Earnings are a purchase price adjustment mechanism commonly used when buying and selling a business where the buyer wants to make a portion of the purchase price contingent on the company's performance after completion over a period of 1 to 3 years. .
This can be any type of performance but is usually related to sales, earnings or earnings before interest, taxes, depreciation and amortization (EBITDA) figures.
In practice, the buyer pays an initial cash amount upon completion of the sale, followed by one or more deferred payments contingent on the company's financial performance during the agreed upon period.
An earn-out clause can reassure a buyer that he will not “overpay” for a company if it underperforms after completion, and conversely can reassure a seller that he will receive the highest sales price achievable if post-completion performance proves stronger than could have been reasonably expected. reasonable.
However, dividends can be very risky for the seller if they do not negotiate appropriate levels of control over the target's operating performance in the post-completion period because they will risk receiving a lower-than-expected payment.
Win-wins are best used when neither party can assert with complete confidence that their forecast expectations for post-completion performance will be correct and there is real room for uncertainty, for example:
- With an early stage company that has good potential for rapid growth;
- When a company has recently launched a new product or service line;
- Where an established company with strong historical performance has suffered a “one-off” negative impact on sales due to an unexpected event such as Covid-19.
Sales or EBITDA targets?
Neither of them is perfect.
Using “total sales” as an earn-out target may put the buyer at risk if profits decline because the seller retains the discretion, for example, to increase the company's marketing spending or offer deferred payment terms to customers.
Using EBITDA as a profit target may expose the seller to risk if the buyer has the right, for example, to unilaterally impose new management fees on the company or increase headcount or other costs.
Therefore, whatever type of profit target is used, contractual protection for both parties will be required to prevent abuse.
Buyer control/interference
After completion, the seller loses control rights over the company derived from being the controlling shareholder, such as appointing the board of directors and senior management.
From the seller's perspective, he or she will want to retain control over the areas of business operation that have the greatest impact on achieving the potential profit target.
The vendor will therefore want to negotiate a service or consulting agreement with the company giving this control (subject to limitations) and will want to negotiate similar agreements for all key team members. Careful attention must be paid to: (1) the duration of the contract which must be co-extended with the duration of the earning period and (2) the termination clause which must restrict the company's right to terminate in situations that justify summary dismissal (which are usually within the control of the individual employee to avoid).
In addition, a series of specific restrictions on action taken by a seller or buyer intended to artificially increase or reduce revenues or profits may be included as well as general principles such as the requirement to continue business “in the ordinary course”. There may be restrictions on the acquisition or disposal of key assets, but the incoming board will need to ensure that they have sufficient control to properly carry out their statutory duties.
If dividend payments are to be made on an interim basis rather than waiting until the end of the full dividend period, provisions may need to be made for the carry forward or carry forward of profits, revenues or costs so that the interim period expires – the possibility of correcting the payments or decreases in the final accounts.
Tax considerations
Finally, tax advice should be taken on structuring the dividend payment so that the most advantageous tax treatment is obtained for the seller. Depending on the circumstances, this may require that the maximum contracted profit be paid by the buyer in installments with the buyer entitled to make a warranty claim for £100 if the guarantee that the profit targets will be achieved proves to be false.
Where a vendor remains in business through a service contract, it will be important to show that the vendor is charging the market rate for the job to reduce the risk of HMRC trying to argue that some of the consideration for the sale of shares is, in fact, disguised bonuses that should be taxed at a higher rate.
Until now it has been possible to obtain illegal clearances from HMRC confirming that HMRC will treat the proceeds of the sale as capital gains rather than income.