Earn-outs have always been popular with private equity acquirers, but trade buyers are now making more use of them than ever. David Prosser reports on the rise of earn-out clauses, and speaks to two leading M&A specialists at UK corporates.
New research from CMS reveals that 27% of deals last year included an earn-out – up from just 10% in 2010, when the professional services firm began its annual surveys of the European M&A market. One notable trend is that while earn-outs have always been popular with private equity acquirers, trade buyers are also now making more use of these structures than ever before. Such clauses have different drivers – and can work well – as long as they’re well thought through.
Earn-outs in practice
Earn-out agreements are bespoke, designed to reflect the needs and ambitions of both parties in each individual transaction.
The most straightforward model is an agreement that offers a one-off payment in addition to the upfront consideration assuming a particular target is hit. Imagine, for example, a buyer agreeing an upfront payment of £100m, based on a multiple of 10 times the previous year’s £10m EBITDA, plus an additional £10m 12 months later if EBITDA rises to £11m over the year following the sale.
Other arrangements are more complex. One recent stock market disclosure revealed the details of a company bought in 2020, with three separate earn-out targets for 2021, 2022 and 2023. In each of these years, the seller was entitled to an additional payment if the business acquired then hit an agreed sales target, with nothing payable if the target was missed.
The agreement also featured a final catch-up payment related to total sales over the whole three-year period, irrespective of whether targets were achieved in individual years.
Taxing times
Earn-out arrangements need to be structured carefully to avoid adverse tax consequences for both sellers and buyers. In the UK in particular, where a director or employee of the acquired business subsequently receives an earn-out payment, HM Revenue & Customs will classify the money as employment income, rather than a capital gain arising from the sale of the business, unless a number of key tests are met. That would be likely to result in a substantially higher tax bill for the individual, with income tax and national insurance due on the payment at a combined rate of up to 47%. The relevant capital gains tax rate, by contrast, is only 20%, or even 10% where business asset disposal relief is available. In these circumstances, the employer would also face national insurance and apprenticeship levy costs. These would be likely to fall on the acquirer, as it will be the employer at the time of the earn-out payment, although some deals include provisions to indemnify sellers against such costs.
HMRC publishes guidance on the criteria it uses to decide whether earn-out payments should be classed as employment income or as part of the sale consideration. But the tax authority considers each case individually, requiring very careful drafting of deal documents. There is guidance on this in the faculty’s earn-outs guideline (see below).
ICAEW support
ICAEW’s Corporate Finance Faculty published a best practice for earn-outs guideline, authored by Grant Thornton, in 2023. It explores the factors that can influence the outcome of an earn-out agreement, for both buyer and seller, illustrates the benefits and shows potential pitfalls.
Alan AdamsonCFO, Havas UK |
Havas UK has made around 10 acquisitions in the past five years or so, and Adamson says earn-outs are almost always a feature of its deals. “Ours is a people business, so when we make an acquisition, what we’re really buying is its strategic leadership and client relationships, rather than what’s on the balance sheet,” he explains. “We want sellers to be motivated to keep driving the growth of the business on an ongoing basis.”
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Give and take |
Working in this way does require some compromise, he concedes. For example, Havas has previously adjusted terms to allow for the fact that in some situations a business might want to invest in building a presence in a new territory overseas. Such an investment would offer the potential for accelerated growth in the medium to long term, but could threaten to undermine the business’s progress towards its shorter-term earn-out targets.
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Edouard CarloneHead of M&A, Rigby Group |
Rigby Group is a technology-focused family office. Carlone (above) says clarity of purpose is key to successful earn-out clauses: “One thing we’ve learned from deals over the years is to focus on what we call sustainable EBITDA. We want our SPA to set out what we’re really looking for in terms of EBITDA – that should be measurable and objective, but there are also conduct-related terms to consider.”
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Mind the gap |
Carlone believes that there can be a role for earn-outs to help bridge a valuation gap between deal parties, so that the buyer doesn’t feel it is overpaying and the seller can look forward to more upside if the business outperforms. But earn-outs designed simply for this purpose are likely to run into problems, he warns, particularly where the seller is looking for an immediate exit.
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Clear thinking |
The key is to end up with an SPA that even non-lawyers can read and understand, particularly when it comes to the earn-out clauses. “The earn-out is the only bit of the agreement that you’re definitely going to look at again two years down the road, so it had better be crystal clear,” says Carlone.
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