An earn out is a purchase price adjustment mechanism commonly used on the sale and purchase of a company where the buyer wishes to make a part of the purchase price contingent on the post-completion performance of the company during a period of between 1 and 3 years.

This can be any type of performance but typically relates to sales figures, profits or EBITDA (Earnings Before Interest Taxes Depreciation and Amortization).

In practice, the buyer pays an initial cash sum on completion of a sale, followed by one or more deferred payments contingent on the company’s financial performance over the agreed period.

An earn-out provision can reassure a buyer that it won’t be “overpaying” for the company if it under-performs post-completion and conversely can reassure a seller that it will receive the highest sale price achievable if post-completion performance proves stronger than could have reasonably been anticipated.

Earn outs can however be extremely risky for the seller if it does not negotiate appropriate levels of control over the target’s operational performance in the post-completion period as it will risk receiving a lower payment than expected.

Earn-outs are best used when neither party can assert with complete confidence that its own anticipated expectation of post-completion performance will be the correct one and there is genuine scope for uncertainty, for example:

• with an early-stage company which has good potential for quick growth;
• where the company has recently introduced a new product or service line;
• where an existing company with strong historic performance has suffered a negative “one-off” impact on sales due to an unexpected event such as Covid-19.

Sales or EBITDA targets?

Neither is perfect.

Using “gross sales” as the earn-out target may put the buyer at risk if profits decrease because the seller retains discretion, for example, to increase the company’s spend on marketing or to provide deferred payment terms for customers.

Using “EBITDA” as an earn-out target may put the seller at risk if the buyer has the right, for example, to impose a new management charge on the company or unilaterally increase staff or other costs.

So whichever type of earn-out target is used contractual protection for both parties will be required to prevent abuse.

Buyer control/ interference

After completion, the seller loses those rights of control over the company which derive from being the controlling shareholder, such as appointing the board and senior management.

From the seller’s perspective, therefore, it will want to retain control of those areas of operation of the business which have the greatest impact on possible achievement of the earn-out target.

The seller will therefore want to negotiate a service or consultancy agreement with the company granting such control (subject to restrictions) and will want to negotiate similar agreements for all key team members.  Careful attention should be paid to: (i) the term of the contract which should be co-extensive which the duration of the earn-out period and (ii) the termination clause which should restrict the company’s right of termination to situations justifying summary dismissal (which are typically in the individual employee’s control to avoid).

In addition, there may be included a series of specific restrictions on action by the seller or buyer with a view to artificially increasing or decreasing revenues or profits plus general principles such as a requirement to carry on the business “in the ordinary course”.  There may be restrictions on the acquisition or disposal of key assets but the incoming board will need to ensure they have sufficient control to carry out their statutory duties correctly.

If earn out payments are to be made on an interim basis rather than waiting to the end of the full earn-out period there may need to be provisions for the carry-forward or carry-back of profits, revenues or costs so that interim over-payments or under-payments can be corrected in the final calculations.

Tax considerations

Finally, tax advice should be taken on structuring the payment of the earn out so that the most beneficial tax treatment for the seller is obtained.  Depending on circumstances, this might require the maximum earn-out to be contracted to be paid by the buyer in instalments with the buyer entitled to make a £ for £ warranty claim if the warranty that the earn-out targets will be met proves incorrect.

Where the seller stays on in the business with a service contract, it will be important to show that the seller is being paid a market rate for the job to reduce the risk of HMRC trying to argue that some of the consideration for the shares sale is in fact disguised emoluments which should be taxed at a higher rate.

Hitherto it has been possible to obtain non-statutory clearances from HMRC confirming that HMRC will treat sale proceeds a capital gain rather than income.

Read more:
Earn outs explained

If you are an owner-managed business but want to maximise sale proceeds at completion (and avoid an earn-out structure) then you need to have bedded-in a new management team ahead of your exit to demonstrate to the buyer that they don’t require you to remain in the business to perform any managerial or sales functions to maintain profitability after completion.

But what sort of remuneration package will you need to offer to recruit and incentivise a management team ahead of your exit from the business?

One element of such a package, obviously, is to offer market-rate salaries, which may have a negative impact on the earnings before interest, taxes, depreciation and amortization (EBITDA) of the business if, as is the case with many businesses, the owner’s salary prior to a sale has been modest with a top-up coming in the form of dividends paid on shares.

A second element is to offer some form of equity incentivisation. This could be in the form of shares, options or phantom equity.

“Phantom equity” means little more than a bonus cash payment from the company or seller to the manager dependent on the level of sale proceeds achieved on an exit and is tax inefficient as it will be subject to Income Tax and National Insurance.

By contrast, if you issue shares to management, they can benefit from dividends prior to a sale and a capital gain upon sale.  If structured correctly the issue of shares can be more tax efficient than phantom equity.  But as you are issuing actual shares you need to consider including provisions in a shareholders agreement or the company’s articles of association to ensure the following: (i) that any voting rights attached to management shares are not sufficient to be able to disrupt your daily management of the company, (ii) that you can easily recover or forfeit the shares if a manager leaves or is terminated prior to an exit, with suitable valuation and vesting provisions for good, bad and intermediate leavers and (iii) that upon the exit itself you can also ensure that managers sell their shares alongside you, usually by inclusion of a ‘drag along’ right.

It is important to take tax advice so that the shares are not seen as emoluments and subject to PAYE and National Insurance (which can be difficult) and the manager receiving them will need to understand potential future Capital Gains Tax (CGT) (or Income Tax) liabilities.

Under current rules, CGT is payable on a sale of shares at 20% unless (amongst other conditions) they have been held for 24 months where they may be capable of qualifying for Business Asset Disposal Relief and a 10% tax rate on the first £1m of gain.

An alternative to issuing shares is to grant options under an Enterprise Management Incentives Scheme (EMI) which is available to companies which meet certain criteria including (non-exhaustively) – gross assets of £30m or less, fewer than 250 full time employees, employees working at least 25 hours a week and limited to £250,000 worth of shares can be granted to each individual.

The advantages of EMI options over the issuance of shares include the following: (i) that options can be written to be exercisable only on an exit and to lapse if a manager leaves prior to an exit without the need physically to transfer or forfeit the shares (ii) that there is no need for management to pay for their shares until a cashless exercise on exit when sale proceeds are available to fund that payment and (iii) that there should be no risks for the company associated with voting by managers or dealing with minority shareholders.

You will of course need to allow the incoming management team time ahead of a proposed exit not only to take over the day-to-day running of the business but also to demonstrate that under their management it is as equally and reliably profitable as it was under your own day-to-day control.  How long this period is will depend on the nature of the business and the idiosyncrasies of the intended buyer but could be as long as 1-2 years to enable the buyer to see a track record of success under the new management team to reassure the buyer that the team are capable.

As always before planning an exit from a business, give yourself time to think about the outcome you want to achieve and build in the best strategy to help deliver that.

Read more:
Management team incentivisation and selling your business

When considering possible exit routes for your business, selling to an Employee Ownership Trust (EOT) can have several benefits, but a word of caution, this is not an exit route that can just be unilaterally imposed on your management team.

I recently met with a business owner who had decided that sale to an EOT was the best way to exit his business and apparently for the twin temptations of paying zero capital gains tax and inflating the sale price. He came up with a generous valuation, drafted transfer documents to suit his own terms and presented all of this to his team to sign without any prior discussion. This didn’t go down well and naturally the team weren’t prepared to sign anything. Thankfully this doesn’t happen often, but there are several mistakes which business owners can make if they don’t take advice on how to approach selling to an EOT.

Not all employees want to become the ‘owner’ of the business they work for. For some it will seem like too much risk or responsibility so you can’t just impose the decision upon them.

The first step needs to be an open discussion around the possibility of sale to an EOT to set out the pros and cons for the business and to give the remaining senior-employee team time to discuss the options available. The time frame for this might be weeks, months or even a couple of years before it takes place to allow everyone time to adjust and plan.

Employees need to have the support of independent legal and financial experts to help them to make informed decisions, which should be paid for by the business.

The next step is looking at what the business is worth so that there is a starting point for negotiations on price. Typically, more than one external valuation should be obtained to facilitate reaching a sensible price somewhere in the middle.

Whilst usually a significant initial payment will be made to the sellers, equally there may be significant deferred payments to be made from future profits of the business for many years after completion. The purchase price and repayment terms must be sustainable to ensure the business can continue to invest and grow.

Those employees that are interested in stepping up and taking on more responsibility need to understand what their new role will be, any legal responsibilities that go with it and how they will be rewarded with an enhanced salary and/or bonus arrangements.

In a well-run process, sellers will take real care to ensure that the senior management team will be stable and well-motivated to make a success of the business following sale, so that the agreed price can be paid in full by the business over the agreed period.  There is often provision made for deferred payments to be accelerated or further deferred depending on how the business is preforming after completion.

In some businesses the culture of employees sharing in the success of the business through share ownership is embedded well before the ultimate sale to the EOT in the form of employee share option arrangements.  For some owners, sale to an EOT is a continuation of this culture and allows employees to feel more empowered and more invested in the future success of the business. There are studies which suggest that in businesses where there is employee share ownership productivity tends to be higher and long-term sickness and issues around poor performance tend to reduce.

When done well a sale to an EOT can be less stressful than a traditional 3rd party sale for all parties involved as there is usually the continuity of the management team and people stay in key roles. There is continuity for customers, suppliers and other key stakeholders and there is time to adjust to the new arrangements.

Clearly this is a brief summary of the legal issues involved, so if you would like to discuss an EOT sale/purchase, get in touch to find out more.

Read more:
The dos and don’ts of selling to an Employee Ownership Trust

It may sound obvious, but it is important to prepare your business for sale to achieve both the best price and a sale process which runs smoothly, with few surprises for either party.

Sometimes this is a process which takes many months if not years in the planning, so where do you start?

Pre-sale restructuring

Firstly, consider if there are any assets in the business that need to be extracted before the sale process begins, for example:

• A property or land which could be leased back to the new business owner
• Cars
• Non-core /ancillary business assets

It will be necessary to obtain valuations of these items to avoid unnecessary tax charges and enforceability.

Due diligence

Consider the due diligence process and the level of scrutiny which is likely to occur when information about your business is supplied to prospective buyers. Preparing for buyer due diligence can be light touch, or might require a deep dive, and there are many factors which will affect this and how long it will take.

The transaction size and the complexity of the business structure and operations is the key factor. It is advisable to complete the pre-sale due diligence process before putting the business on the open market especially if there is likely to be competition to buy the business, so that you can run a smooth sale process. It is also advisable so any potential problems can be remedied before the sale process starts. This pre-sale due diligence process should address the following:

• Tax/ financial position:
  • How well does the company’s earnings before interest, taxes, depreciation and amortization (EBITDA) reflect normalised EBITDA? Family-owned companies often reward shareholder executives with dividends instead of market rate salaries resulting in EBITDA which is artificially inflated.
  • Are assets which the business uses from related companies being charged in at market rates?
  • How well does operational data translate across the accounts?  Does an integrated balance sheet and cash flow statement exist? Is there a 3-year forecast available to tell the future story to prospective buyers?
  • Have items been properly categorised as income vs capital and tax properly calculated and paid? Is a third-party audit worthwhile?
  • Sometimes all of the above will need to be addressed before launching the sale process to enable the management team to defend a target sale price confidently.
• How robust is the target’s legal position?
  • Does the target have all licences it needs?
  • Are company books accurate and up to date?
  • Are employees’ terms and conditions compliant with latest legislation?
  • How well-documented are key customer / supplier contracts?
  • Are the terms on which the business occupies land properly documented?
• Preparation of an online data room to assist buyer due diligence:
  • There are various online providers, but some are better than others e.g. automatic indexing, redacting of confidential material, monitoring levels of buyer activity in the DR, water-marking documents etc.
  • They are easy to use and when uploading documents, it is advisable to do so in a manner which follows the format of a typical buy-side due diligence request.
  • Consider who will upload documents, can this be done internally by the business to avoid professional fees, and can this be done confidentially?

 Other matters

•  Incentivisation:
• • Consider if some employees need to be incentivised with bonuses to put the extra hours in to assist in the sale process and to keep matters confidential.
  • Do some employees deserve a share of sale proceeds for their contribution e.g. Enterprise Management Incentive options; if so, beware of leaving the grant of these too near to a subsequent sale as this can cause significant risk of PAYE and NIC issues if HMRC considers the exercise price too low.
• Who are the selling shareholders?
  • Identify what percentage each holds and if they will sell willingly; if there is doubt do provisions of a shareholder’s agreement or the articles need to be invoked (e.g. Drag Along)?  What is their financial and emotional position?
  • Are there likely to be any conflicts between sellers who leave the business completely and those who might continue employment with the buyer?
• Who will advise the seller through the sale process?

Sometimes, not always, an intermediary is used to identify a buyer but beware of their high fees vs low added value. Sometimes a good a financial/tax adviser will be sufficient to opine on price and financial adjustments and a good legal adviser will offer advice on tactics and market norms and will co-ordinate the whole sale process and all documents to effect the sale.

Don’t just go with the first advisor who contacts you as most advisers are willing to meet for free to present their credentials.

If you would like advice or support to help you to buy or sell a business, get in touch with our team today.

Read more:
Selling a business – where to start