Investment banks and corporate advisors use earn outs as a way of bridging the gap between what you -- as the seller think the business is worth, and what the buyer thinks it is worth. The way in which it is done is basically a dare: you dare the buyer to pay you what you think it is worth in the future if the business performs as you say it will. The purchaser gives you one amount at settlement - and further amounts if you are right.
So you would think that earn outs are a good way to reach agreement on the price of the business so that you can keep the deal moving towards a conclusion. Indeed, many professional buyers readily agree to earn outs, simply because they know what the issues might be and they know how to massage the earn out in their favour. So as a seller, you really need to know the intricacies of earn outs before you agree to one.
If you want an earn out that is going to work, you need to agree on KPIs that can be measured easily and that can be audited by third parties easily. In Australia, more than half the earn outs in deals less than $200M are linked to KPIs such as revenue, EBIT, EBITDA, Earnings per Share or net equity. There are a few that use a combination of all of these, but most of the time, it is one or two of these KPIs.
The type of KPI depends on the type of company. The KPIs above are for traditional companies. Some companies, especially internet companies, use KPIs such as users, subscribers, beta testing results or other internet metrics.
Whatever the benchmarks, if you want any chance at all of picking up a second cheque, they have to be really clear. That means that the formulas based on those benchmarks, as well as the way in which they are measured, also have to be clear. This is where your investment banker or corporate advisor has to be able to articulate the earn out parameters clearly to your transaction lawyer.
In Australia, there are 2 methods that are usually used to work out the payment formula:
- The seller gets paid an agreed amount when the KPI is reached (i.e.: $500,000 on hitting $20m in EBITDA), or
- The seller gets paid an agreed percentage when the KPI is reached (i.e.: 3.33% of $20m on hitting $15m in EBITDA).
The usual milestones are financial, but you can also agree non-financial milestones, in which case the payment is usually a flat amount of cash or flat number of shares when that milestone is reached (i.e.: $500,000 on reaching 1,000,000 paying subscribers).
Earn outs require some time for your hockey stick projections to come true. That's why earn out periods are usually between one and three years. From what we have seen in Australia, most earn outs are for one year, with only about 10%-15% stretching out to three years. Knowing this, you could press for a shorter earn out period during negotiations.
Problems with Annual Payments
Most earn outs are structured around an annual payment when the KPIs are reached. Over the years, however, I have noticed the same issues coming up:
- 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?
Granted, most people don't consider these practical issues when they are negotiating their agreements. They are usually too entranced with the headline number to think through the practicalities. What happens, however, is that when you sell to a company that is much bigger than you and that specialises in buying companies to drive growth, they know these issues and structure the deal to circumvent them - in their favour.
Problems in Integration
Here's another big one. When your company is bought out and then integrated into the buyer's much bigger (or more efficient) organisation, there is an improved performance after settlement because the buyer is stronger than your company or because it has more efficiencies than your company ever did. So is that why the KPIs were reached easily? Was it due to your company's potential, or the acquirer's synergies? Should you get a reward because once your company was integrated into their organisation, it hit all the KPIs and more?
We notice this particularly when a public company buys a private company and there is a private to public uplift. This is where your 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 your company is valued at nine times earnings. So is it right that you get to share in that instant uplift? "Yes" you might say. Especially if they did not think to draft the clause in light of this obvious effect. But really, should you actually collect a second cheque for this?
Even if the buyer is not publicly listed, if the buyer's efficiencies are the sole reason for an increase the EBITDA of your company, should allowance be made for this
- Four times earnings in year one
- Three times earnings in year two etc.?
Earn Out Payments in Shares
Most publicly listed companies will try paying you partly or fully in shares. At first blush, this might seem quite attractive. You can see the price of the shares online and you can sell them the day after you settle the sale of your company if you like. You can mortgage the shares -- you can possibly put them in your SMSF, and there is even the vague possibility that the shares might go up.
The problem is that the acquirer might insist on lock-up periods where you can't sell the shares for a certain time. If the shares are in a public unlisted company, there will probably be drag along/tag along rights or rights of first refusal that affect your right to sell the shares.
If you are going to accept shares, then, do what you can to insist on shares that have special rights, such as redeemable preference shares, convertible notes. The special rights (at least in unlisted companies) could include anti-dilution provisions or liquidation preferences.Â There is nothing to say that you as a seller can't table your own "terms sheet" when you are negotiating an earn out.
Then there is the real question of valuation of these shares. If they are listed, then you can see the value on the ASX. If, however, they are shares in an unlisted public or private company, you need to be sure that the shares really worth the money. Otherwise, you should insist on cash.
Taxation of Earn Outs
Tax is always changing, so this is not gospel. Don't rely on it and check it with your accountant before doing anything. As at the date of this article, however, there is a proposed amendment to the Income Tax Assessment Act in Australia that treats earn out payments as an addition to the acquirer's cost base for the company or business. That means correspondingly, the money you receive is treated a additional capital proceeds for the sale of the company or business.
Conversely, 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.
Subject to the disclaimers above, the present position is this:
- In a normal earn out, you as the seller have to pay tax on the estimated value of the earn out, even though you have not yet received the money and you may never receive it. Nonetheless, you have to try to value this unearned earn out and this costs a lot in accountants' fees, adding to the sting.
- When the seller gets the earn out payment, a second CGT event is triggered. This is because the payment is characterised as a payment on the cessation of a right (i.e.: 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. The second CGT event is problematic because:
- It does not qualify for small business CGT concessions
- If it 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.
If you can get the price you want at settlement, by all means take it and don't worry about earn outs. If, however, you want an earn out to get the price you originally envisaged, or even as icing on the cake, then be aware that there is more to them than meets the eye. More in the next post!