Dr McDeal title What is an earn out?

Back to basics here, I’m afraid doc. What exactly is an earn-out?

An earn-out anticipates the sale of 100 per cent of the issued share capital of your company at the point of legal completion. It is a pure contractual commitment by a purchaser to pay further value for your company if you meet
agreed performance targets. From the purchaser’s perspective, the purpose is to incentivise you to ensure that the acquisition is a success. For you, an earn-out can be an important means of bridging any valuation gap between your price expectation and the price that a purchaser is willing to pay based on your company’s financial performance. In many cases, the amount that vendors can achieve under the earn-out can exceed the amount received at completion.

So when and in what types of businesses are earn-outs most appropriate?

Earn-outs make sense when you intend to stay on after the sale and will continue to make a significant contribution to the business. They become more problematic when not all of the vendors are involved in the day-to-day running of the business, for example when the business that is being bought is partly owned by a private equity house. In such cases, there is frequently a potential conflict between those vendors who want the maximum amount paid on exit and those that are keen to maximise the earn-out. Corporate vendors selling a subsidiary generally have no interest in earn-outs as, once the company has been sold, they cannot influence the achievement of any performance targets.

What terms and conditions need to appear? Are there cases where, although possible, an earn-out just won’t work?

The terms of the earn-out need to be carefully tailored to meet individual circumstances. If the acquired company is to be run largely autonomously postacquisition, then a profit-based earn-out may be appropriate. If, however, the target company is to be entirely integrated within the business of the acquirer, an earnout may not be appropriate. If a purchaser wishes to extract
immediate synergies from buying a target, the “ring-fencing” of the target’s business required as a result of an earn-out can make an earnout unattractive. In most cases, the existence of an earn-out requires a large degree of shared expectation for the outcome of the transaction between yourself and the purchaser.

That all sounds fine and dandy, but how do I protect myself in an earn-out deal?

Before entering into an earn-out, you must understand and endorse the reasons behind the purchaser’s wish to make the acquisition and the way in which the two organisations will work together in the future. You should be an important contributor to achieving those objectives. Measuring the extent to which objectives have been achieved will be fundamental and will need agreement on the accounting policies to be used, the treatment of any management or central charges levied on you, the cost of funding and the availability of resources to pursue business opportunities.

The important principle is that you must be given the freedom to achieve the performance targets for your earn-out. This means that your company must be “ringfenced” from undue interference by its new parent company for the length of the earn-out period. All of the necessary checks and balances will be dealt with in the share sale agreement.

Corporate governance needs to be agreed beforehand; you want the maximum opportunity to achieve the earn-out, while the acquirer will want the right to protect his investment. Conflicts can arise where the acquirer may want to do something which is in the overall best interests of his enlarged group but which you feel is to his advantage. New business opportunities may well fall into this category. Most vendors will seek to achieve the earn-out within two or three years with interim payments. As earn-outs extend in time, they generally become more uncertain.

Let’s say I’m not too keen on an earn-out. What are my alternatives?

One option is for you to take shares in the acquirer as part of the consideration. This may enable you to benefit from the advantages that the acquirer expects to gain from the acquisition. To be effective in this way, however, the transaction has to be material to the acquirer and you will need considerableknowledge of - and confidence in - the acquirer’s share liquidity,
activities and prospects. Another alternative is to convert the earnout into a royalty agreement. This implies a lower level of involvement in the business after the disposal. In many cases, vendors will join the acquirer on a long-term basis and benefit from salary and bonuses in the normal way. Finally, it may be possible to structure a deal around combining the sale of an initial minority or majority shareholding in the target company with the grant of an option or options to acquire the remaining shares over an agreed period of time based on a negotiated valuation formula.

Last, but not least, how should I get paid?

This is an important technical consideration - how the future earn-out payments are settled under the earn-out. If the earnout payments are in cash, the Inland Revenue will make its own assessment of the proportion of the earn-out it thinks you will receive and then charge you CGT on the hypothetical gain at the date of the initial sale of 100 per cent of your company. As a result, earnouts are conventionally structured around the payment of future value in the form of “paper”: loan notes or shares to be issued by the purchaser in due course. This enables any capital gain to be rolled into the loan notes or shares, and CGT is only payable at the redemption or sale of those “paper” instruments.