Buying a business presents significant risks to the buyer. This is particularly so for any “people” business where customer relationships may be inextricably linked to you or other key members of your team. Buying assets that go “up and down in the lift”, as one observer once put it, can be very high risk.
The earn-out is a legal structure that has been devised to protect the buyer. Payment is linked to the future financial performance of the business to be bought. Often 50% or more of the consideration may be represented by the earn-out.
The cynical observer will, with some justification, ridicule the headline deal value on which the seller has been induced to sell. A tax adviser arguing that the earn-out is truly a capital receipt and not disguised remuneration will assert, if challenged by HMRC, that the earn-out is a price discovery mechanism. The day one price they argue is discovered by the results in fact delivered over the next two to three years.
Leaving aside that accepted valuation sophistry what are the practicalities of which you, the business owner, should be aware?
The starting point to remember is that your interests as seller will be diametrically opposed to those of the buyer so far as the earn-out is concerned. You will have a short term focus, but the buyer will be looking at the long term and the future success of the business.
Here are our top tips on what to do when it comes to negotiating your earn-out:
- The first point is to be very clear on the minimum sum in cash paid up front that must be delivered on completion. Having perhaps spent 20 or 30 years growing your business through good times and bad avoid the temptation to view the headline price as the deal price. Cash up front is the real valuation that the buyer is putting on your business. It may be all you ever get. So make sure it is sufficient. Make sure too that the risk of warranty and indemnity claims does not mean you may have to return some of that minimum deal price.
- Avoid structuring a deal on the basis of an uncommercially low PAYE salary for you. Switching income taxable at 45% to a multiple of net profit and thereby achieve a capital gain taxable at just 10% may be tempting but HMRC can strike down deals that they characterise as disguised remuneration. There is a helpful guidance in HMRC’s Employment Related Securities Manual, see this link. One “no no” is earn-outs linked to continued employment which presents problems if some shareholders are going to stay on and others are leaving. All must participate in the earn-out.
- Securing formal tax clearances (e.g. in relation to extracting surplus cash as a capital receipt) will be advisable. This gives the opportunity to paint the full commercial background but a clearance that omits material facts will not protect you. HMRC offers a non-statutory clearance procedure if advisers have technical queries to raise. They have recently made it clear, though, that they will not rubber stamp the commerciality of a deal.
- You should avoid an earn out linked to a financial performance that is out of your control. You do not want the buyer unfairly attributing overhead or the time of key personnel to the entity on which your earn-out depends. Ideally strike an earn-out based on turnover or, if that is not acceptable on gross profit.
- Consider with your advisers the key risks areas on the earn-out. An obvious example would be your business being subsumed into the buyer’s wider business or sold or your employment terminated during the earn-out period. There could be other significant issues: perhaps an early premises move that might lead to higher costs and a relocation that might see key employees leaving is a possibility. The buyer may have his eye on a key member of your team for a role outside your business. Considering these “what if scenarios” means they could be listed in the Share Sale Agreement and represent ring-fence protections for you.
As the Americans say, good fences make good neighbours. Discussing these issues openly before a deal allows for buyer and seller to reach an understanding on future conduct.
- But having a promise on ring-fence protection is only part of the story. In law a breach of a contractual promise places the promisee (you the seller) in the position of having to prove your loss. This may well be almost impossible. So coupled with the ring-fence protection must be a liquidated damages clause. This will specify your remedy (if you opt to take it) if the protections are breached. Perhaps 75% of the maximum of the earn-out over the two years?
This note flags the danger of the earn-out. But, if cultures and ambitions are aligned, an earn‑out can be an astonishingly good way to grow a people business and for sellers to gain significant capital rewards.
The key will be shrewd negotiations on your part with the benefit of expert advice.
As Michael Barnier the EU negotiator is keen on saying, “nothing is agreed until everything is agreed”. So tough negotiation on your earn-out may win you other critical concessions. You may even persuade the buyer to pay you a reduced sum but all up front!
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