Earn-outs – as valuable as they first appear?
You’ve had a cracking offer for your business but part of the purchase price is linked to an earn-out – is the offer as attractive as it first appears?
What is an earn-out?
An earn-out allows a proportion of, or less commonly, the entire, purchase price of a share or business sale to be paid at a later date calculated by reference to future performance of the target company or business (the “Target”). The most common form of earn-out is linked to the future profit of the Target over a set time period post-sale.
Advantages and disadvantages
Where earn-outs are used it is common for the sellers to be required to remain running the Target for a set period which offers the buyer the benefits of continuity of service with key members of the Target remaining in the business motivated to maintain the success of the Target to maximise their earn-out potential. The buyer benefits from deferring the payment of some of the consideration to a later date.
On the downside, there may not be a “clean break” which may be desirable and there is no guarantee for the sellers that the earn-out targets will be hit (particularly if they will not be continuing in the business) meaning that they could end up only receiving the purchase monies paid on completion.
So what should you consider before accepting an earn-out?
In most cases, the continued success of the Target is in the interests of both the buyer and sellers however this does not stop issues from arising. When deciding whether an earn-out is appropriate careful consideration should be given to the management of the Target post completion including:
- to what extent the sellers should retain day to day control of the running of the business;
- what commitments the buyer will make to introducing new business to the Target and/or not allowing members of the buyer’s group to compete with the Target;
- what resources the buyer will commit to making available to the Target (for example financial, market, production, sales and personnel resources);
- the level, if any, of management charges the buyer or its group may impose on the Target; and
- restrictions on seconding the Target’s staff to other members of the buyer’s group.
On the flip-side, the buyer may want its own commitments from the sellers to prevent them running the business in a way designed to artificially inflate the Target’s performance and therefore the amount of the earn-out.
Be wary of the tax treatment of earn-outs
Earn-outs are rarely used where the seller is a company because it is likely to be subject to corporation tax on capital gains.
Individual sellers often assume that the earn-out element of the purchase price will qualify for entrepreneurs’ relief. This is not always the case and HMRC may deem any earn-out payment as an employment related bonus subject to income tax and national insurance resulting in a significantly higher tax liability.
Before agreeing to an earn-out sellers need to carefully consider the risk that they will not receive any monies under the earn-out and both parties need to look at the terms to ensure appropriate protections are in place and that the desired tax treatment is achieved.