An earn-out allows the purchase price of a business to be varied according to the financial performance of the business after the sale, and often, to be paid from future cashflows of the business being sold.
The provision is typically used if the buyer cannot obtain financing for the purchase price in full, and/or the buyer and the seller want to use the future performance of the business to agree the purchase price.
What is an ‘earn-out’ exactly?
An ‘earn-out’ is a provision in the sale agreement for the business which adjusts the overall purchase price by referring to a financial measure for the business after the sale.
The purchase price will typically be divided into an initial agreed lump sum amount, followed by one or more further earn-out amounts which are calculated by reference to the profit of the business over one or more agreed periods after completion of the business sale.
The further earn-out amounts could also be linked to measures other than profit, such as revenue, new clients or number of products sold during the earn-out period.
What are the advantages of using an earn-out?
An earn-out might be advantageous to both the buyer and the seller:
The buyer, by deferring part of the purchase price, may be able to reduce dependence on third party financing and improve cashflow. The seller may benefit indirectly by obtaining a higher overall purchase price by agreeing to the deferral of part of the purchase price.
The business may be more accurately valued since the purchase price will be based on actual business performance, rather than past performance or predictions of future performance. The buyer is protected from overpaying, and the seller receives a price which is not discounted as a result of doubts concerning the actual profitability or value of the business.
What are the disadvantages of using an earn-out?
An earn-out has potential disadvantages, for example:
There is no ‘clean break’ following the sale. The buyer usually has significant restrictions as to what can and cannot be done with the business during the earn-out period.
The seller may not receive the further earn-out amounts, at all or promptly, if the buyer has financial difficulties after the sale, or if there is any dispute regarding the sale (such as a warranty claim) or the calculation of the further earn-out amounts.
The business may suffer from a conflict of interest between the seller and the buyer in the earn-out period. If the seller is managing the business during the earn-out period, the business may be managed solely to achieve the earn-out targets. Conversely, if the buyer is managing the business, there will be a temptation to manage the business in a way so as not to reach the earn-out targets.
Fluctuations in business profits in the earn-out period can be caused by external factors, and it can be difficult to exclude such fluctuations from the earn-out calculation.
There can be adverse tax consequences for individual sellers, if earn-out payments are re-characterised by HMRC as payments relating to employment.
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