Earn outs explained

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An earn out is a purchase price adjustment mechanism commonly used on the sale and purchase of a company where the buyer wishes to make a part of the purchase price contingent on the post-completion performance of the company during a period of between 1 and 3 years.

This can be any type of performance but typically relates to sales figures, profits or EBITDA (Earnings Before Interest Taxes Depreciation and Amortization).

In practice, the buyer pays an initial cash sum on completion of a sale, followed by one or more deferred payments contingent on the company’s financial performance over the agreed period.

An earn-out provision can reassure a buyer that it won’t be “overpaying” for the company if it under-performs post-completion and conversely can reassure a seller that it will receive the highest sale price achievable if post-completion performance proves stronger than could have reasonably been anticipated.

Earn outs can however be extremely risky for the seller if it does not negotiate appropriate levels of control over the target’s operational performance in the post-completion period as it will risk receiving a lower payment than expected.

Earn-outs are best used when neither party can assert with complete confidence that its own anticipated expectation of post-completion performance will be the correct one and there is genuine scope for uncertainty, for example:

with an early-stage company which has good potential for quick growth;
where the company has recently introduced a new product or service line;
where an existing company with strong historic performance has suffered a negative “one-off” impact on sales due to an unexpected event such as Covid-19.

Sales or EBITDA targets?

Neither is perfect.

Using “gross sales” as the earn-out target may put the buyer at risk if profits decrease because the seller retains discretion, for example, to increase the company’s spend on marketing or to provide deferred payment terms for customers.

Using “EBITDA” as an earn-out target may put the seller at risk if the buyer has the right, for example, to impose a new management charge on the company or unilaterally increase staff or other costs.

So whichever type of earn-out target is used contractual protection for both parties will be required to prevent abuse.

Buyer control/ interference

After completion, the seller loses those rights of control over the company which derive from being the controlling shareholder, such as appointing the board and senior management.

From the seller’s perspective, therefore, it will want to retain control of those areas of operation of the business which have the greatest impact on possible achievement of the earn-out target.

The seller will therefore want to negotiate a service or consultancy agreement with the company granting such control (subject to restrictions) and will want to negotiate similar agreements for all key team members.  Careful attention should be paid to: (i) the term of the contract which should be co-extensive which the duration of the earn-out period and (ii) the termination clause which should restrict the company’s right of termination to situations justifying summary dismissal (which are typically in the individual employee’s control to avoid).

In addition, there may be included a series of specific restrictions on action by the seller or buyer with a view to artificially increasing or decreasing revenues or profits plus general principles such as a requirement to carry on the business “in the ordinary course”.  There may be restrictions on the acquisition or disposal of key assets but the incoming board will need to ensure they have sufficient control to carry out their statutory duties correctly.

If earn out payments are to be made on an interim basis rather than waiting to the end of the full earn-out period there may need to be provisions for the carry-forward or carry-back of profits, revenues or costs so that interim over-payments or under-payments can be corrected in the final calculations.

Tax considerations

Finally, tax advice should be taken on structuring the payment of the earn out so that the most beneficial tax treatment for the seller is obtained.  Depending on circumstances, this might require the maximum earn-out to be contracted to be paid by the buyer in instalments with the buyer entitled to make a £ for £ warranty claim if the warranty that the earn-out targets will be met proves incorrect.

Where the seller stays on in the business with a service contract, it will be important to show that the seller is being paid a market rate for the job to reduce the risk of HMRC trying to argue that some of the consideration for the shares sale is in fact disguised emoluments which should be taxed at a higher rate.

Hitherto it has been possible to obtain non-statutory clearances from HMRC confirming that HMRC will treat sale proceeds a capital gain rather than income.

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