Many business owners imagine that when they take their company to market, they get paid in one lump sum and walk away. The truth is often very different as many purchasers insist on earn-outs when you sell your company or merge it with another.

An earn-out is a part of a purchase price for your business that is dependent on its future performance, your future participation, or both. Earn-outs are, by their very nature, much riskier for the seller than the buyers.

In this article, we look at earn-outs, how they work, and the pitfalls you may come across.

Earn-outs – the stages involved in selling your business

Most company owners, when selling their business, will conduct a mixture of an auction and a beauty parade between business brokers, sometimes called business transfer agents.

Some might say unfairly, but many business brokers have a bad reputation. You may be able to do it all yourself.

Although this link comes with no endorsement, the UK Business Brokers blog offers advice on all aspects of how to sell your business, including how to do it yourself. Please note that some parts of this site are paid-for.

Whichever way you go about it, you’ll (hopefully) get one or more offers for your business from prospective buyers.

The conversation will normally go something like this –

BUYER: “I’ll offer you £500,000 for your business”

YOU: “I’d like £600,000″

BUYER: “It’s not worth £600,000″

YOU: “Yes, it is”

BUYER: “No, it isn’t”

(continued…)

Your buyer will eventually say that they don’t accept your valuation of £600,000 however they’re prepared to pay it.

However, you’re going to have to work for it and the mechanism used to facilitate this type of transaction is called an “earn-out”.

Earn-outs – when they are used

Earn-outs can be used, like in the above example, to bridge a disagreement between what you value your business at and what your buyer values your business about.

There is an added benefit to the buyer in these arrangement – you.

First and foremost, the fear in a buyer’s mind is that the minute you leave, revenues will collapse, customers will strike and they’ll be staff resignations en masse. It’s not an unreasonable fear. Change is scary and unpredictable and your buyers want as much assurance as they can have before they part with a penny, let alone £600,000.

Having an earn-out structure allows them to keep the ship steady and have access to your vital industry knowledge, connections, and contacts to make sure that business runs as normal post-completion.

In this example, you may agree to be paid £300,000 up-front with 4 further payments of £75,000 every three or six months depending on the ongoing financial performance and profitability of the company. When this happens, beware.

Earn-outs – heads of terms

“Heads of terms” is like a contract before a contract. They’re the type of things solicitors will often use to help two parties come to an agreement before the messy and expensive business of coming to the real agreement – in this case, the Sale and Purchase Agreement (SPA). The SPA is the title of the main legal agreement that will transfer your business to its new owner.

The subject of earn-outs is likely to be raised during informal discussions you have with your buyer and during the Heads of Terms negotiations.

At this point, make sure you have legal representation. Why?

Earn-outs – you’re going to need your solicitors and your accountants more than you’ve ever needed them before

Selling a business is, in most cases, a war of attrition between you and your buyer.

You’re trying to secure the best possible deal for yourself. And so are they. It’s very rare that you’ll have matching interests and desired outcomes. And if they’ve got all this money to spend on your business, you can rest assured that their solicitors and accountants are going to be more expensive than yours.

The actual difference between a top-charging solicitor or accountant and a fully-qualified solicitor or accountant is not that big. What the top-charging solicitors and accountants are there to do, other than to protect their client’s interests, is to raise your costs.

There will come a point where the legal and accounting bills you have racked up run into the tens of thousands. These costs are non-recoverable. Once it passes a certain point, it may mean financial ruin or hardship to walk away from a deal.

We and your solicitors will back up you all the way. We’ll watch out for the following types of trap:

• “fines” if you don’t perform your tasks in a satisfactory way post-completion

• changes to accounting rules meaning that your earn-outs become unachievable

• a brand new entity or an existing opaque entity buying your firm (perfect for transferring assets to another company and crashing the vehicle used to buy your business)

Protect yourself as much as possible during these discussions. Work with us and your solicitors to make sure that, if your buyer is less than honourable, you can recover the maximum amount of money possible and be unimpeded in returning to your old line of business.

Earn-outs – earn-outs and tax

If you sell shares in a company you’ve owned for more than 12 months, you will (in most cases) pay 10% Capital Gains Tax with Entrepreneurs’ Relief. Your actual capital gain is the amount of money you received less reasonable expenses in expediting the sale (for example, solicitor fees, accountant fees, business broker commissions).

Different types of tax become payable depending on whether you sold the shares of your company or some or all of its assets.

If someone has approached you to buy your business, or you’re thinking about it, please be sure to give us a call on 01606 333 900 or email us at hello@burtonbeavan.co.uk.

And one last thing.

Be careful out there.