64 deals £1.780 Billion

Dow Schofield Watts llp

 

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PEARLS OF WISDOM
   

EARN OUTS

Basically an earn-out is deferred consideration dependent upon the future performance of the business being acquired.

The principal purpose is to bridge the price expectation gap between the buyer who will pay a price on past profits and the seller who expects a price based on the future potential of the business.  

The difficulty is balancing the needs of vendor to run the business and the purchaser to control it.  The vendor needs to retain control over staff and day-to-day expenditure, the purchaser needs to be involved in shareholder issues - new investments.  

Features of Earn-outs
 
Usually based on pre-tax profits;
Usually based on averages of profits of two or more periods;
Usually between 2 and 4 years;
Targets are usually set in profit bands ie  profits >£a multiplied by x,

 

 Benefits to Buyer
 
Smaller initial consideration, “buy now pay later”;
A pool to offset warranty and indemnity claims;
Motivated seller and continued commitment;
Maximum cost is known (if capped);
Secures non-competition.

 

Disadvantages to Buyer  
 
Harder to integrate; will all the acquisition benefits be achieved ?
Difficult to motivate past management;
Cash generated is not normally sufficient to meet earn-out consideration;
Need to ensure funding will be available at the end of the period.

 

Benefits to Seller
 
Higher price;
Employees can benefit;
Retain "directorship", but needs protection in the employment contract.

 

Disadvantages to Seller
 
Risk of not receiving full price;
Profit disputes or working capital situation;
Not a full exit;
Tax treatment, earn-out consideration is included in the capital gain and a subsequent loss cannot be carried back. 
Dependent upon the financial strength of the buyer.

 

Practical Issues  

1.    Which accounting policies are to be adopted?  Are each relevant year's accounts covered by the auditing/reporting and dispute resolution process?

2.    Will earn-out payments be governed by audited accounts or are adjustments required?

3.    Is the earn-out based on pre-tax or post-tax profits?  If post-tax, are provisions required for avoiding manipulation of the tax charge?

4.    Is there control over the purchaser's actions?  Can the purchaser exercise control over the business?  What effect will this have on the earn-out?

5.    How will changes in business practice, or accounting law or practice, be dealt with?

6.    How will purchaser group relationships (eg management charges, directors remuneration, group relief payments) be dealt with?  What constitutes an arm's length management charge?

7.    Is vendor management remaining in place?  With what powers?

8.    Who controls the business (eg management remuneration, expenses, hiring and firing, capital expenditure)?