If you’re buying or selling a business, you may be considering an earn-out agreement. In a business acquisition, earn-out payments are a form of seller compensation dependent upon the future success of the company.
Earn-outs provide a sense of security for both the buyer and the seller. However, they can be complicated to understand and execute, and can contribute to post-deal disputes.
In this guide, we’ll explain what earn-out payments are and when they might be used. We’ll also discuss their pros and cons for both parties involved in the acquisition.
What Is an Earn-Out?
An earn-out is a type of contractual agreement put in place when buying or selling a business. It involves the buyer making payments to the seller over time, contingent upon the business meeting certain financial targets. It’s estimated that around 40% of mergers and acquisitions involve an earn-out deal of some kind.
Earn-out agreements are useful when the buyer and seller disagree upon the business’s value. At acquisition, the buyer pays a lump sum based on the business’s current revenue. Then, earn-out payments are made to the seller if the company’s profits increase over time.
These payments may be a percentage of gross sales, or a predetermined amount agreed upon in the contract.
Earn-Out Agreement Example
For example, a buyer values a business for sale at £5 million. This is based on the company’s average EBITDA (earnings before interest, taxes, depreciation and amortisation).
However, the seller values their business at £8 million due to a new development in the company. The upcoming launch of a new product is projected to boost future sales.
The buyer therefore agrees to pay an initial lump sum of £5 million upon acquisition. Over the next 5 years, the buyer will make regular payments to cover the remaining £3 million. However, these are structured as an earn-out, meaning they are contingent upon certain sales targets being met.
Why are Earn-Out Agreements Used?
Earn-out agreements help ensure the seller receives a fair price for their business based on the work they’ve put into it. Being paid in instalments through an earn-out deal also means that the seller can spread out their Capital Gains Tax over time.
For the buyer, earn-out deals have many advantages. Firstly, the acquisition is paid off in stages, rather than all at once. This is a useful alternative to financing if the buyer cannot fund the entire purchase price. And if future profits turn out to be lower than expected, they won’t pay as much.
Furthermore, the seller is incentivised to help the business succeed long-term. This means they may offer the buyer free advice or help manage the business after the sale.
Contingency-based deals also provide security when the business’s future performance is uncertain. Some earn-out examples include purchasing a business in a newly formed industry, or a start-up with little financial history.
How to Structure an Acquisition Earn-Out Deal
The earn-out structure is decided by the seller and the buyer and their advisors. It should determine:
- The purchase price and percentage of which will be paid up front
- The length of the contract and frequency of contingent payments
- The specific targets the company must meet, and which financial metrics will be used to calculate whether these have been achieved
- The individuals involved in the deal and how payments will be made
- How much involvement the seller will have in the business until the debt is paid
- What will happen if the buyer cannot make payments as agreed
These terms and conditions are laid out as a clause in the purchase of business agreement. This is a legally binding contract which all parties must sign.
Earn-Out Accounting and Tax Considerations
An earn-out agreement can be more complicated to arrange than a straightforward sale. It will affect the buyer’s statutory accounts and tax owed by both the buyer and the seller.
Earn-out tax treatment and accounting treatment can vary depending on:
- How the contractual agreement is worded (e.g. payments may be taxed as employment income or as capital gains)
- Who the transaction is between (are shareholders, employees and/or third-party investors involved?)
- Whether the earn-out is treated as a financial liability or equity
Buyers may also have to pay stamp duty on payments depending on the terms and conditions of the earn-out. The chargeable amount is highly variable, so speak to your accountant if you’re unsure.
What Are the Disadvantages of Earn-Out Payments?
Though earn-outs can be advantageous for both the buyer and the seller, they have some downsides. For example, earn-out clauses can take a long time to negotiate. For the seller, there’s also a risk that the targets upon which the payment is contingent will not be met.
Earn-outs are also among the most common reasons for post-deal disputes. Earn-out disputes are often caused by a lack of clarity in the contract. This can lead to confusion regarding how EBITDA is calculated or whether a performance target has been met.
If you’re considering an earn-out deal, contact an acquisitions specialist such as Chelsea Corporate for advice. Working with legal experts, they can help you draft a clear, realistic earn-out agreement that works for both parties.
Contact Chelsea Corporate: Off-Market M&A Experts
Chelsea Corporate are buy-side merger and acquisition experts specialising in off-market sales. We match our clients with lucrative opportunities and facilitate the acquisition from start to finish.
Working together with the buyer and seller, we aid in negotiations, carry out due diligence and finalise the perfect deal for both parties. Our experts are on hand throughout to answer any queries about earn-out agreements, tax or anything else.