Earnouts explained

An earn-out is a purchase price adjustment mechanism commonly used in the sale and purchase of a business, where the buyer wishes to make part of the purchase price dependent on the performance of the business upon completion for a period of 1 to 3 years. .

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

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

An earn-out provision can reassure a buyer that they are not “overpaying” for the business if it underperforms post-completion, and conversely can reassure a seller that they will receive the highest achievable sales price if its performance proves post-completion. stronger than could reasonably have been expected.

However, earnouts can be extremely risky for the seller if they do not negotiate the appropriate level of control over the target’s operating performance in the post-completion period, as they risk receiving a lower payment than expected.

Earnouts are best used when neither party can claim with complete confidence that their own expectations of post-completion performance will be correct and there is real room for uncertainty, for example:

• with a start-up company that has good potential for rapid growth;
• where the company has recently introduced a new product or service line;
• where an existing business with strong historical 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 an earn-out target can put the buyer at risk if profits decline, as the seller retains discretion to, for example, increase the company’s spending on marketing or offer deferred payment to customers.

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

Whichever type of earn-out purpose is used, contractual protection for both parties will therefore be necessary to prevent abuse.

Buyer’s Control/Interference

Upon completion, the seller loses control rights over the company arising from being the controlling shareholder, such as the appointment of the board and senior management.

From the seller’s perspective, he will therefore want to retain control over those business activities that have the greatest impact on the possible achievement of the earn-out target.

The seller will therefore want to negotiate a service or consulting agreement with the company providing such control (subject to limitations) and will want to enter into similar agreements for all key team members. Careful attention should be paid to: (i) the term of the contract, which should be as long as the duration of the earn-out period, and (ii) the termination clause which should limit the company’s right to dismiss to situations requiring dismissal standing foot justify. (which are generally within the individual employee’s control to avoid).

In addition, it may include a range of specific restrictions on the seller’s or buyer’s actions for the purpose of artificially increasing or decreasing revenues or profits, plus general principles such as a requirement to continue the business “in the ordinary course of business” to put. There may be restrictions on the acquisition or sale of key assets, but the new board will need to ensure they have sufficient control to properly carry out their statutory duties.

If earn-out payments are to be made on an interim basis rather than waiting until the end of the full earn-out period, it may be necessary to make provision for carrying forward or carrying back profits, revenues or costs so that interim transfers to be possible. -payments or underpayments can be corrected in the final calculations.

Tax considerations

Finally, tax advice should be sought on structuring the earn-out payment so as to obtain the most favorable tax treatment for the seller. Depending on the circumstances, this may require the maximum earn-out to be contracted to be paid by the buyer in instalments, with the buyer entitled to a £ for £ warranty claim if the guarantee that the earn-out targets will be met proves incorrect to be.

Where the seller remains in the business with a service contract, it will be important to demonstrate 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 share sale was in fact disguised emoluments that should be taxed at a higher rate.

To date it has been possible to obtain non-statutory approvals from HMRC confirming that HMRC will treat the sale proceeds as capital gains rather than income.