June 6, 2022

A guide to Earn-Out provisions

Commercial solicitor, Katherine Waumsley, discusses the use of Earn-Out when arranging the sale of a business.

If you are considering selling or buying the shares in a business, Earn-Out provisions are something you may wish to consider, especially in light of the current economic climate and the impact that Covid has had on many businesses.

What is an Earn-Out?

An Earn-Out is the term for a provision which can be utilised on the sale and purchase of a business. These provisions enable the purchase price to be partially determined by, or conditional on, the performance of the Business following completion of the sale and purchase.

Whilst Earn-Out provisions vary from agreement to agreement, the most frequent type of Earn-Out provisions utilised are often based on profit over a set period of time following completion.

As well as the basis upon which the Earn-Out provisions relate, the basis for calculating the Earn-Out also vary from agreement to agreement. Whilst some negotiate set percentages, others may include contingent payments which are payable once set targets are met.

Earn-Out Provisions therefore need to be carefully negotiated and drafted to ensure that they reflect the agreement between the parties.

Why would you use an Earn-Out?

Earn-Out provisions are used for a variety of reasons. However, at present, one of the reasons likely to attract parties, is the impact Covid has had on many businesses. With Businesses failing, ceasing to exist and facing uncertain economic times, Earn-Out provisions could provide a mechanism by which an uplift on the purchase price is payable to a Seller, in the event that certain requirements are met which are tied to the performance of the business.

Broadly speaking, if the business thrives and does well following completion, the Buyer will benefit from operating a successful business which it now owns and the Seller benefits by achieving an uplift on the purchase price originally paid.

No provisions are without risk, and where Earn-Out provisions are tied to the performance of the business, it is of course possible that the business does not do well following completion and that no additional payments are therefore due or payable.

Avoiding Earn-Out disputes

As with all elements of a business sale, there are matters which should be considered before entering into Earn-Out provisions. These include:-

  • Determining the basis upon which the Earn-Out provisions will be set.
  • The length of the Earn-Out period.
  • Determining how the performance of the business will be measured.
  • How the Earn-Out payments will be calculated.
  • When the Earn-Out payments will be made.
  • What involvement (if any) the Seller will have following completion of the sale and purchase.
  • Determining how any potential Earn-Out dispute will be dealt with under the terms of these provisions.

Please note that this is not an exhaustive list but highlight some of the areas that will need to be negotiated between the Buyer and the Seller. By giving due consideration to these matters, future Earn-Out disputes are less likely.

Earn-Out Tax Implications

If the Seller remains an employee or officer of the business following completion, and an Earn-out mechanism is in place, then there is a risk that the Earn-out consideration that the Seller may receive is regarded as remuneration for their continuing role in the business and will therefore be taxed as income in the Seller’s hands (including employee NI and employer NI contributions for the limited company). 

HMRC has key indicators which they will assess to determine whether an Earn-out is further sale consideration rather than remuneration for the Seller (see HMRC manual ERSM110940), including that the Earn-out is not conditional on the Seller’s future employment and that non-employees or former employees receive the Earn-out on the same terms as the employees remaining.

It is therefore important to be mindful of these indicators when drafting and negotiating an Earn-out provision.

How We Can Help

Holmes & Hills have a team of specialist commercial solicitors who will be able to assist with the sale of your business, including the preparation and negotiation of Earn-Out Provisions.

Get Earn-Out Provisions advice

If you need advice on Earn-Out Provisions, call our specialist commercial lawyers on 01206 593933.

Key Contact

Katherine Waumsley

Solicitor

kmw@holmes-hills.co.uk

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