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Selling a Company: Earn-Out Arrangements

Getting Paid for Potential

Getting Paid for Potential

An earn-out when selling a private company is primarily a mechanism for putting a value on a high-growth company that reflects it future potential. It is notoriously difficult to design an earn-out structure that works for both buyer and seller.

So what is an earn-out? In strict terms it is an arrangement where a large part of the payment for a company is tied to the sellers staying in post after the sale to deliver a growth plan. As an active UK business broker we see this approach most often when sellers are projecting strong future growth, but the buyers are reluctant to pay for potential upfront.

The term is often misused for deferred payment arrangements where part of the amount to be paid is tied to the company maintaining turnover and margin for a period after the sale. This type of arrangement is really a protective mechanism for the buyer, not an earn-out where the seller is required to stay to deliver a growth plan.
 
What Is The Difference Between An Earn-Out And A Deferred Payment Structure When Selling A Company?

Earn-outs are really a special form of deferred payment arrangement. The term “Deferred Payment” when selling a private company is more commonly used to describe an arrangement to pay a fixed sum at regular intervals over a defined period of time. We explain deferred payments and how they work in another article in our blog: Deferred Payments When Selling A Company

What Are The Main Elements Of An Earn-Out When Selling A Company?
 
The underlying principals of an earn-out are that the sellers are responsible for driving the growth of the company after the change of ownership. The earn-out offers the potential to receive a much larger payment for the company if sales and profits can be grown. Typically the sellers would be expected to stay for between one and three years.

Payment might be a large bonus at the end of a defined period if targets are met, or preferably an additional payment for shares or trading assets which can be structured in a tax effective way. Constructing tax efficient earn-out arrangements is complex area, and one in which both seller and buyer need to get expert advice. If the arrangement is incorrectly structured the seller can be hit buy large tax bills at legal completion – long before any payment is received from the earn-out mechanism.
 
How Do Venture Capital Companies Use Earn-Outs?
 
Venture capital companies have developed a number of innovative ways to structure tax efficient earn-outs for the owners of companies in which they invest. They work because the venture capitalist is explicitly looking to sell the company on within 3-5 years. The original owners are issued new shares in the company prior to the exit. They might for example get new shares equal to 30% of the equity if the business is sold after 3 years, but only 10% if sold after 5 years.

The number of shares might also be tied to an exit multiple. If the company is sold on a multiple of 3 the original owners get new shares equal to 10% of the equity, if on a multiple of 5 new shares equal to 20% of the equity.

The essence of these approaches is that the more successful the owners are, the bigger the share of the proceeds that comes their way. For obvious reasons these are often referred to as “ratchet” arrangements.
 
What Is The Best Way To Structure An Earn-Out Arrangement When Selling A Company?
 
An earn-out can be a win-win solution for both buyer and seller if some basic rules are followed:

Draft Tight Rules

The rules and calculations on which payment will be paid need to be tightly drafted, and in enough detail to avoid any future misunderstandings.

Use Simple To Calculate Measures

If the measure of success is too complex it becomes easier for both buyer and seller to find ways to manipulate the calculation in their favour. The law of unintended consequences often comes into play in these situations. We have found that calculations based on sales or gross margin are easier to administer and less prone to manipulation.

Keep The Timescale Short

A downside of any earn-out arrangement is that the buyers have to keep the acquired company intact to maintain the measurement methods on which the earn-out is based. The longer the term of the earn-out, the more likely it is that the sellers will want to reorganise the company to take account of new circumstances. A short timescale, certainly no more than two years, will reduce the risk of unforeseen events undermining the plan.

A Right To Audit

Both buyer’s and seller’s lawyers need to make sure they secure a right to audit the books to check calculations.

Security Of Funding

One feature of any structure in which payment is deferred is that the buyers must have access to sufficient funds when the pay-out is eventually due. Sellers need to be confident of the financial strength of the buying company.

Get Tax Advice

HMRC pay close attention to earn-out arrangements. There is always a concern that they might be clever schemes designed primarily to delay or avoid taxation. Professional tax advice from advisors with practical expertise in this area of tax is essential.

 

If you are interested in finding out more about these and other issues relating to the sale of a private company one of our business sale experts would be delighted to talk to you in complete confidentiality. Click CONTACT ME to book an initial phone conversation or call us on 01604 432964.

 
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2 comments on “Selling a Company: Earn-Out Arrangements

  1. Pingback: Deferred Payments When Selling a Company | Select Business Sales

  2. Pingback: The Different Ways Buyers Pay For Companies | Select Business Sales

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