An earn-out arrangement is one where all or part of the price for acquiring a business is based on the business’s future performance. This part of the price is unascertained at the time of completion and is typically measured by the increase in one or more metrics over a period of time. For example, the metric might depend on EBITDA, total revenue under new contracts, the retention of certain key contracts, profitability or a combination of these.
If you have sold a business in exchange for a future earn-out payment or you have bought a business on the basis of retaining the seller’s skills to achieve certain outcomes, there might be a benefit in varying the earn-out arrangement that you have reached.
Earn-out renegotiation could benefit the buyer and/or the seller
The following benefits may result from a renegotiation.
- Avoiding disputes as to the terms of the agreement – for example, as to whether exceptional items (say Furlough payments or expected redundancy liabilities) should be recognised in the EBITDA calculation, whether covenants in respect of business management have been met or whether a force-majeure clause applies in the present situation.
- By extending the period during which the expertise and value of the seller is available, the buyer could maximise any up-turn in economic activity and enable post acquisition operational changes to be managed.
- The agreeing of a specific figure in place of an uncertain earn-out right might provide welcome certainty for the parties.
- A renegotiation could enable the buyer to achieve a value that more accurately reflects the true value of the business and the legacy of the seller’s stewardship – rather than a reduced value based on the present exceptional downturn.
Earn outs are sensitive from a tax perspective and altering a deal without formal advice could have a number of disadvantages.
- Altering an earn-out agreement so that the seller receives an agreed amount rather than a right to an unascertained future sum may give rise to a present tax liability which otherwise would have been deferrable. Similarly, if a seller agrees to accept cash rather than shares or loan notes, the seller may not be able to benefit from a tax deferral that could have been available.
- The sale agreement will typically contain tax warranties and assurances that should be reviewed before agreeing to any variation in the commercial terms.
- A varied earn-out payment could fall inadvertently to be taxed to income whereas typically an earn-out arrangement will be arranged to attract capital gains tax treatment.
- Other matters to consider ahead of agreeing any variation include the potential to use an earn-out loss as well as any impact on the seller’s Entrepreneurs Relief position (now known as Business Asset Disposal Relief).
There may be much to be said for reconsidering earn-out rights at the present time – and when doing so it is key to remember that the optimum outcome will depend on the tax consequences of any change and the broader terms of the share sale agreement.