1. EARN-OUT AGREEMENTS Divya Raman Corporate Department Altacit Global Email: info@altacit.com Website: www.altacit.com

2. Introduction An earn out is a type of payment agreement which is sometimes used when companies are sold. Under an earn out agreement, the seller receives part of the purchase price up front, and additional funds over time. The terms of the earn out are written into the sales contract, and the earn out can be structured in a number of different ways.

3. Introduction Contd.. Companies reach such an agreement because there is a dispute about the value of the company being acquired. The buyer may not want to pay the full purchase price up front, due to concerns that the company may fail to do as expected. Under an earn out agreement, the buyer might offer to pay, for example, 80% of the purchase price at the time of sale, and the remaining 20% over a period of five years.

4. Because of the complexity and dynamics of an earn-out agreement, it is essential that the buyer and seller shall obtain advise of legal, accounting and tax professionals who are experienced with earn-out transactions.

5. Fundamental issues that frame the negotiations of an earn-out package 1. Type of Agreement: In a business acquisition, an earn-out is the part of the consideration paid to the Seller that is contingent upon the attainment of a performance target or event. An earn-out can be included as a clause in the Purchase Agreement or set forth in a separate agreement. There are different ways to form an earn-out including: The earn-out clause can be included either in a stock purchase agreement or in a license/royalty agreement or commission agreement etc.

6. 2. Performance Target: The performance target sets forth the metric that needs to be achieved in order for the earn-out to be “earned.” The performance target can be tied to revenues, margins or profits. In some cases, the target can be defined as the completion of a project or attainment of a business objective.

7. 3.Term of the Earn-Out: There is a beginning and ending date to the seller’s eligibility to make their earn-out. The length of that period should be reasonably sufficient for the seller to reach the performance objective and allow the buyer to achieve the anticipated return on investment. A long-term agreement means that the seller and buyer are going to have a long-term relationship.

8. 4.Earn-Out Formula: When the performance target is hit, the earn-out payment becomes “earned” and payable subject to the earn-out formula. The earn-out formula can include a. Lump-sum amount. b. Percentage of the performance target. c. Minimum amount plus a percentage of the performance target. d. Ceiling or cap on the amount earned during any one period. e. Ceiling or cap of the total amount earned over the term of the agreement.

9. 5. Distribution of Earn-Out Payments: There can be one formula for determining the amount of an earn-out that has been earned and another that directs how the earn-out is distributed. Depending upon the type of earn-out agreement, payments can be made monthly, quarterly, or annually. In addition, payments can be made at the end of the agreement’s term along with periodic payments. The information required to calculate the earn-out based upon the formula needs to be available. Therefore, the buyer will need a reasonable amount of time to gather the necessary data. An earn-out agreement can provide for simple periodic payments without recourse.

10. 6.Method or Form of Payment: Since the seller has already deferred the earn-out payment and shouldered the risk of not meeting the performance target, earn-outs are often payable in cash. However, there may be occasions when the earn-out payment is distributed as a note payable or in stock. Using stock (or rights to equity) as well as note(s) as a currency for earn-out payments raises a number of potentially gnarly issues.

11. Common Performance Measurements Earn-outs can be based on any number of financial or non-financial measures, including gross sales; earnings before interest, tax, depreciation, and amortization (often referred to as "EBITDA"); net income; obtaining regulatory approval of a product; obtaining patent protection for an invention; or the number of sales of a pre-closing product line. Using gross sales as a measure of the seller's performance following closing is advantageous to the seller because gross sales are easy to measure and hard to manipulate.

12. Advantages 1. To the Buyers: a. More accurate company valuation. b. Less risk of paying too much for the company. c. The seller is incentivised to continue to contribute to the business. d. There is an opportunity to become familiar with the business while it continues to be run by the seller. e. The risk of losing key contracts is reduced (where the seller remains involved). f. The initial funding requirement is reduced. g. The deferred consideration can be financed from company profits.

13. To the Seller: Potentially higher consideration than if the full payment was made on completion of the sale; there may be benefits from being part of a larger group that positively impact performance. Capital gains tax rollover relief may be available until the earn-out is paid.

14. Disadvantages To the Buyer The buyer faces an inherent conflict of interest: the better the company’s performance during the earn-out period the larger the earn-out payment to the seller. The seller may focus his efforts on boosting his earn-out potential and neglect other business considerations;. The buyer’s commercial decisions may be restricted by protective covenants imposed by the seller.

15. 2. To the Seller a. The delay in receiving the full consideration. b. Increased risk that the buyer will be unable or unwilling to pay the deferred consideration. c. The focus of the business may switch to non earn-out generating areas that do not contribute to the earn-out. d. Expenses from non earn-out generating areas may impact on the earn-out. e. The buyer’s accounting policies will typically be used to calculate the earn-out, so the seller must take great care to ensure that the performance targets for earn-out payments are set appropriately. f. An earn-out cap will typically be required for a listed seller. g. HM Revenue & Customs may treat the earn-out as an employment-related bonus payment and tax it accordingly.

16. Factors to be considered when structuring earn-out 1.Maintenance of existing accounting principles throughout the earn-out period. 2. Maintenance of existing financial periods throughout the earn-out period. 3. Allowable deductions. 4. One-off costs incurred during the earn-out period, for example costs associated with redundancy or relocation.

17. 5. Non-trading profit impacts, for example profits from the sale of assets and cost reduction benefits resulting from any post acquisition synergies; 6. The level of management charges levied by the buyer’s group (where applicable). 7. The level of research and development costs over the earn-out period. 8. Whether profits can be carried forward or carried back during the earn-out period. 9. Whether the earn-out should be capped (generally required for a listed company).

18. Tax Implication Specialist tax advice should be sought when entering an earn-out arrangement. The earn-out consideration may be subject to either capital gains tax (CGT) or income tax depending upon the structuring of the earn-out. The seller should take early tax advice before negotiating the sale/purchase contract to optimise the tax treatment of the consideration. A particularly thorny issue is the employment status of the seller’s management if they continue to contribute to the business post-acquisition.

19. Conclusion An earn-out can be a useful addition to a purchase agreement when there are differences between a seller and a purchaser regarding the purchase price for a business. The concept is simple, but the actual details of the earn-out require careful negotiation and drafting to ensure that each party's goals are met and future litigation is avoided. The earn-out should address details such as the performance measures that are applicable, the specific accounting methods and policies to be used, how much control the seller will have over the business after closing, the time frame for the earn-out, as well as issues such as what effect the purchaser's sale of the business during the earn-out period or the discontinuance of a product line of the seller will have on the computation. Disputes with respect to earn-outs are fairly common, but with the right amount of thought and drafting up front, it may be the key to salvaging a deal.

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