Understanding the role of earnouts in business sales

Earnout arrangements allow the purchase price of a target company to be determined by its future performance, providing a means for buyers and sellers to navigate uncertainties and bridge valuation gaps. 

In this article, we will explore earnouts from a legal perspective, highlighting the key components, potential pitfalls, and tax implications of business sales and purchases.

Why use an earnout in a business sale?

Utilising an earnout in a business sale can ensure both compromise and incentivised engagement.

• Compromise: When buyers and sellers hold different views on the prospects of a target company, agreeing on a fixed purchase price can be challenging. Sellers may have an optimistic outlook, justifying a higher price, while buyers tend to be more conservative. Earnouts serve as a compromise in such scenarios, allowing both parties to share the risk and potential upside based on the company's post-acquisition performance.
   
• Golden handcuffs: Buyers often require the continued involvement of key management players from the seller's side to ensure a smooth transition and tap into their expertise. By tying a portion of the purchase price to future performance, earnouts incentivise retained management to work towards the company's success, effectively creating golden handcuffs that keep them engaged.

How should you structure an earnout?

Structuring an earnout correctly is essential, and having a skilled solicitor is crucial to ensure the legal aspects are accurately defined in the share purchase agreement, with careful consideration of the following components:

• Benchmark and performance metrics: The chosen benchmarks (often financial metrics like EBITDA, revenue, or profit) and how they are calculated should be explicitly outlined to avoid disputes.
   
• Earnout period: Specify the timeframe during which the company's performance will be assessed for calculating earnout payments.
   
• Accounts preparation: The manner in which the company's accounts are prepared can impact the ultimate purchase price, necessitating clarity in the agreement.
   
• Payment terms and dispute resolution: Outline how and when earnout payments will be made, as well as the process to resolve disputes that may arise.
   
• Continuing seller involvement: Define the roles, responsibilities, and limitations of both parties during the earnout period to ensure efficient decision-making and protect the interests of all parties involved.

While the share purchase agreement (SPA) is the primary document for structuring earnouts and should explicitly cover earnout-related terms and conditions, a shareholders agreement can provide additional clarity on the roles, responsibilities, and governance of the shareholders during the earnout period.

What are the potential pitfalls of earnouts?

Earnout mechanisms have seen increased use, especially in times of economic uncertainty. While they can help overcome valuation discrepancies, parties sometimes overlook the impact of earnout mechanism drafting, resulting in disputes.

Tying sellers to the business through earnouts can be a double-edged sword. While their expertise can help maintain performance, disputes over earnout calculations can jeopardise the overall success. 

Earnouts can also encourage short-term decision-making that may not be optimal for the company's long-term performance. 

For example, imagine a seller and buyer agreeing to an earnout based on achieving a specific revenue target within the first year after acquisition. To maximise their earnout, the seller may focus solely on short-term strategies to boost revenue, such as offering deep discounts or reducing investments in research and development. While this might lead to a temporary revenue increase, it could harm the company's long-term competitiveness and innovation, potentially diminishing its value in the following years.

The share purchase agreement should also include protections for the seller, defining how the earnout target is calculated and how the business is run during the earnout period. Sellers remaining in the company should have a say in its operations, and the agreement should also address any potential impact on the earnout due to changes in the business structure.

What about tax considerations?

Understanding the tax implications of an earnout agreement is a vital aspect. Careful structuring and tax advice are essential to optimise the tax treatment and prevent unforeseen liabilities. 

Generally, you can expect to be taxed on earnout proceeds as a capital gain, but complexities around the timing and structure of earnouts can affect the tax treatment for both sellers and buyers. 

Earnout amounts must also meet specific criteria to avoid reclassification as employment income. Sellers and buyers must ensure that earnout arrangements adhere to the principles of capital payments rather than employment income to avoid higher tax rates and employer's National Insurance Contributions (NIC).

Your solicitor can work closely with other specialist teams, including your accountants and IFAs, to ensure the transaction is structured optimally.

Contact our corporate solicitors

Earnouts, as legal mechanisms in M&A transactions, serve as powerful tools for aligning the interests of buyers and sellers, managing risk, and navigating valuation uncertainties. However, they are not without their challenges. 

Our business sale solicitors provide specialist advice and legal expertise to ensure that earnout agreements function as intended and to prevent potential disputes.

We have solicitors in London, Brighton, East Sussex, and Cumbria, and we work with clients nationwide.