How to structure an earn-out

An earn-out has long been a business purchase arrangement that can ensure the maximum possible return on a sale. The structuring of an earn-out looks to the future performance of a business - to its potential for greater value - to determine the value of a sale and can prove very beneficial to both the buyer and the seller. So if you are selling, or considering selling, your business, it could well be worth your while to consider whether an earn-out might be right for you.

In a basic earn-out, during the process of selling shares or assets of a company, a certain amount of a business's purchase value is calculated on the predicted future fortunes of the business. The proceeds are paid to the buyer once certain, pre-determined goals are achieved by the company.

The measures that can be used to calculate these goals can include reference to net assets, turnover and profits, among other measures, with profits being the most likely choice. The time frame set for an earn-out is predetermined and usually mid-term in length - often two to three years. Very short or very long-term earn-outs can make a buyer cautious about a seller's short-term intentions, which can make them wary of deferring the completion of the transaction and payment for too long a period.

If your business is in the service industry then an earn-out is more likely to be suitable for you. The earn-out method of sale can be at its most valuable when the worth of the sale has been calculated on the business’s potential for growth, especially when the assets of the company concerned constitutes only a tiny proportion of the value of the sale.

In terms of direct benefits for the seller of a business, an earn-out is able to earn the optimum value for a readily profitable business without having to negotiate with a buyer over concerns about the actual profitability. It also allows for the potential benefits the business being sold gains if it becomes part of a larger group of businesses.

If you are considering an earn-out from the perspective of a buyer, then the plus points are multiple. An earn-out can allow you to defer part of the purchase price, and it can ensure that the purchase price is directly linked to the company's performance after completion. Furthermore, it can act as an incentive to the seller and ensure you of their post-sale loyalty.

Conversely, earn-outs can bring with them certain limiting - but important - disadvantages, of which both sellers and buyers must be aware.

The seller will often retain a significant interest in the company, if it is sold through an earn-out, often taking the form of day-to-day involvement - a sharp contrast to a 'clean break' on completion method of sale. The process and duration of the earn-out also usually puts limits on what the buyer can do during that period, which is a crucial consideration for the buyer when deciding their short- and long-term intentions.

So when it comes to structuring and negotiating an earn-out, where do you begin? The profit figure is the first and most crucial port of call. The figure should be calculated with the same accounting methods that were used in the audited accounts of the company for the period immediately before the intended sale. Bad debts, any redundancy costs, any relocation costs - these will all have to be factored in to and often taken away from the final determined value.

An area of possible contention between the buyer and seller may come when assessing the potential benefits the company may gain for the buyer, such as a reduced workforce or the added power it gets from being part of a larger group. A buyer is likely to want to exclude these from the profit figure, while a seller is not.

And so, the issue of seller protection is raised. The value of the earn-out can be reduced by the actions of the buyer after the completion of the deal, which means if you are the seller, then it is imperative to write contractual provisions preventing such actions into the terms of the deal. The activities in question can include directing business to other companies within the buyer's group or foisting large intra-company management costs on it.

Like the calculation of the profit value, this can prove to be another bone of contention, but can be successfully negotiated with the right provisions and prohibitions. Somewhat taut negotiations are likely to be expected as buyers will, naturally, want to minimise any loss of freedom in their operations of the company once the deal has been cemented. The buyer can usually expect that the seller will insist upon having mechanisms in place to ensure financial transparency over the earn-out period.

As is the case with any deal based on the predicted state of any business, there is an element of risk involved in an earn-out. In agreeing to defer some of the purchase price of the company, the seller is taking a chance on the buyer being able to make the deferred payment when the time comes. There are a number of methods that will allow the seller to ensure the security of the buyer's undertaking. These include the seller asking for a charge over the assets of the company, or over its shares. The seller can also ask for a guarantee from its bank or parent company, or that a set amount is held over in secure account in an 'escrow' set-up. Many of these are again potentially heckle-raising for the buyer, but can easily be calmly negotiated.

The taxation issues surrounding an earn-out can often be key factors in the ultimate structure of the deal. Taxation on chargeable gains, entrepreneurs' relief income tax and employee remuneration issues are definitive, but complex and nuanced.
Scheduling the delivery of earn-out payments to coincide with the most advantageous tax periods is often a priority for vendors. They will sometimes use loan notes to ensure that tax is only paid when money is actually received.
Forging ahead with an earn-out without the specialist advice and assistance of a tax professional is ill-advised, and the hiring of an expert will prove beneficial for both buyer and seller.
While not being the simplest mode of selling - or buying - a business, the financial advantages of selling your business through an earn-out are patent and profitable. There is evidence that in a harsh economic climate with thin levels of available bank finance, providing vendor finance through an earn-out is one of the more popular strategies to ensure that more buyers are able to join the negotiating table, increasing competition and the likelihood of a higher price being struck.
With the right advice, professional services and reasoned and calm negotiations, it can be the best way of progressing a successful sale.

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