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earn out - avoiding burn out

February 2006

Earn outs in M&A transactions - where the purchase price is split between a payment at closing and one or more contingent payments dependent on certain targets being met - are an important tool for both buyers and sellers as they enable the price to be fixed retrospectively. Indeed, in today's market, it would be rare not to see some form of earn out where an unquoted technology or services company is being purchased. Set out below are some of the key points to be addressed in an earn out to ensure the objectives are met.

Why use an earn out?

Earn outs have a definite appeal to a buyer as they:-

Valuation. Focus a seller's attention on valuation issues (e.g. the financial projections given to the buyer) by forcing it to accept that part of the price will only be paid if the agreed targets are met. The logic for an earn out is particularly compelling where a services company is being bought whose profits are dependent on the management team or the price is being calculated by reference to profit projections not supported by 'traditional' valuation techniques.
Incentive. Act as a management retention and incentive tool (if the management team are sellers). The management team will be minded to stay with the business to maximize the value of their earn out. If this is one of the buyer's key aims, it should take care that the earn out targets are realistic as, if they are not being met, the management team may lose interest. This could result in the buyer having to 'sweeten the deal'.
Exposure. Reduce its exposure to variations in the business' performance post-acquisition. This is particularly important where a number of uncertainties exist at the time of sale such as the loss of key contracts or appetite for the company's product line in the market.
Recovery. Reduce the price if certain assumptions are incorrect sometimes avoiding the need for a warranty claim. The earn out payment can also be set off against claims under the sale agreement.
Cash flow. Allow it to reduce the up front consideration.

For a seller, an earn out:-

Disagreement as to Price. Provides a mechanism for dealing with a disagreement as to price with the buyer. An example of this is where and early stage company is being purchased with key customers and technology of significant potential. The shareholders of the company are likely to argue that the value of the company is substantially greater than a simple earnings multiple. However, the buyer is unlikely to want to pay for the potential profit value of the technology up front. An earn out can bridge this issue.
Access to Resources. Frequently gives the target company a negotiating position (by being part of a larger group) and access to resources, such as a buyer's sales channels, that may otherwise be unavailable to it.

While there are examples of successful earn outs, including some where a ratchet upwards leads to substantial subsequent payment, a seller should only rely on the initial payment with any certainly. Given this, a seller should explore other routes - e.g. put and call option agreements over different proportions of the equity, exercisable in certain specific circumstances (possibly profits targets being reached), or simply waiting until the buyer's concerns are shown not to exist - before agreeing to an earn out.

Structuring the Earn Out

A seller and buyer have considerable flexibility in structuring the earn out to achieve the agreed objectives. For instance, it can be linked to general or specific targets (such as revenues, margins, growth rates or return assets), offered to all or a certain class of seller and be geared to performance of a business unit or the overall performance of a company. Careful consideration will need to be given to how the targets are calculated; for instance, linking the earn out to profitability is likely to require input from accountants as to how profit is calculated and what revenue and expenses are to be ignored. The sale agreement should be clear and unequivocal on these points and on the mechanism for resolving disputes (such as reference to an independent accountant) to reduce the risk of subsequent litigation.

The time frame for an earn out can vary significantly depending on what the objective is. Typically an earn out for the purchase of an unquoted technology or services company is in the range of 18 months to 3 years. It's quite rare to see an earn out last beyond 5 years. Buyers frequently resist very short earn outs as they encourage very opportunistic short-term behavior (e.g. maximising revenues and ignoring long-term growth).

Protecting the seller

A seller who agrees to an earn out will be exposed to activities of the buyer in reducing the value of the earn out even where the business interest of the parties are clearly aligned. As a result, a seller will seek to contractually secure a number of protective provisions. The nature of these provisions will be driven by the nature of the underlying business and the type of earn out. For instance, restrictions on the buyer making management and other charges may not be appropriate if the earn out uses a revenue target.

Some of the provisions that may be required by sellers managing the business post acquisition include:

The right to manage the business. For a technology company, this could include autonomy over the product development and release to ensure that a reactive and creative environment is retained.
A general provision that nothing will be done with the intention of reducing the amount of the earn out or to divert business to other group companies.
An acceleration or modification of the earn out if the company's business or assets are sold or changed in a way which would adversely effect the earn out or which would make the agreed methods of calculation difficult to apply.
Specific commitments as to provision of financial or other resources and access to sales channels. These are frequently set out in a business plan appended to the sale agreement.

Sellers often also seek some form of security in relation to payment of the earn out, particularly if the earn out is being used because the buyer is unable to fully finance the acquisition of the company.

A buyer is likely to heavily negotiate these protective provisions to ensure that they are tailored to areas of particular risk for the sellers and give the buyer the right to preserve its economic interest in the business. For instance, if sellers are to have management control post acquisition, the buyer may want the right to take over management or require expenses to be brought down if the business is not hitting agreed targets. This can be particularly problematic as this is the very time when sellers wish to increase expenses/take drastic action to ensure that the earn out targets are met.

A clear downside for a buyer in agreeing to extensive protective provisions is that it creates an artificial barrier between the business it is acquiring and its other business units. This may represent an additional cost to it in terms of separate calculation of the financial results. Indeed, such protective provisions may prevent the benefits of the acquisition from being fully realised during the earn out period.

As an overriding comment, sellers should note that whatever contractual protections are in place, the reality is that post acquisition they will lose a considerable degree of control. Therefore, it is important that the 'cultural fit' is right and that there is a high degree of trust.

Tax Issues

An earn out raises a host of tax issues and, frequently, these issues drive the structure of the earn out as they have a significant financial impact. These include:-

Capital Gains Tax

The value of an earn out will be taken into account in calculating a seller's liability to capital gains tax on the sale of its shares even where the value of the earn out is unascertainable. This can lead to discussions as to value although it is usual for the value of the earn out to be considerably lower than its maximum possible amount. The practical implication is that the seller may be required to pay capital gains tax on an asset it has not yet received. This problem can (subject to various conditions being satisfied) be avoided if the earn out is satisfied in shares or loan notes as the capital gain will be held over until a later date.
Individuals who are sellers can, subject to certain conditions being satisfied, have the benefit of taper relief on a sale of their shares. Taper relief operates by tapering the capital gains tax payable on a sale of the share by the number of years they have been held. Assuming that various conditions are satisfied, if a seller has held shares for 2 whole years, it may only have to pay capital gains tax at a rate of 10% (as opposed to 40% if the seller is a higher rate tax payer). For this reason, sellers are likely to want to roll over any gain into shares or loan notes where this is possible.

Income Tax Treatment

Individuals who are sellers will look for the earn out to be subject to capital gains tax rather than income tax and national insurance (as this can make a significant difference to the net proceeds received).
However, if a seller is the employee of the acquiring company or a subsidiary (e.g. the target) post-acquisition, there is a risk that the earn out will be regarded as employee remuneration and therefore subject to income tax and national insurance, not capital gains tax. Only where the seller can show the earn out operates entirely to cover further proceeds of sale, with no element of remuneration, will the seller escape this treatment. HMRC has published guidance on the 'key indicators' that the earn out is related to employment. Given this, it is vital that the earn out be structured as further consideration for the sale shares. However, structuring the earn out this way is likely to be at the cost of using the earn out as a retention too.

Summary

In theory, earn outs are flexible, provide a mechanism for dealing with valuation disagreements and foster co-operation in developing and building a business. In practice, they can become extremely complex, leave both sides exposed and lead to disputes. It is therefore essential that the earn out be structured carefully, both in terms of the targets, operational issues and in terms of what is to happen in the event of a disagreement or if the earn out targets are not being met.

If you have any questions or would like to discuss anything in this article in more detail, please contact Charles Claisse on 020 7600 8080.