When selling a business the role of the earn out is simply stated: it is to bridge the gap between the Purchaser’s and the Vendor’s assessment of the value of the Target. It is additional consideration paid following the sale to reflect value asserted by the Vendor at the time of the sale now evidenced, typically by way of profits or other financial targets met over a defined period (usually two to three years) after the sale. The earn out payment may be satisfied by one payment made at the end of the earn out period or a series of such payments as yearly targets are met over the course of that period.
For the Purchaser the earn out serves to hold back part of his purchase price until such time that the profits valued (or other financial metrics or commercial benefits) are delivered. Although the earn out is generally linked to profits the Purchaser may value other benefits to be derived from the Target: the assets, its intellectual property, the client base, the team: in short the Targets “fit” and ability to deliver synergies for the Purchaser. The earn out may therefore be linked to some other value driver.
The earn out will often play a wider role for the Purchaser than simply meeting an “expectation gap” with the Vendor. In a services business in particular, the vendor shareholders will generally represent the key management and employees upon which the value of the business depends. In these circumstances the earn out offers a means to retain and to incentivise “the vendor team” in the ownership of the Purchaser.
A tension and a temptation arises here. The Purchaser may seek to incorporate into the earn out a reward that goes beyond simply a price adjustment for the acquisition of the Target. It may be “enhanced” to provide a reward and incentive for the future services of the vendor team—in effect disguised remuneration. The vendor team may be happy to acquiesce, if not encourage, such a weighting of the earn out in view of the favorable tax treatment that results. The earn out will be subject to capital gains tax in the hands of the vendor team, potentially taxed at the entrepreneur’s relief rate of 10 per cent, whereas employment income would be taxed at the individual’s marginal rate of income tax together with an NIC charge. It is important to understand where the tax risk lies and seek appropriate protection under the sale agreement from the risk of HMRC treating the earn out as employment income.
For the Vendor the earn out holds out the prospect of further consideration linked to the future performance of the business and a total consideration potentially well beyond what might be negotiated “on the nail”. It effectively provides a mechanism to share in the continued growth in value of the business (or as the vendor might contend, value already inherent in the business). Again tax intrudes to create both an opportunity and risk for the Vendor.
It might reasonably be expected that the overall consideration received for the vendor’s shares in Target would be subject to capital gains tax with further tax being paid as and when additional earn out consideration is received. Nothing so simple. The value of the earn out requires to be estimated at the time of the sale and this value brought into the calculation of the gain (together with the upfront consideration) to be taxed at the entrepreneur’s relief rate of 10 per cent. The capital gain therefore includes the estimated value of the earn out yet to be received (and which may never be). The temptation is to take a very prudent view of the value of the earn out in order to mitigate the upfront capital gains tax charge. However should the earn out consideration subsequently received exceed this original estimate the excess is subject to capital gains tax at that time (reasonable enough) but without the benefit of entrepreneur’s relief such that this part of the gain will be taxed, in all probability, at the full CGT rate of 28 per cent! The solution may be to err on the optimistic side in valuing the earn out in order to maximise the gain that ultimately benefits from entrepreneur’s relief but accepting a higher upfront tax charge.
One positive arises from this treatment of the earn out: where, as is often the case, options are exercised by members of the vendor team immediately in advance of the sale, a sum equal to the value of the shares acquired pursuant to those options is available as a deduction for corporation tax purposes to the Target. The value of the shares for these purposes will reflect the value of the earn out. Here an optimistic view on the value of the earn out assists in maximising the value of the shares and thus the corporation tax deduction for Target. The Vendors should ensure that the sale agreement gives proper recognition for the value of this tax asset crystailised by the sale.
The earn out exists for the simple purpose of providing a bridge between the Purchaser and the Vendor in order to agree the price to be paid for the Target. An understanding of its role and structure is therefore required in order to maximise the consideration negotiated. Understanding its tax treatment and maximising the after tax consideration is not as simple, either as it should, or could, be.
By Neil Simpson, Tax Partner, haysmacintyre