The danger of the earn-out clause

Although an earn-out clause may seem like a good idea, but there are real dangers that business sellers must be aware of. ANDREW KENT

With the private business market favouring the buyer at present, there are business owners signing up to sale deals they shouldn’t.

While there is no doubt the sale price is important, it is by no means the only thing to consider. In a market in which business capital is hard to find, and the economy is tending down, many potential purchasers are pushing for and getting long earn-out arrangements.

The original idea of the earn-out was to motivate the seller to hand over the business in good condition while providing the purchaser with an opportunity to ensure that the client goodwill crossed over with the business.

In today’s business environment, some buyers are using the earn-out as a means of prolonging the purchase period. There are two reasons for this; first to assist them in finding time to raise the purchase capital, and second to reduce the price/risk equation by having the current owner work through the economic downturn. Business vendors need to be wary of this and protect themselves from some major risks.

The biggest risk arises from the purchaser being unable to raise the capital to complete the transaction. The vendor needs to ensure that they have the ability to unwind the sale without any cost to them. To do this they need to ensure that the nature of the earn-out does not have the ownership of the business transferred with the initial down-payment.

Second, they need to ensure that the initial payments are treated as deposits, or that the overall transaction is contained within a single tax year. Otherwise the owners may find themselves in the position of needing to refund the initial payments to regain ownership of their business and unable to do so because they have already paid tax on the initial amounts.

A secondary risk is that due to external factors (including interference from the would-be purchaser) the business performs badly during the earn-out period and subsequently the purchase price is dramatically reduced.

To avoid this scenario the vendor needs to ensure that there are minimum values included in the contract of sale regardless of performance. The purchaser may want to counter this with the handover being brought forward or the sale being void if certain minimal performance limits are not met.

Whatever the particulars, the key point is to consider the possible scenarios and ensure that the contract deals with them appropriately.

Andrew Kent is a director of BizExchange, an independent marketplace for business for sale or seeking investment. BizExchange has a directory of independent advisers and business brokers and information on valuations.

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Comments

David S says: Great advice. I wish I’d known about putting in “minimum values regardless of performance” when I was selling my business because in the end I felt dudded.