The pros and cons of an earn out and why it is vital to plan your exit strategy carefully
An ‘earn out’ may be attractive to someone buying a business but less appealing to a seller and disputes can often arise about the amounts payable.
When you come to sell your business there will probably be a difference between the price that you think your business is worth and the amount that a buyer wishes to pay you. A possible middle ground is to negotiate an ‘earn out’ which is a structure whereby on the sale of a company you receive an initial amount, and then further sums will be paid dependent on the performance of the business following the sale. An earn out is also useful in a situation where a new business has not yet fully established its profitability or track record.
If you agree to an ‘earn out’ arrangement, you will be required to remain as a paid employee of the company, and your conduct during that period will be on certain agreed terms.
This is a way of the buyer protecting their investment. It makes sense to the buyer to do this because if your business is as good as you claim, then both parties will win.
Plan your exit
If you are considering selling your business, it is vital that you plan your exit strategy accordingly. The calculation of an earn out will centre around the criteria by which your business’s performance will be measured, and how and when further payments will then be paid, assuming your business meets those targets.
Make sure that you know your facts and figures, and think about your parameters:
- What will you accept?
- What is non-negotiable?
- How will your future look, both during the earn out and afterwards.
Remember that after the earn out period ends, you will no longer have the salary benefits and other perks of your business. Plan what your life will be like after you have received the money.
You must also seek advice on your personal tax position, in particular whether you qualify for Entrepreneurs’ Relief. The way that HMRC treats the taxation of earn outs can be extremely complicated.
While experts can help you to decide what your business is worth, only you know whether you have the appetite to work in the business with a loss of control and under very different conditions. It does not suit everyone, and for some it is better to settle for a potentially lower amount of money in a clean break sale.
Pros and cons
It may be possible for a seller to negotiate a more lucrative deal with an earn out, as both buyer and seller benefit from the future success of the business. The risk on future performance is shared. The buyer may be prepared to pay substantially more than a fixed price deal. The structure, however, will ultimately be dependent on the bargaining power of the respective parties.
The benefits to you as the seller of the business include:
- you will get a cash sum up front;
- you can phase yourself out of your business, and remain part of the team’s success;
- you will be salaried during this time;
- you can influence growth to hopefully obtain a further substantial sum in the future;
- payments can be staged, which may help with tax planning; and
- if the acquisition is a big success, you may get more money than anticipated and earlier.
There are also disadvantages and risks associated with an earn out, including:
- future payments could be calculated based on profit rather than turnover;
- the buyer could increase liabilities and overheads diminishing profits;
- key members of the team could leave and take other individuals with them;
- the business could lose revenue and customers, or worse it could become insolvent;
- the new owners could relocate elsewhere, losing substantial proportions of the business’s talent; or
- the way that the business is run may make it very difficult to stay in while watching others take it in a direction that you feel is wrong.
Importance of seeking legal advice
An earn out may be very attractive to a buyer but can be less appealing to a seller, and disputes can often arise about the amount payable. These can be stressful and costly to resolve over a lengthy period.
Your solicitor will advise you on the negotiation of terms which are right for your circumstances and will ensure they are accurately reflected in the acquisition agreement. It is vitally important to seek expert legal advice on your specific circumstances at an early stage.
For further information, please contact our Corporate Team on 01733 882800 or email [email protected].
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