A Teardown of Earn Outs – Part One

 

 

Earn outs are a way of bridging the valuation gap where the seller thinks the business or company is worth more than the buyer does – which is most of the time.  The earn out is an amount of money that is paid after settlement if the target company or business achieves agreed KPIs in an agreed number of years.

 

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On the face of it, then, earn outs are an easy way to reach agreement on price and keep the deal moving.  So lets look further into them to see what the issues might be.

 

Benchmarks


The art of having a workable earn out is to have KPIs that are easily measurable and that can be audited.  More than half of all earn outs in the <$200m deal="" range="" are="" linked="" to="" revenues="" ebit="" ebitda="" eps="" or="" net="" equity="" a="" small="" number="" of="" earn="" outs="" track="" combination="" these="" in="" internet="" companies="" the="" kpis="" can="" be="" users="" beta="" testing="" results="" other="" metrics="" p="">

 

The benchmarks have to be really clear.  So do the formulas based on those benchmarks and way in which they are measured.

 

Payment Formulas


There are two main methods of working out the payment formula:

  • An agreed amount on reaching the KPI (ie: $500,000 on hitting $15m in EBITDA), or
  • A percentage of the KPI (ie: 3.33% of $15m on hitting $15m in EBITDA).

There are also non-financial milestones that could be agreed, in which case the payment is usually a flat amount of cash or flat number of shares.

 

The earn out period is usually between one and three years.  Anecdotally it seems most earn outs in Australia are for one year, with only about 10%-15% stretching out to three years.

 

Problems with Annual Payments


Many earn outs have an annual payment, but over the years, I have noticed the following issues coming up again and again:

  • When the performance of the target was strong in the first year or two after settlement, but falls away in year two or three, can the buyer get some of the “excess” payments back?
  • Conversely, if performance was poor in the first year or two, but increases strongly in year two or three, does the target company or business have to recover those poor performances somehow before the earn out has to be paid?
  • Should the annual payments be lowered in favour of a larger end of earn out payment so that the buyer is cushioned from poor performances?

Conceptual Problems in Integration


When the target is acquired and integrated into the buyer’s bigger (or more efficient) organisation, the question arises as to whether the improved performance of the target post settlement is due to the inherent strengths of the target or due to the larger size (or efficiencies) of the buyer.  This is particularly so with the “private to public uplift” – where a private company valued at (say) four times earnings is bought by a public company trading at (say) nine times earnings (because of greater liquidity, greater governance or other factors).  Now the target is valued at nine times earnings – is it right that the sellers share in that uplift?   Even if the acquirer is not publicly listed, if its efficiencies alone increase the EBITDA of the target, should allowance be made for this, like:

  • Four times earnings in year one,
  • Three times earnings in year two etc?

Earn Out Payments in Shares


There is a certain attraction to sellers being paid in shares of a publicly listed acquirer.  They can sell the shares on the open market the next day, they can mortgage the shares and there is the possibility that listed shares might even go up.

 

There may, however, be lock up periods or other restrictions on transfer.  In the case of shares issued in unlisted private or unlisted public companies, there will also likely be drag along/tag along rights that affect disposal rights.

 

Sellers would be well advised to take a leaf out of the venture capitalists playbook and insist on shares with special rights, such as redeemable preference shares, convertible notes, anti-dilution provisions or liquidation preferences.  There is nothing to say a seller can’t proffer its own Terms Sheet to back up the offer of an earn out.  There is also the issue of valuing the shares in a unlisted public or private company – are their shares really worth the money or should the seller insist on cash?

 

Taxation of Earn Outs


Tax is always in a state of flux, so check with your accountant before taking this as gospel.  As at the date of this post, there is a proposed amendment to the ITAA that treats earn out payments as an addition to the buyer’s cost base for the company or business. Correspondingly, the money received by the seller is treated as additional capital proceeds for the sale of the company or business.

 

If there is a “reverse earn out” or post purchase adjustment (“PPA”), the PPA paid by the buyer is treated as a repayment of part of the capital proceeds for the disposal of company or business and will reduces the buyer’s cost base.

 

The present position is this:

  • In a normal earn out, the seller has to pay tax on the estimated value of the earn out, even though the money has not yet been received – and may never be received. Trying to value this unearned earn out costs a lot in accountants’ fees, adding to the sting.
  • When the seller gets the earn out payment, a second CGT event is triggered because the payment is characterised as a payment on the cessation of a right (ie: on the cessation of an earn out right). So there are two CGT events – one on the sale of the company or business and one on the payment of the earn out.
  • One bad thing about this second CGT event is that it does not qualify for small business CGT concessions.
  • Another bad thing is that if this second CGT event creates a loss for the seller, the seller can’t carry back that loss and offset it against a gain that arose on the sale of the business if that sale was in a previous income year.

So there are other considerations to take into account before eagerly agreeing to an earn out.

 

Conclusion

As always, if you can get a deal where you get the price you want at settlement, then take it.  If, however, you need to have an earn out to get what you want, be aware that there is more to them than meet the eye. 


 

 

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