Despite the current tech sector recession, many owner-managers have an inflated view of the value of their business, perhaps one of the lingering effects of the dot com boom. But in the current market, potential Purchasers are unwilling to match their expectations. The most common method for bridging this expectation gap is the earn-out, where the vendor receives a payment based on the future performance of the business, conditional on achieving certain revenue and/or profits.
It is rare, in today’s market, for the sale of an owner-managed IT business not to feature some kind of earn-out for the outgoing proprietors. Whether the sale is of shares or of assets and whether the earn-out is squarely directed at exiting shareholders or comes in the form of future performance bonuses aimed at non-shareholder or minority shareholder managers, much negotiation time is soaked up in discussing the ins and outs of the proposed scheme.
The most common form of earn-out in a share sale is a possible future payment to be made to shareholders (over and above any sums they have received on completion), dependent on the future performance of the business in its new hands.
Whilst not unique to the IT sector, the use of earn-out is particularly prevalent in the sale of IT businesses due in no small part to the particular volatility and uncertainties of the sector over recent years (and arguably for the foreseeable future).
The rationale
From a purchaser’s viewpoint an earn-out can have definite appeal. It focuses attention onto the (often optimistic) financial projections and prospect lists put forward by a vendor and forces a vendor to “put his money where his mouth is” by accepting that part of the consideration will only become payable if the expected income levels are met. The purchaser will pay the earn-out slice of the consideration only if the outcome, over what could be a lengthy period, is as expected (ie the purchaser pays only if he gets what he thought he was buying). This is particularly attractive for a Purchaser where the overall price has been calculated by reference to profitability, as it enables the deal to be structured so that payment of the final element of the price is dependent on those profitability levels being maintained or enhanced.
From the Vendor perspective the earn-out can also be tempting. Bridging the price expectation gap is once again a plus, as a Vendor could otherwise be frustrated at a Purchaser’s inability to recognise (by way of a higher price) the market potential seen by the Vendor. Evidently, before considering an earn-out, a Vendor needs to analyse his own reasons for sale and his own requirements from the sale process. The most crucial issue as regards earn-out is whether the Vendor wishes to remain involved in the business. If he does not then the suitability of an earn-out structure must be doubtful as, in order to maximise the chances of benefiting from an earn-out, a Vendor (all or most of them, if more than one) really has to be significantly involved in the business in its new ownership and capable of influencing the outcome.
An earn-out would be inappropriate if a clean break is required (eg due to retirement or change of direction on the part of the Vendor or due to a wish to take a new broom to the management of the business by the Purchaser).
The current economic uncertainty still hanging over the IT sector is encouraging the use of earn-outs. Industry gurus currently disagree with each other and with the industry whose (privately expressed) views about the likelihood of the “good times” returning to the industry they aim to “play back”. There is also active debate about whether the growth of the IT industry has slowed because it has reached maturity or whether it has stalled due to self-inflicted ills but with plenty of scope yet for growing ahead of GDP once it gets its house in order.
Typical features of earn-out provisions
The period over which an earn-out typically lasts can vary considerably. A few months is appropriate if the earn-out process is intended just to relate to payments if certain contracts “on the brink” of being closed are indeed completed within a short time. Earn-outs lasting two or three years are common and, although conventional wisdom states that they should not extend over too long a period, up to five years is sometimes seen.
It is most important that earn-out provisions be clear and unequivocal. Linkage to turnover, net profit etc. calls for careful definition of those terms for the purposes of earn-out. This demands a detailed description of accounting policies and methods of measurement such as deductions allowable in calculating profit, the description and extent of management charges which may be imposed by the new business owners, the resources to be made available by the new owners and the point in time at which revenue is recognised. Leaving loose ends creates scope for argument later which is undesirable per se but particularly where Purchaser and Vendor are continuing to work together and need to maintain a good relationship.
The calculation of earn-out according to detailed rules is practical only if the acquired business retains its autonomy post acquisition. Protective provisions are therefore often included aimed at keeping the business unit “as is”. Other protections often sought for the benefit of the Vendor are that a proportion of the projected earn-out or a fixed figure be paid if the business is moved into another division or an associated company, or is sold.
Clearly the potential problems with any earn-out can be lessened if there is a good fit between the objectives of the Purchaser (and the actions required to meet those objectives) and the conditions and actions desirable to maximise the earn-out.
There are significant tax implications inherent in earn-outs which will vary according to the precise nature of the arrangements. Under the Marren v Ingles principle a right for shareholders to receive certain unascertainable consideration for their shares under an earn-out will be valued as a right in itself (chose in action) on which tax is payable straight away. Further tax, without the benefit of full business taper relief, will be due on any gain (or a tax loss will be available to carry back) once the actual amount of the earn-out is clear. It may be prudent in tax terms to arrange for payment of earn-out to be made in loan notes. Where the earn-out is actually paid as a performance bonus linked to employment (perhaps because the earn-out rewards need to go to non-shareholders or to be shared in a different ratio to the Vendor’s shareholdings), then income tax and NI will have to be paid. There may be an impact on stamp duty in some circumstances.
It is usually prudent for the Vendor to negotiate for a parent company guarantee from the Purchaser’s parent in respect of potential future earn-out payments.
Negotiations with or clearance from the Inland Revenue may be needed in relation to the CGT treatment of earn-out.
Downside
If the recommended protection provisions are built into the terms of the earn-out then this creates an artificial barrier between the target business and the rest of the Purchaser’s business. This must impair the ability of the Purchaser to derive the full benefits which should be gained by total and immediate integration (economies of scale etc).
There is likely to be conflict between what is desirable across the whole of the Purchaser’s business (eg cross selling of products) and the actions the Vendor needs to take to maximise earn-out payments, which are hard to resolve in the small print of the earn-out terms. In this way the earn-out can change the dynamics and drivers of the business unit towards maximising the earn-out rather than securing the medium/long-term success of the Purchaser’s business as a whole.
The negotiation, documentation and implications of the earn-out will take up a lot of time and attention in the sale/purchase process. The issues are usually very particular to the deal concerned and so not susceptible to much standardisation across different deals. The implications for integration (or lack of it) have to be thought through and minimised where possible. Certain accounting policies are particularly hot topics, eg within the IT sector revenue recognition issues need particular attention and may be treated differently in an earn-out than they would be if, for instance, trying to satisfy US GAAP in the Purchaser’s accounts.
Inevitably, over time and due to changing circumstances, it will get more difficult to apply the accounting rules for calculation of earn-out set down at the outset. Because of the room for interpretation and the plain fact that the Purchaser is in ultimate control of the business, any changes are more likely to work against the Vendor than in his favour. Actual payouts under earn-out provisions are inevitably likely to be far less than the maximum possible and may be much less than the Vendor’s original expectations.
Upside
An earn-out as part of the sale consideration is a powerful motivator for the Vendor to achieve what is necessary for earn-out success in cash terms. It also exploits the natural pride of a Vendor in having built a business up and the desire to see that business continue to prosper and grow. He is likely to be able to increase the potential consideration receivable well over and above what the Purchaser would be prepared to pay up front.
From the Purchaser’s perspective, inclusion of an earn-out arguably reduces the need to rely on warranties (especially if the amount of consideration based on earn-out is significant) and it is potentially easier to withhold earn-out payment than to make a warranty claim (at least in the period after any retention in respect of warranty claims has been paid over). The Vendor managers of the business are normally tied in, post acquisition, which will usually suit the Purchaser, at least for a period, so as to achieve a smooth transition and knowledge transfer. The Purchaser has the advantage that he will not pay the earn-out element until later, if at all, and is protected against unjustified optimism on part of the Vendor.
Conclusion
Earn-outs are likely to remain a feature of acquisitions in the IT sector for the foreseeable future.
Statistics have shown that 80% of all businesses perform less well after an acquisition than they did before it. One of the main reasons is that insufficient thought is given to integrating the target into the Purchaser’s business. Unfortunately, the need to integrate runs counter to one of the commonest principles of an earn-out, which is to preserve the status quo (so that measurement of performance, consistent with past practices, can be achieved post acquisition).
The prudent advice to a Vendor must be that deferred payment may not be paid at all and seldom is the entire earn-out expected actually fully paid. Efforts should be concentrated on grooming a business for sale and ensuring that as much consideration is received up front as possible.
The IT sector is perhaps suffering from the legacy of its recent attitudes to winning business – the “if it won’t affect this quarter’s number it is not worth doing“ mentality which leads to the business being more interested in closing a fast deal than in customer satisfaction. As this translates into lack of sustainability in IT businesses, Purchasers are rightly looking at ways to limit the risk that optimistic projections in target businesses come to nought. The earn-out provisions crafted to cover this will, for the moment, continue to yield pretty slim pickings for Vendors.
Earn-out checklist – From the perspective of a Vendor of an IT business
| Objective | Factors to consider |
| To keep the business unit “as is” |
|
| To maintain consistent accounting policies |
|
| To avoid competition | New owner must not market competing product |
| To maximise cross selling by others in new owner’s group | Agree tariff for revenues to be credited to earn-out unit. |
| To limit imposition of on-costs from new owner | Agree framework/tariff for management charges |
| Calculation of earn-out |
|
| Rules for departure of earn-out beneficiary | “Good leaver” and “bad leaver” provisions |
| Sweeping up provision | New owner will not enter into any transaction outside the normal course of business [the purpose of which is to reduce or defer or divert revenues or profits or increase the losses of the business] [which is not entered into in good faith in the best interests of the business]. |
Rosemary Downs is a director of IT law firm v-lex limited. She specialises in corporate work for IT businesses.
