This week's Corporate Hot Topic focuses on 'earn-outs'. An earn-out is a common feature in lots of corporate deals - and it's imperative that a seller seeks good advice to understand the associated risks.

Every seller of a business would usually prefer to receive 100% of the agreed consideration in cash in full on completion of the deal.  Unfortunately, the buyer is usually not prepared to agree to such a deal. Most deals that we are involved with at Lupton Fawcett involve an element of deferred consideration.

An “earn-out” is one way to structure an element of deferred consideration, where a seller has to accept that some of the value for the shares in the target company will only be paid at a later date.

An earn-out is an arrangement where part of the purchase price is contingent upon the positive performance of the target company for an agreed period following completion. The earn-out payment may be conditional upon achieving a turnout target, and/or a net profit target, during the “earn-out period”.

It is imperative that a seller appreciates the risks in accepting a deal that involves an earn-out.

From the buyer’s perspective, the main advantage of an earn-out is the fact that that part of the share consideration only has to be paid if the target business performs – and if the business does hit the turnover/profit projections that the seller has suggested are achievable, then most buyers will be happy to hand over the earn-out payment. An earn-out is also a good way for a buyer to incentivise and motivate the departing shareholders to stay on and work in the business following completion.

From a seller’s perspective, whilst an earn-out constitutes a chance to achieve a higher price, fundamentally a seller is no longer in control of the business and so there is always a risk that none of the earn-out payment will be actually received.

Put simply, an earn-out often constitutes an inherent conflict between buyer and seller: buyer has acquired the business and therefore wants to run it as the buyer sees fit (i.e. which might involve a long term plan to integrate the business into the buyer’s existing group), but the seller is really only interested in achieving the earn-out targets (usually) over a much shorter time period.

It sometimes helps a seller to view the payment on completion as the “cake”, with any earn-out payment being the “cherry” on that cake. Given the risks that come with accepting a deal that involves an element of the purchase price being subject to an earn-out, would the seller ultimately still be happy with the deal if there was no cherry on the cake?

There are also a number of tax issues that must be considered before agreeing to a deal that involves an earn-out.

The Corporate Finance team at Lupton Fawcett have extensive experience of advising on all types of corporate deals that involve earn-outs for both buyers and sellers, including tax.  Please feel free to get in touch – we’d be happy very to discuss any queries that you may have.

If you want to contact someone about any of the issues raised in this article please contact Giles Clegg or a member of our Corporate Finance Team.

Please note this information is provided by way of example and may not be complete and is certainly not intended to constitute legal advice. You should take bespoke advice for your circumstances.

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