08 December 2023
Earnouts are a type of purchase agreement where an element of the price is contingent upon the performance of the business after the sale. They are often linked to a post-deal EBITDA target, but can also be driven by revenue or other KPIs, depending on the circumstances.
When a seller and a buyer have different expectations about the future potential of a business, an earnout can allow the seller to benefit from additional compensation if the business performs well, and the buyer might get some protection against underperformance. An earnout might also help to align the buyer and seller on the expected post-deal performance of the business.
Earnouts are seen more frequently in tech, healthcare and other businesses with high growth potential. We have seen relatively fewer earnouts in mid-market M&A in recent years. In a sellers’ market, buyers have had to meet the seller’s price and deal structure expectations. However, economic uncertainty means that earnouts are again on the up, as a way to bridge gaps in perceived value and expectations of future performance.
The Share Purchase Agreement (SPA) defines the metric used to calculate the earnout. An adjusted EBITDA is commonly used. An earnout is typically paid in cash to sellers following the end of the relevant period if the metric is achieved but may, sometimes, be paid by way of shares in the parent company.
An earnout is often linked to a multiplier or a ratchet. For example, for every £ in excess of a minimum EBITDA, the earnout could be a multiple of 5x. The earnout can then be easily skewed by a relatively small impact on the profit metric. By way of a simple example, sellers might receive a multiple of 5x for every £1 that EBITDA is exceeded over a certain amount (say £2m) but nothing if it is less than £2m. So, if the business achieved EBITDA of £2.3m for the period, the earnout would be £1.5m (£300k x 5).
The opening position should be carefully accounted for, as any material errors in the opening balance sheet at the start of the earnout period may impact the earnings during the period. The parties may therefore want the opportunity to review and amend the opening position if relevant or align it with the position in the completion accounts (if prepared).
While an earnout might look like a neat way to bridge the gap between a buyer and seller’s expectation, there are also some downsides and areas in respect of an earnout where we commonly see disputes arise.
Tying sellers into the business can be a double-edged sword. Their expertise can help the business to maintain its performance, but if there is a dispute over the earnout calculations at the end of year one, it can jeopardise performance over the rest of the earnout period.
An earnout could also encourage short-term behaviours that are sub-optimal for the business’ longer-term performance, like reducing margins to increase volumes or cutting marketing expenditure. Conversely, a buyer could recruit additional staff to take a short-term hit during the earnout period, but a long-term gain.
It is common to have provisions which set out the parties’ conduct during the earnout period. These “Good/bad leaver” provisions set out details of the circumstances in which sellers who remain within the business post-completion may and may not be entitled to leave the business within the earnout period. These types of provisions can be used against sellers to reduce or avoid earnout payments if they are considered bad leavers or in breach their conduct provisions post-Completion.
A typical earnout period is between 1 and 3 years. Sellers usually have to remain in the business throughout this period and meet buyer expectations of performance in order to extract the full value of their shares. In extreme circumstances, sellers may be removed from the business and their entitlement to an earnout removed if they fall foul of their conduct provisions. A buyer may wish to remove sellers who they consider to be underperforming, surplus to requirements or simply do not like.
Given the importance of these provisions to both parties, they need to be clearly drafted. They need to ensure the sellers remaining in the business know what is expected of them but also provide sufficient comfort and security for their ongoing employment within the business. Similarly, the buyer will want the ability to remove a seller from the business if they are underperforming.
The accounting hierarchy
The earnout schedule to the SPA will typically set out the order of priority for accounting policies or rule used in the calculation for the earnout.
Typically, the accounting hierarchy will be in the following order of priority:
The accounting policies is another common area of tension between the sellers, who prefer their accounting policies from when they owned the business, and the buyer who will want to use their own accounting policies.
The buyer may want to use their own accounting policies as the basis for preparing the reference/relevant accounts for the earnout. Adopting a different policy can impact significantly on the metric being used to calculate the earnout. There is a clear incentive for a buyer to use their own policies or manipulate the policies if it results in a lower earnout.
Sellers typically try to resist the imposition of policies from the buyer to minimise the risk of manipulation. They should try to ensure that the same basis of preparation and policies are used to that in preparing the earnout amount and mechanism during negotiations. Alternatively, a buyer may seek to simply use the post-completion audited accounts of the target as the earnout accounts to make the process less onerous and easier.
Each party will try to protect their own interest and the choice of metric is a key factor. The SPA needs to tightly define the metric to be used, for example Adjusted EBITDA, and how it should be calculated.
Careful consideration should also be given to accounting for the opening position in the earnout period. Any material errors in the balance sheet at the start of the earnout period may impact the earnings in the period. The parties may want the opportunity to review and amend the opening position or align it with the position in the completion accounts if those have been prepared.
As explained in the earlier example of how an earnout works, it is common for an earnout to be linked to a multiplier or a ratchet depending on the level of earnings achieved. The actual impact of a ‘£’ adjustment to EBITDA in a dispute can then be worth far more to the parties due to the multiplier and/or ratchet being used. It is possible for the earnout amount to be changed by a relatively small impact on the profit metric.
There is potential for other areas of the SPA and claims to impact on the earnout post-Completion. For example, a buyer can bring a breach of warranty claim, where there is a right of set off against the earnout. This may be for genuine commercial reasons or can also be used to delay, reduce or even avoid the earnout amount. This could be to achieve a cashflow advantage or to frustrate the sellers if relationships have broken down.
Legal advice should be sought if a breach of warranty claim is made.
When it is not possible for the parties to reach a full settlement of an earn-out dispute, the SPA will usually specify that the dispute should proceed to an expert determination. This is usually an independent, forensic accountant with experience in M&A matters, instructed by both parties.
Occasionally, the independent accountant may decide to use a process that is different from the one specified by the SPA. This process typically involves each party providing a submission setting out their key arguments and evidence to support their position, a counter-submission and then responding to any further requests for information or questions from the independent accountant.
The SPA should contain protections for the seller that define how the relevant earnout target is to be calculated, and how the buyer should conduct business during the earnout period. If the seller is remaining in the business post-completion, then they ought to ensure they have a say in how the business is going to be run during the earnout period – maybe through a place on the board.
Commonly, a buyer may absorb the target into their existing business or restructure the target business. This can make it difficult for a true ‘like for like’ comparison to be made against the earnout metric. As a result, it is important for sellers to have protection via clauses in the SPA which stipulate what a buyer can and cannot do to the business during the relevant period (typically these as known as ‘conduct of buyer’ clauses.
Once a buyer controls the business, they may want to use their own accounting policies to prepare the relevant accounts for the earnout. The seller should try to ensure that the same basis of preparation and policies are used in preparing the earnout amount and mechanism during negotiations. A buyer may also seek to simply use the post-completion audited accounts of the target as the earnout accounts. However, there are challenges in doing so given that they will have been prepared and overseen by the buyer who may use different estimation techniques in their preparation.
Generally, vendors/management will expect to be taxed on earnout proceeds as a capital gain. However, there are complexities as to the timing of tax. Furthermore, if the earnout conditions are not carefully drafted earnout amounts can be taxed as employment income resulting in both higher rates of tax for the individuals and an employer’s NIC liability for the business.
If the ‘earnout’ amount is ascertainable at the time of the transaction it will be taxable in full as if it were an amount received on completion (this could be the case even if whether it is payable is based on a future event, eg ‘£200k if the EBITDA is more than £5m next year’ is an ascertainable, albeit contingent, amount). If the amount is subsequently not received the calculation of the gain in the vendor’s tax return in the year if the transaction can be amended with any overpaid tax refunded. If the vendor qualifies for business asset disposal relief (‘BADR’, the 10% rate of capital gains tax on £1m of lifetime gains) then the ’earnout’ amount should also qualify if within the relevant limit.
If the earnout amount is not ascertainable at the time of the transaction the earnout right itself is treated as a separate asset. The gain in the year of transaction will need to include the market value of that earnout right at the time of the transaction given it is the consideration given by the purchaser for the shares sold. Depending on the earnout conditions this may be a fairly small amount or something close to the maximum that can be paid out under the arrangements. When the earnout pays out this will be treated as a disposal of the earnout right for the amount then received. The earnout right’s base cost for tax purposes will be the value brought into account for tax in the year of the original transaction with a gain or loss arising on the difference with the amount actually received. This will be taxed in the year the earnout amount is received. BADR will not be available on the receipt of earnout amounts in this case as the earnout right itself is not an asset qualifying for BADR.
There are some further complexities where the earnout is paid in multiple instalments or where it is satisfied in shares or loan notes.
Finally, it is worth noting that the definition of ascertainable for these purposes is different from that for stamp duty purposes (but that’s a separate discussion).
In order to avoid such a reclassification amounts to be received by vendors need to ‘walk and talk’ like capital payments as consideration for the shares sold:
HMRC have published some helpful guidance on the issue and their full guidance can be found here.
A buyer will need to remember that any amounts that are characterised as employment income will bear employer’s NIC at 13.8% which will be a cost of the business as it cannot be recovered from the employee.
The question of how earnouts are taxed is a complex and nuanced one. Appropriate tax advice before finalising the details and drafting of earnout arrangements is vital to avoid unforeseen tax liabilities on both the individuals with the right to earnout payments and the business (ie the post-transaction group).
The M&A Forensic Services team at BDO have significant experience in advising on the preparation or review of earnout accounts and then if there is a dispute, both in acting as independent accountant and also acting as a party advisor in preparing submissions etc. to the independent accountant.
If you want to discuss funding options for your business, get in touch with Lawrence McGinley or James Pratt.