Earn-outs: A Deal Clincher?
Linda Roberts
21-Jun-07
Over half of all private company acquisitions now involve an earn-out arrangement. Linda Roberts explores the pros and cons of an increasingly popular exit strategy.
Earn-outs are becoming more and more popular as a structure for the sale of shares in a company. They are particularly suitable in the sale of start-up companies (that may appeal to an Angel Investor) where historical profits may be low, potential performance is promising and where owner managers are themselves a significant business asset.
Optimally structured, an earn-out can be attractive to both parties and can overcome a common source of contention: the business valuation. The seller obviously wants to get the best price for his company and wants that price to reflect his prediction of future profits. The buyer is more likely to expect a conservative price based on past performance. If the two parties cannot agree on future performance, a potential way forward is to structure a deal to include an earn-out where part of the total consideration payment for a business is deferred. In this way, the seller receives a payment on completion and a further payment after an agreed period based on future business performance. An earn-out therefore represents a results based further consideration for the purchase of the company and may be considered by both parties as the fairest means of valuation.
The amount of the deferred consideration is based on agreed performance criteria and is generally calculated as a multiplier with reference to historical profits although it may be based on turnover or other financial criteria. The earn-out period may run from a number of months to a number of years and may include earn-out payments at different stages during the period. Earn-out periods are typically in the range 18 months to 3 years.
Typically, the seller will receive a cash sum, or an initial issue of securities, plus an earn-out consisting of:
- A right to receive loan notes (issued by the buyer) after a certain period has elapsed and dependent on the performance of the newly taken-over business. The loan notes would be redeemable after a certain period or periods, or
- A right to receive securities in the buyer or its parent company after a certain period has elapsed and dependent on the performance of the newly taken-over business. These may or may not have restrictions placed on them.
Earn-outs can also be constructed using:
- Restricted (forfeitable) securities (shares or loan notes) issued by the purchaser and which vest after certain performance targets have been reached. OR
- Convertible securities, issued by the purchaser and which convert into a more valuable security after certain performance targets have been reached.
It seems simple, but in reality earn-outs can be both legally and financially complex. Bearing in mind that an earn-out is often initiated as a result of the failure to agree a business valuation that is deemed fair by both the buyer and the seller, these parties may come to an earn-out with conflicting interests.
The buyer will want to maximise the future performance of the target company and may therefore wish to benefit from the seller’s knowledge and experience through continued employment. However, he will not want to risk his capital expenditure by relinquishing too much control. As the seller’s earn-out payment will be based on the future performance of the target company he will also want to be able to exercise control over how the company is run and may require adequate working capital during the earn-out period. The introduction of succeeding management and the associated handover may further complicate the issue of who’s in control.
The buyer will need to consider the short-term, mid-term and long-term future of the company. He may wish to incur costs in the short-term for long-term benefits. The seller will be focussed on the short-term and will require adequate working capital for the period. He will be looking to maximise company performance during the earn-out period to amplify his earn-out payment. He may also require the earn-out generating part of the business to be ‘ring-fenced’ so that the relevant profits are not adversely affected by unrelated costs or expenses.
There are advantages and disadvantages for both the seller and the buyer and these must be considered carefully at the time the earn-out is structured. It’s easy to see why an earn-out arrangement may appeal to a buyer. The buyer can purchase the target company through an initial payment followed by performance related payment/s at a later stage. If the target company doesn’t reach the performance benchmarks no further payments may be due. In reality, where the seller is an owner manager the performance incentive encourages the seller to continue his contribution to the business often resulting in a higher total consideration for him than he would receive from a one-off payment. The main advantages of an earn-out to the buyer include:
- More accurate company valuation.
- Less risk of paying too much for the company.
- The seller is incentivised to continue to contribute to the business.
- There is an opportunity to become familiar with the business while it continues to be run by the seller.
- The risk of losing key contracts is reduced (where the seller remains involved).
- The initial funding requirement is reduced.
- The deferred consideration can be financed from company profits.
The main advantages of an earn-out to the seller include:
- Potentially higher consideration than if the full payment was made on completion of the sale; there may be benefits from being part of a larger group that positively impact performance.
- Capital gains tax rollover relief may be available until the earn-out is paid.
An inherent disadvantage of an earn-out arrangement to both parties is the added complexity and duration of the transaction giving rise to increased professional fees for both parties from accountants, lawyers and earn-out experts.
The main disadvantages of an earn-out to the buyer include:
- The buyer faces an inherent conflict of interest: the better the company’s performance during the earn-out period the larger the earn-out payment to the seller.
- The seller may focus his efforts on boosting his earn-out potential and neglect other business considerations;.
- The buyer’s commercial decisions may be restricted by protective covenants imposed by the seller.
The main disadvantages of an earn-out to the seller include:
- The delay in receiving the full consideration.
- Increased risk that the buyer will be unable or unwilling to pay the deferred consideration.
- The focus of the business may switch to non earn-out generating areas that do not contribute to the earn-out.
- Expenses from non earn-out generating areas may impact on the earn-out.
- The buyer’s accounting policies will typically be used to calculate the earn-out, so the seller must take great care to ensure that the performance targets for earn-out payments are set appropriately.
- An earn-out cap will typically be required for a listed seller.
- HM Revenue & Customs may treat the earn-out as an employment-related bonus payment and tax it accordingly.
There are numerous legal considerations for both parties when structuring an earn-out, including the securing of the deferred payment. By default, where an earn-out arrangement is used the seller will only have an unsecured creditor claim against the buyer. Therefore any deferred consideration should be secured until it becomes payable. Although there is inevitably a cost for securing the payment, from the buyer’s perspective the cost may far outweigh the benefit to cash flow and gearing of deferring part of the consideration. There are a number of mechanisms available to provide this security as follows:
- There could be a charge over the target assets if there is available security in the assets. However, this may not be an acceptable option to the buyer or the buyer’s funders.
- There could be a charge over the target shares but this could cause problems if the value of the shares over which the charge is held is greater than the agreed deferred consideration.
- A bank guarantee could be provided; it may be costly, but the cost could be contributed to by both parties.
- The buyer’s parent company may provide a guarantee.
- An escrow account could be used to maintain a constant or increasing portion of the potential deferred consideration. This however negates the cash flow and gearing benefits of the earn-out arrangement.
The seller will wish to undertake legal protection against the risk that the buyer may consciously or other wise take decisions and actions that adversely affect business performance in areas whose profits the earn-out is based on. One option is to include covenants in the sale/purchase contract to ensure that the business is run in the same manner as previously and that nothing is done (or not done) to adversely affect relevant profits during the earn-out period. A breach of such a covenant would allow the seller to claim damages and perhaps gain an injunction against further breaches. Where the seller remains an active contributor to the company during the earn-out period, that risk is obviously reduced.
The seller may also seek protections in such areas as business planning, remuneration, key personnel, management fees, intra-group borrowing, accounting procedures and the possible re-sale or merger of the company. Expert legal advice should always be sought when drawing up a customised list of seller protections.
The buyer will also require legal protections. In cases where the business is heavily reliant on the skills of the seller, the buyer will be keen to tie-in the seller throughout the earn-out period. The buyer may seek to include a restrictive covenant in the purchase contract whereby the seller would lose his entitlement to any future earn-out payments if he left before the end of the earn-out period. Alternatively, the earn-out may be linked to the circumstance under which the seller leaves the company. If the seller were to become ill or retire, the payment of the earn-out could be accelerated. If the seller were to join a competitor, the earn-out payment could be reduced.
The financial structuring of an earn-out is no less complicated. An earn-out is typically structured so that the payment is calculated as a percentage of the profits of either all parts of a business or of pre-defined parts of a business over an agreed earn-out period. In some cases, the earn-out amount is calculated as a percentage of turnover or net assets depending on the agreed method of valuing the target company.
The following factors should be considered when structuring the earn-out:
- Maintenance of existing accounting principles throughout the earn-out period.
- Maintenance of existing financial periods throughout the earn-out period.
- Allowable deductions.
- One-off costs incurred during the earn-out period, for example costs associated with redundancy or relocation.
- Non-trading profit impacts, for example profits from the sale of assets and cost reduction benefits resulting from any post acquisition synergies;
- The level of management charges levied by the buyer’s group (where applicable).
- The level of research and development costs over the earn-out period.
- Whether profits can be carried forward or carried back during the earn-out period.
- Whether the earn-out should be capped (generally required for a listed company).
Both parties’ accountants will be required to agree the accounting principles employed in calculating the earn-out. When an earn-out becomes payable, if the buyer and seller cannot agree on the calculated earn-out, the matter will usually be referred to an independent expert whose decision is final. The sale/purchase contract should therefore state how any dispute regarding the earn-out calculation will be resolved and who will pay any resultant costs or interest payments.
Specialist tax advice should be sought when entering an earn-out arrangement. The earn-out consideration may be subject to either capital gains tax (CGT) or income tax depending upon the structuring of the earn-out. The seller should take early tax advice before negotiating the sale/purchase contract to optimise the tax treatment of the consideration. A particularly thorny issue is the employment status of the seller’s management if they continue to contribute to the business post-acquisition.
Where an earn-out includes an element that passes value to a prospective employee of the acquiring company as reward for services over a performance period, then that remuneration element will be subject to both income tax and National Insurance Contributions (NICs). Where the earn-out can be shown to be deferred sale proceeds rather than employee remuneration then CGT will apply. The timing of the tax levy varies according to the structure of the earn-out, whether the consideration is variable or unascertainable and whether it is satisfied in cash, loan notes or shares.
Despite the inevitable conflicts, an earn-out can reap financial rewards for both the buyer and seller if each party is prepared to compromise and implement a practical and commercial solution. Communication and trust are crucial factors to the success of the initial negotiations and throughout the earn-out period. Other sale options are available, but all have their drawbacks and may provide less incentive for the seller to continue his contribution to the profitability of the business. For an Angel Investor, an earn-out may therefore give feasibility to a deal that may otherwise flounder by overcoming the valuation hurdles, securing the seller’s future commitment and making viable an investment where the historical profits belie the potential performance of the target business.
Linda Roberts is the editor of a leading online business library of over 700 business publications covering such topics as taxation, business law, employment law, company structure, investment vehicles etc. She also provides company profiles, white papers, brochures and other marketing and technical collateral. She can be contacted at linda.roberts@it-allies.co.uk
