Earnouts – The benefits, complexities and tax considerations

An earnout – a financial arrangement in M&A in which a portion of a company’s purchase price is deferred and contingent upon its future performance – is a popular deal structure, especially during times of heightened risk or economic uncertainty.

For buyers, earnouts enable them to pay a lower cost upfront and spread the ultimate purchase price over a period of time (often as much as three years post-deal). For sellers, meanwhile, earnouts can generate a steady stream of cash in the post-sale period, providing the performance conditions are met.

In 2020, while M&A declined precipitously as a result of COVID-19, the percentage of deals involving earnouts increased, as buyers and sellers sought to mitigate the risks of their transactions and to bridge valuation gaps that resulted from the crisis.

According to private equity firm Allen & Overy, 20 per cent of the M&A deals they were involved in during 2020 utilised an earnout structure, a sharp increase from just 9 per cent of the deals they conducted during 2019.

With valuations forecast to be one of the main sticking points to M&A activity this year, it is likely that earnouts will once again prove to be integral to many hoping to strike deals, both on the buy and sell side.

However, an earnout is by no means a simple solution to gaps in valuation or to structuring deals in more financially feasible terms. It is an approach that requires extensive negotiation and rigorous structuring in order to reach an arrangement that both sides can agree on.

Before an agreement on the earnout structure can be reached, there are numerous considerations that need to be addressed, ranging from the payment terms and earnout period to tax implications and issues relating to governance and control during the post-deal period.

Why an earnout?

If structured well and in a way that both parties have fully agreed upon, earnouts can offer a range of benefits to both buyers and sellers. For buyers, the key advantage of an earnout is the ability to pay a lower upfront cost. By spreading some of the purchase price over a post-deal period and making it subject to performance-related criteria, buyers can pay a significantly lower cost when the deal completes.

This is one aspect that makes earnouts such a popular deal structure during times of economic contraction or uncertainty. As in the current climate, economic uncertainty means that financing conditions are tighter, lenders are more stringent and, overall, buyers may have smaller pools of capital with which to make acquisitions. Under such conditions, the ability to reduce the upfront cost of a deal can be invaluable.

Another factor that often complicates deals during downturns or recessions is risk on the buyer’s side. If the economy is turbulent, then buyers run the risk of acquiring a company that may underperform and not deliver value on the price that the buyer has paid. With an earnout, a portion of the price is tied into the company’s future performance, meaning that any such underperformance will be reflected in the amount that is ultimately paid, mitigating the risk of overpaying.

Finally, an earnout can provide some reassurance for a buyer that the seller is motivated to ensure the business performs well post-acquisition. Unlike with a deferred consideration, in which a set amount is agreed to be paid at some point post-deal, an earnout means that the seller is reliant on the company hitting performance targets in order for the full consideration to be paid. As a result, the company’s strong post-sale performance is as much in the seller’s interest as the buyer’s.

In an ideal world sellers would, of course, reject an earnout in favour of 100 per cent cash up front!

However, in the absence of bidders prepared to pay the full asking price, earn-outs are a way for the buyer and seller to bridge the valuation gap, yielding a higher sale price over time to the seller. Earnouts are often contemplated when both parties are happy with the acquisition in general, yet price remains an issue - but it’s not ridiculously far out. In negotiating strategy parlance, buyer and seller are both in the ZOPA arena, or ‘zone of possible agreement’.

Another side effect of the UK’s current economic turbulence is that company valuations have fallen somewhat over the past year. For sellers looking to exit a solvent business, this may mean that the kind of offers they are attracting for their business are falling well below the price range they would have hoped to command.

An astute seller in this situation will leave a portion of the consideration on the table, contingent upon future performance, and negotiate a higher top end for the purchase price. Providing they do not agree to terms that are unlikely to ever be achieved, this can mean that a seller can have the opportunity to get closer to (and sometimes higher than) the kind of valuation they would normally hope to achieve.

Another potential upside for seller’s disposing of their business through an earnout structure is that they will have a continuing level of control, and sometimes a stake, in the business post-sale. This means that, should the business’ performance improve, not only are they likely to achieve the full consideration, but they will also share in the company’s success for the duration of the earnout period – something that would not be the case with an outright sale.


In May 2022, Edinburgh-based bathroom wall panel business Grant Westfield was acquired by bathroom and kitchen products firm Norcros. The deal was struck with an enterprise value of £80 million, representing a 7.9x multiple of the target’s £10.1 million adjusted EBITDA for 2021.

However, the deal also included a further £12 million in an earnout, taking the potential deal value to £92 million and the potential EBITDA multiple up to 9.1x, depending upon Grant Westfield achieving certain performance criteria.

Potential difficulties

Of course, despite all the potential benefits that an earnout structure can deliver for buyers and sellers, they can also pose significant challenges, risks and disadvantages to both parties that will need to be considered and, where possible, mitigated in negotiations and deal structure.

For sellers, the key downside to an earnout is the uncertainty generated by tying a significant portion of the sale price into the business’ future performance. While an earnout can enable a seller to ultimately achieve a higher sale price, this type of deal structure also poses the risk of a sale generating significantly less should the business underperform post-acquisition.

Sellers will typically have several concerns:

Are the earnout targets realistic?

Are the potential future payments enough to compensate for not getting the full amount up-front?

How can the seller be sure that the buyer doesn’t run the business in a way that minimises or vaporises the earnout payment(s)?

What commitments can the buyer make that the business will be supported well enough, such that its chances of achieving the targets are optimised?

What safeguards can be put in place to prevent the buyer from manipulating the financial metrics that may adversely affect the earnout payments?

There have been many documented cases that have demonstrated the dangers of including profits as an earnout metric with insufficient safeguards or guidelines set out in the sale agreement. For instance, where the buyer’s Head Office or associated company allocates central overhead or administrative expenses to the acquired firm, which will obviously lower its earnings.

Sellers may also find it personally challenging to relinquish a significant degree of control during the earnout period. Thus it is absolutely vital to rigorously work out issues relating to governance and control during the negotiation stage of an earnout.

For buyers, the first disadvantage of an earnout is that it adds another layer of complexity to the process. While an earnout has numerous benefits and can help to bridge significant challenges such as valuation gaps, they also require a significant amount of negotiation.

An earnout can also create integration challenges that a buyer might not face if they were to acquire a business outright. Using an earnout structure will typically mean the seller retaining some control or even a stake in the business during the resulting period, potentially creating challenges for buyers looking to integrate the new acquisition into their existing operations.

Given the fact that they extend deals over a period of, typically, 1 – 3 years, earnouts also increase the potential for disputes between the buyer and the seller, particularly over the achievement of the performance-related goals that dictate the ultimate purchase price.

If the earnout goals are not rigidly delineated during negotiations, then there is heightened scope for disputes over whether the business’ performance merits earnout payments being activated. If the earnout agreement itself is not solid and legally binding, then this raises the potential that disagreements could even lead to legal proceedings.

Finally, earnouts also come with significant tax considerations that can pose considerable difficulties for both buyers and sellers. As we will explore in a dedicated section, these considerations will require both parties to undertake extensive negotiations and enlist professional advice in order to navigate and mitigate the potential risks.

What is the best way to structure an earnout?

When structuring an earnout there are, naturally, a huge number of variables, depending on factors such as the nature of the business, the sector it operates in and the objectives on both the buy and sell side of the deal. However, there are some general considerations that will typically need to be factored into the structure of most earnouts.

Firstly, it will be vital for both sides to clearly define the metrics of the earnout. Essentially, what goals does the business need to achieve in the post-deal period that will activate the payment of the earnout? Earnouts are typically tied into performance metrics such as revenue growth, profitability or customer retention. Negotiations should determine the exact nature of these goals. For example, what percentage will revenue or profitability need to increase by within a defined period in order for the earnout to be triggered, how will it be measured, by whom and what seller safeguards can be put in place?

For buyers, it is important that the targets are challenging, in order to incentivise the business in the post-sale period and guard against the risk of overpaying for an underperforming company (defeating one of the main objectives behind an earnout). For sellers, meanwhile, it will be important for the targets to be realistic and achievable, otherwise the earnout is unlikely to be activated and they face losing their business at a low valuation.

Of course, both parties will have a mutual interest in ensuring that the targets are both challenging and achievable. If not, then this increases the risk of disputes and potential legal proceedings arising further down the line. A typical approach to setting performance targets during an earnout is to base them on historical performance (I.e., a business’ revenue growth over the past three years) and future projections (what is the business’ projected revenue growth over the next three years?)

In order to minimise the risk of confusion and potential disputes at a later date, the payment terms must be clearly defined and easy to understand, utilising a formula or calculation that both parties have agreed upon to determine the earnout amount.

A key component of setting performance targets is determining the timeframe of the earnout period. Typically, earnout periods run from between one to three years post-completion. Depending on the agreed-upon timeframe, the two parties will then need to negotiate the timing of payments.

The timeframe will have a significant impact on the payment structure of the deal, as the buyer and seller will need to agree upon the timings of the payments in relation to the earnout period. For example, with an earnout period of one year, the earnout might be paid as a lump sum at the end of the year. However, in the case of, for example, a £10 million acquisition with £6 million paid up-front, plus up to £4 million paid via earnout over three years, how would the earnout be spread? Equally over three years if and when the annual EBITDA target is met? What if the target was missed in year 1 but made up for in year 2? Or would it be stacked towards the end of the 3-year period, if a cumulative EBITDA total is set as the target?

The structure of the earnout will also need to address the significant risks that can arise during these types of deals. Something that is particularly salient in the current era of economic uncertainty and geopolitical upheaval is for the agreement to provide for contingencies.

Non-financial metrics may also be used as milestone earnout triggers i.e. the regulatory acceptance or passing of clinical trials of a drug developed by a pharmaceutical company; or the release to market of a video game.

Where possible, the structure should factor in risks such as changes in the business environment, competitive pressures that may emerge either as a result of change within the industry or within the broader economy, as well as unexpected events that could arise and impact the business’ performance. If minimum and/or maximum payments are set out in the agreement, and if there is a minimum amount specified, it ought be discussed as to whether this is guaranteed or set aside in escrow.

As mentioned earlier, the agreement should also be absolutely clear on issues of governance and control. An earnout period can often last for as much as three years. This is a significant amount of time for both buyer and vendor to remain involved in a business and, with both having a financial stake in its performance, the possibility for disputes over control is high. In order to mitigate this risk, the earnout agreement must be absolutely clear regarding the role of the buyer and the seller during the earnout period.

Ultimately, the most reliable way to avoid disputes and disagreements during the earnout period is for both parties to consult with legal and financial experts in order to ensure that the structure of the earnout agreement if legally enforceable, financially sound and that both parties are fully satisfied with the terms as they are laid out. It is not uncommon for buyer and seller to agree on a preferred dispute mechanism in order to prevent a chaotic situation arising that might lead to long and costly litigation.


Ecodeck is a plastic products firm supplying building and landscape products such as driveway grids, pathway grids and shed bases, all made from 100 per cent recycled plastic. In October 2022 the company was acquired by plastics manufacturer Coral Products in a £6.8 million deal comprising an initial £3.35 million and up to £1.25 million in performance-related earnouts.

The earnout covered an 18 month period and comprised three potential payouts. The first, payable for the year ending January 31 2023, would involve an additional £3 for every £1 of pre-tax profit Ecodeck registered over £1 million, up to a maximum payment of £1.15 million.

The second earnout involved a 10 per cent profit share of pre-tax profits for the three months ending April 30 2023, providing pre-tax profits exceeded £1.5 million for the year ending on that date. Finally, the third earnout would, again, be a 10 per cent profit share of pre-tax profits over £1.5 million for the year to April 30 2024. Coral Products stipulated that the maximum payments across the second and third earnouts would not exceed £100,000.

The tax considerations of an earnout

Income or capital gains?
Tax considerations are one of the main complications when it comes to business sales utilising an earnout structure. Tax issues can have an effect on both the buy and sell side and are a major hurdle to overcome in negotiations and in structuring the earnout agreement.

The main complication is the possibility that the earnout element of the acquisition price could be taxed as employment income rather than as a capital gain, something that would lead to significantly more tax being paid on the deferred amount.

As the seller will remain employed by the company during the earnout period, there is a possibility that HMRC will view the earnout proceeds as income rather than funds due as part of the disposal of the business, in the event of which the vendor would pay tax of up to 37 per cent on the earnout amount (47 per cent top additional rate income tax and National Insurance less BADR relief of 10 per cent) - significantly higher than the potential rate of capital gains tax on any disposal. For buyer’s, meanwhile, the earnout consideration being taxed as employment income means that they would incur employer’s National Insurance.

In order to avoid the earnout amount being taxed as income for the vendor, the earnout agreement must be structured in such a way as to satisfy HMRC requirements. This is one of the core reasons why it is so critical for dealmakers using earnouts to engage tax specialists.


HMRC’s requirements (ERSM110940) for demonstrating that an earnout amount is a continuation of the sale consideration rather than employment income are as follows:

1) The sale agreement demonstrates that the earn-out is part of the valuable consideration given for the securities in the target;

2) The value received from the earn-out reflects the value of the securities given up;

3) Where the vendor continues to be employed in the business, the earn-out is not compensation for the vendor not being fully remunerated for continuing employment;

4) Where the vendor continues to be employed, the earn-out is not conditional on future employment, beyond a reasonable requirement to stay to protect the value of the business being sold;

5) Where the vendor continues to be employed, there are no personal performance targets incorporated in the earn-out; and

6) Non-employees or former employees receive the earn-out on the same terms as employees remaining.

While these rules have been criticised as leaving a considerable degree of uncertainty and arguably not definitively stating when an earnout element will be taxed as capital gains rather than income, HMRC will typically accept that a consideration should be taxed as capital gains providing that non-employees (such as investors) and employees who will exit the company once the deal completes receive the earn out on the same terms as employees.

If doubts still linger, HMRC also provides a service enabling sellers to gain confirmation that the earnout will be taxed as a capital gain. However, for this clarity to be provided, there needs to be material uncertainty over how the earnout will be treated as tax. If not, HMRC may not agree to provide confirmation.

Capital gains tax
Providing the earnout amount isn’t taxed as employment income, it would be taxed as a capital gain and, therefore, subject to Capital Gains Tax (CGT). The standard CGT rate stands at 20 per cent, but, when disposing of a business through a share sale, sellers can qualify for Business Asset Disposal Relief (previously Entrepreneurs’ Relief), which will reduce the CGT rate to 10 per cent up to a lifetime limit of £1 million.

With a sale involving an earnout there are, of course, added layers of complexity. When it comes to the CGT implications of an earnout, much depends upon the structure of the deal and the points in time at which the earnout would be paid.

In the event that a fixed amount is set to be paid based upon events that have already occurred at the time the sale goes through, then CGT will be due on the whole consideration at the end of the tax year in which the deal is completed. If the final amount paid proves less than what was taxed, then the seller can typically claim a refund.

However, if the earnout amount cannot be calculated at the time the deal is closed (typically because it is tied into some measure of the business’ future performance) then the seller will need to estimate the present value of their right to future earnout payments. This sum, along with any proceeds payable upon the closing of the deal, will either lead to a capital gain, upon which CGT will be payable, or a capital loss.

If the earnout amount proves to be in excess of the estimated sum when it is received, the seller may be liable for an additional CGT payment. However, if the amount is lower, the seller will be able to claim a capital loss on the difference.

Conclusion

Earnouts offer a significant number of benefits to parties on both sides of a business sale that make them popular deal structure, especially during times of economic uncertainty. However, this comes at a price and dealmakers will need to be vigilant to ensure that disputes don’t arise and unwanted tax liabilities aren’t incurred.

Given the benefits, though, buyers and sellers may find it worthwhile to engage the proper tax, financial and legal advice in order to ensure that they can structure an earnout in such a way as to fully reap the rewards that they can offer.

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