every seller is looking to maximise their potential return on the sale of their business. In this article, we consider the use of earn-outs to achieve this including the benefits, risks and key negotiation points for the parties.
The term “earn-out” is used where, on the sale and purchase of a company’s shares (or of its business and assets), an element of the purchase price - which may be cash or shares in the purchasing company - is determined by reference to the future performance of the company that has been purchased. The earn-out is paid to the seller once specific targets are achieved by that company in a defined period following completion.
The classic earn-out is calculated by reference to profits over the two or three financial periods after completion. However, it is possible to link the earn-out to turnover, net assets or any other financial measure which is appropriate to the transaction. It is unusual to see very short or very long earn-out periods. Buyers would be concerned that this would incentivise sellers to behave in a short term way and the seller will not want to defer their payment too far into the future.
Earn-outs are most frequently used where the company in question is in the service industry, where the assets being acquired may be worth only a small fraction of the purchase price or the price has been calculated on the growth potential of the company.
Earn-outs have advantages for both sellers and buyers.
From the seller’s perspective, earn-outs can:
From the buyer’s perspective, earn-outs can:
However, earn-outs are not without disadvantages. Usually, the seller retains a very significant interest and, in most cases, a day-to-day involvement in the target company (as opposed to a clean break on completion). It is also usual for the buyer to be constrained as to what it can and cannot do with the target company during the earn-out period.
For profit-based earn-outs, establishing the principles for the calculation of the profit figure is critical. The normal starting point is to employ the accounting practices and principles used in preparing the audited accounts of the target company for the period ended immediately prior to completion.
However, there will inevitably be discussions regarding specific further adjustments for bad debts or for any extraordinary items that the parties will know about, such as relocation costs as a result of the transaction, redundancy costs and so on.
The buyer may also want to exclude any benefits to the target company which have come about through the acquisition by the buyer. Examples of this could include reduced headcount or the greater purchasing power of a larger group. This is normally a contentious point for both the buyer and seller and will require careful negotiation by their legal advisers.
Even if the seller remains involved in the target business after completion, the earn-out is potentially vulnerable to activities by the buyer which may have the effect of artificially reducing the earn-out. Examples of these include diverting business to other companies in the group and charging excessive intra-group management fees.
Accordingly, the parties will negotiate contractual provisions which restrict the buyer from doing anything that could have this effect. Sometimes this is dealt with by the inclusion of simple prohibitions, breach of which would result in an action for breach of contract. It can also be addressed in the calculation of the profit figure ie by exclusion of such items from the calculation of the profit figure.
The negotiations surrounding such restrictions are usually another contentious area. This is because the buyer will be anxious to minimise the loss of its freedom to run the target as it sees fit after completion.
By agreeing that some of the purchase price will be deferred, the seller is taking a risk on the buyer’s ability to make the deferred payment. Therefore, the seller will need to consider the question of security for the buyer’s obligations. There are various methods of achieving this, most of which will be resisted to some extent by the buyer. The seller can request that they are granted a charge over the assets of or shares in the company; that the earn-out is guaranteed, either by a bank or a parent company; or that some element is held in escrow in a secure account.
The availability of entrepreneurs’ relief, income tax and employee remuneration issues and taxation on chargeable gains are often key drivers behind the earn-out structure. These are, unsurprisingly, complex and nuanced considerations that require specialist taxation advice to ensure maximum benefit to the parties.
While an earn-out can be the subject of tricky negotiations between the seller and the buyer, it has potentially significant advantages for both parties as it allows the seller to maximise the proceeds from the sale of their business and the buyer to retain the knowledge and experience of the seller in the business in the important post-completion handover period.
To read more about the processes and considerations involved when selling a business, please see the Penningtons Manches Cooper Guide to Selling a Business by clicking the banner below or by getting in touch with your usual PMC contact.
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This article is intended to provide a summary of the law in this area as at July 2022 and does not constitute legal advice. Should you wish to obtain advice based on specific facts and circumstances, please contact us.
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