• Earn-out period: An earn-out will be measured over a specific period – usually this is between one and three years following completion. The main consideration when negotiating the earn-out period is identifying a period that is expected to allow the performance metrics to be satisfied, but that does not encourage short-term action, such as accepting low margin work to increase revenue or not investing in capital expenditure, which may harm the long-term success of the business.
• Payment of the earn-out: The duration of the earn-out period will usually drive the payment structure. Shorter earn-out periods typically result in a single earn-out payment if the relevant performance metrics are satisfied, whereas staged payments during the earn-out period are more common where the earn-out period spans a number of years.
• Operation of the business in the earn-out period: Given its financial interest in ensuring that the earn-out is maximised, a seller will usually want to maintain some level of operational control of the business during the earn-out period. This may often be the case if the seller is a founder who is staying with the business for a period following completion. However, this can prove problematic from a buyer’s perspective as it will not want to be subject to onerous restrictions on how it operates the business post-completion. For example, a buyer may be making a bolt-on acquisition but could then be restricted from integrating the business during the earn-out period or from making any changes to the key management team. It can be a fine balance to find a position that satisfies all parties and is also workable in practice.
• Leaver provisions: In addition to being a useful pricing mechanism, an earn-out is also often used to financially incentivise a founder seller who is staying in the business to maximise the objectives of the business during the earn-out period. Therefore it is common for an earn-out to include provisions similar to leaver provisions in a private equity transaction, resulting in all or some of the earn-out ceasing to be payable if the founder is not engaged in the business at the time of payment of the earn-out due to specific circumstances (for example, resignation or summary termination).
• Tax: There are a number of tax points that should be considered when structuring an earn-out, including
  •  Sale consideration or employment income: For sellers who stay with the business, a question can arise as to whether the earn-out should be taxed as additional sale consideration (and so subject to capital gains tax (currently at a rate of 20%)) or as employment income (and so subject to income tax (currently at a rate of up to 45%) and NICs). This will be an important question for the buyer as well, as, if the earn-out is treated as employment income, the target company may be responsible for accounting for any such employment taxes via payroll and paying associated employer’s NICs. HMRC guidance sets out certain factors that should be considered when determining whether an earn-out is additional sale consideration or employment income, so it is important to involve tax advisors early in the process to ensure that this is taken into account as far as possible when structuring the earn-out and reflected in the purchase agreement.
    
    Leaver provisions, in particular, are an area that can cause complexity for the tax analysis of the earn-out – it will be important to ensure that any leaver provisions are limited to what is reasonable to protect the value of the business being acquired and only apply for as long as needed to give the target company sufficient time to wean itself off the sellers (we typically see up to three years; however, this would need to be considered on a case-by-case basis).
  • Timing: Depending on the length of the earn-out period, sellers may be required to pay tax on the value of the earn-out before they actually receive any earn-out payments. If this applies, it should be considered whether structuring the earn-out so that it is satisfied through the issue of loan notes can help.
  • Stamp duty: Care should be taken when providing for an earn-out to be subject to a maximum cap. Where caps are included, stamp duty (at 0.5%) is payable by the buyer by reference to that cap, even if it’s not expected that the cap will be reached and where the eventual earn-out payment is lower. However, commercially, a buyer may be willing to accept this additional cost for the sake of certainty on its exposure under the earn-out.

Client Alert 2023-233