Messing up on the Earn Out
When the time comes to sell your business you will need to know about something called an earn out.
It is normally the seller who gets his fingers burned when he sells on an earn out. The recent case of Treatt plc v Barratt was an example of a badly advised buyer. The lawyer messed up by not thinking things through; the Share Purchase Agreement provided for the earn out to be based on audited accounts by reference to calendar years but he ignored the fact that the buyer had a 30 September year end.
The buyer decided to be practical. It thought it would save itself the trouble and the cost of an extra audit. So the buyer ignored the Share Purchase Agreement and sent to the seller an earn out statement based on management accounts.
The seller was not happy and the case ended up in the Court of Appeal. The Court was having none of the pragmatic approach of resorting to management accounts. The Court decided that the seller was entitled to see the audited accounts even if the buyer would have to incur an extra audit fee. The use of audited accounts gave the sellers valuable protection and was not simply to be ignored by a badly advised buyer.
In 99 cases out of 100 it is the naïve or badly advised seller who comes a cropper with an earn out.
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Negotiations
When seller and buyer cannot agree on a straight price, whether or not payment or part of it is to be delayed, the earn out needs to be negotiated. The purist will say the technique enables the “post deal discovery of the day one price”.
In fast moving consultancy businesses the challenges of structuring the earn out can be acute. The commercial rationale for the deal will invariably depend on post deal synergy and co-operation. The purist will again analyse the earn out as an elegant method to discover the synergist value of the combination and thereby fix, in the future by reference to actual results, the day one value.
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Tax Clearance
You may not be surprised to discover that Her Majesty’s Revenue and Customs has their own take on earn outs fearing (not without reason) that they may be used to avoid tax. A post deal payment that might otherwise be characterised as income and be subject to PAYE and NICs can magically become a capital receipt subject to tax at just 10% with entrepreneur’s relief.
A non-statutory clearance procedure now exists that allows the cautious seller and buyer to check in advance what view HMRC will take on the earn out. Naturally a proper, post deal PAYE salary for the seller, will be a must. But there are no easy answers as to whether a post-sale payment should truly be regarded as payment for your shares rather than your post deal services as an employee.
Another tricky decision will come when you fill in your first tax return after you have sold your company. Unless your earn out has been structured as a loan note you are going to have to estimate the net present value of the earn out on the day you sold your company. Hopefully you will have a good period of actual performance to help your judgement of hindsight and to avoid the risk of paying too much tax on a gain you never receive.
Be careful though of being too cautious. Any gain not taxed in your first self-assessment return after the deal will be taxed at 28% (or 18%) and not 10%. This is because the earn out is regarded as a chose in action. The cashing in of that chose in action is a capital gains tax disposal. What is more, it has no base cost so the full amount is taxable.
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If all of this has left you dizzy at the complexity before you sell your business remember that few cash out deals work as you the seller hoped.
The reason is simple. You want to maximise your sale price and have a short term horizon. The buyer’s interests are diametrically opposed. He wants to minimise the price and is looking to the medium and long term. The scope for a falling out is very great.
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Top tips
So what are the top five tips to remember when negotiating your earn out?
- Make sure you maximise the up front cash. If you have enough certain cash the earn out can be the icing on the cake.
- Fix your earn out by reference to the turnover of your business or its gross profits, not its net profits: that way there is less opportunity for the unscrupulous buyer to fiddle the figures.
- Keep the earn out period as short as possible: the longer the period the greater the risk of a fall out between you and the buyer.
- Negotiate ring fence undertakings to protect your earn out: these are things the buyer cannot do to your business during the earn out period.
- Protect those ring fence undertaking with a liquidated damages clause: that way a breach of the undertakings does not leave you in in the impossible position legally of trying to prove your loss.
You only get one chance to sell your business. Make sure you do not mess up on your earn out!
