Plugdin Insights: What to consider when faced with an earn-out

Read time: 7 minutes

What should be a seller’s first consideration when faced with an earn-out? 

Earn-outs are a common feature of M&A transactions - but they are not always straightforward to structure. They require all parties to not only agree metrics but also anticipate and agree on the treatment of issues that are both likely and unlikely to occur over a period of time. The first thing to consider is – do you have a full understanding of what offer is on the table when it comes to an earn-out, and what you’d need to do to achieve that offer, as well as full confidence in your business plan put forward to the buyer?

Many business owners are nervous about accepting earn-outs, as they’re concerned about their chances of cashing out that portion of the value. However, when used properly, earn-outs can provide the seller with an additional opportunity post-deal to true-up and validate the headline price, ie achieve the full value of your business. The daunting element for most sellers is the loss of control – you’re now operating in a world where you no longer have full control over the business and how it operates, for example you depend heavily on a management that may be subject to changes under new ownership or not properly incentivised to help deliver the earn-out.

Most misunderstandings, when people end up in court or endless legal battles, arise when one of the parties has not properly thought through or detailed in the legal agreement how the earn-out will work.

How can business sellers’ approach influence the structuring of an earn-out? 

Typically, it’s the buyer who’ll put forward a deal structure, including any earn-out element, but if you’ve got strong advisers on your side, they’ll be able to influence the shape of the offer on the table from the get go. For example, we’d be having conversations with the prospective buyers throughout the process to give them an understanding of the type of structure that the seller would be most inclined to entertain or what would constitute a hard ‘no’ for the seller.

Initial conversations often focus on financial metrics, but a good adviser will make sure other factors are also considered. They’ll help you develop possible scenarios and assess how these could affect you as a seller – ie what happens if you sign up a lot of customers, but, for whatever reason, there's a delay in the associated revenues or profits coming in? That delay could be for technological reasons or factors completely out of your control, like the Covid pandemic, but it could mean you miss out if the earn-out is structured purely on financial metrics. Including commercial KPIs in an earn-out conversation, for example rolling out a product within a set timeframe or bringing on a set number of new customers, can be incredibly valuable.

Do you have any tips for negotiation? 

It’s all about having the right advisers by your side. Unlike traditional buyouts, earn-outs mean you’re likely to be working closely with the buyer for the foreseeable future. During negotiations things can, and often do, get very tense and it’s helpful to have advisers acting as a buffer between you and the buyer. Your adviser will move on when the transaction is completed, but you may have to work with the buyer for several years and don’t want to jeopardise your future relationship, and maybe even your chance of achieving the full earn-out.

Are there any common contractual pitfalls to watch out for?

An earn-out should always be a perceived as a win-win situation. Yes, the seller gets some extra money over a period of time, but the buyer also benefits from extra value being generated for the business. There needs to be some level of balance, and if there isn’t, one party may try to manipulate things to their advantage, which will ultimately lead to tensions and disputes.

To avoid this, when it comes to the legal agreements, it is a case of “more is more”. It is of course impossible to structure an earn-out that addresses every unforeseeable event, however the legal agreement should be as detailed as possible and provide clarity of the outcome, timings and all the ‘hoops’ the seller needs to jump through to achieve the earn-out provisions. 

Make sure every scenario is explored and accounted for, because once the agreement is signed, it's done! And if something is not accounted for, then anybody can take liberties with it.

Are there any tax considerations to think about?

Plenty. Firstly, you will need to appoint a tax adviser who understands how transactions work in this sector and is up to date with the latest trends in earn-out structures. This isn’t always going to be the same tax adviser who has completed your tax returns.

HMRC will always have the right to enquire as to why “earn-outs” are not taxable as “earnings” and subject to income tax and NIC, which would see sellers paying a high rate of tax. This is something that needs to be considered and structured robustly in the early stages of negotiation. A common issue is whether leavers during an earn-out should be allowed to keep their share of future earn-out payments.  This issue also has accounting, tax and other implications for the buyer, so needs to be addressed collaboratively.

There is also the issue of whether vendors would prefer to “bank” the current rates of tax or pay tax at whatever rates apply when earn-out payments are made. Careful structuring can introduce this flexibility and also enable sellers to reclaim tax already paid if the earn-out falls short of expectations. 

Sometimes a transaction structure simply will not work commercially when post-tax proceeds are calculated. This can often arise where highly priced share options are involved or where sellers are located in a number of different countries. In these cases the tax adviser can help to modify the transaction structure to accommodate the pinch points and keep the commercial deal moving forward.

What’s the biggest earn-out risk for sellers? 

This can happen for a number of reasons; it can be something as unexpected as Covid where many businesses find themselves in a position where they aren’t able to grow. Or, once the business changes hands, you may find that there’s an imbalance between how the new owner wants to run things and what you need to have happen in order to achieve your earn-out. Or it could be that the financial forecast is unrealistic to begin with.

There are also risks around the company’s employees and management. Every business depends on a group of people working together and if key people aren’t incentivised to stay on once the company changes hands, all of a sudden you don't have the right people in place for potentially months at a time. That affects your ability to reach certain metrics during your earn-out period. It is a delicate dance of making sure you look after the key people that can help achieve your earn-out.

There are other little things too. For example, when a business changes hands the new entity will integrate into an existing structure. It may be that there are different accounting processes, such as revenue being recognised in a different way. And ultimately, that will affect the financial metrics for the earn-out. 

To avoid future issues, it is essential that these details are debated and covered ahead of signing on the dotted line. 

Are there any alternatives to an earn-out?

There are several deal structuring approaches that can achieve some of the benefits of having an earn-out element.  One of which would be giving the seller shares in the buyer’s business as part of the purchase price. However, this brings its own set of challenges, for example, agreeing a fair valuation for those shares.

Another option, which isn’t necessarily an alternative to an earn-out, but another way of shaping one, is agreeing an overage or what’s commonly known as an anti-embarrassment clause. This can detail things like additional consideration owed to the seller if certain “trigger events” take place, for example if the buyer re-sells the company for profit within a certain short period of time. 

What would you say to any businesses considering an earn-out?

If you fully understand what is on the table and you genuinely believe in your business and what it can deliver, earn-outs can be a useful tool and a fantastic way of ensuring you realise the full value of your business. They are incredibly useful and flexible for both parties, but only when they're approached in the right way. By that I mean with a full understanding on both sides, and everything being completely detailed in a legal document that everybody signs up to and is happy to adhere to going forward.

Professional advice is invaluable when considering the suitability of an earn-out, and the legal agreement (SPA) will need to include detailed and well-considered terms setting out how the earn-out is to be calculated and what protections will be given to each of the parties.

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