Mitigating the impact of Coronavirus on earn-outs
Many shareholders of marketing services and media businesses will be familiar with the concept of an earn-out in the context of a company sale. An earn-out arrangement involves the buyer paying a certain percentage of the overall deal value at completion, with the remainder due to be paid over a period of time. Normally, this is anywhere between one and five years, and contingent on the underlying performance of the business being acquired during that period.
Most earn-outs depend on the actual profits generated by the company being acquired but there can be additional factors to account for. These include revenue and gross profit levels, annual and compound growth rates in profit or revenue, and margin percentages.
Good for business
Earn-outs are commonly used by those buying creative and people-dependent businesses. This is because earn-outs enable them to lock in and incentivise the sellers of the business for a period post-acquisition. This gives the acquirer more time to consolidate client and staff relationships. If the selling shareholders choose to leave at the end of the earn-out period, the business is less affected.
Sellers can also benefit from earn-outs. If the business really performs well during the earn-out period, they might achieve a higher overall payment than had they been paid 100% of their business’s former value at completion.
That is all well and good if the economy is functioning normally. However, now the effects of Coronavirus on the creative sector in particular have left some shareholders concerned about the earn-out arrangements they have signed up to.
Facing up to challenges
Companies working in live entertainment, TV, film, and commercial production and events may have no income at all at present. Agencies may be less badly affected, depending on the nature of their clients, but will be experiencing project-freezes, deferments and cancellations.
If lockdown continues for an extended period and if business is slow to get back to previous levels once everyone starts to emerge, selling shareholders may run out of time to make up for any temporary shortfall in performance within the specified earn-out period.
It is not just sellers who lose out if the financial performance of their companies is so badly affected by factors outside of their control that their earn-out payments are in jeopardy. Contrary to popular belief, purchasers want selling shareholders to achieve their full earn-outs because it demonstrates that they have bought a successful, growing business, and means they can retain key management for longer.
Good for both buyer and seller
Sometimes it becomes clear that selling shareholders are going to receive no or significantly reduced earn-out payments under the original earn-out formula (through no particular fault of their own). It is likely that they will become disillusioned, disengage from the business and even seek to exit the business early, leaving the purchaser with a significant management issue.
It is in the interests of both purchaser and seller to look at current earn-out arrangements and whether anything should be done differently to retain and reward selling shareholders for their continued involvement in the business. Revised arrangements could help preserve the underlying value and market position of the business, and enable it to take full advantage once the economic environment improves.
It is unlikely that the sale and purchase agreement, signed by both parties, will contain provisions for significant variations to the earn-out. Of course, it is worth exploring this avenue first. However, any contract can be varied or superseded by the agreement of both parties in writing. Our advice to selling shareholders looking disconsolately at their new earn-out forecasts is to open a dialogue with the purchaser – their reaction might be a pleasant surprise.
Alternative arrangements
The purchaser will want to ensure the business it has acquired will survive and trade through this period to be able to deliver value for the group in the future. If they need the assistance of the selling shareholders to achieve this, they will be open to suggestions regarding alternative arrangements.
Possible ways of mitigating the Coronavirus effects on the earn-out could include extending the earn-out period, allowing averaging over a longer period to minimise the impact of short-term disruption.
Alternatively, 2020 could be excluded entirely from the earn-out calculation, on the basis that it is an exceptional or extraordinary year. Much will depend on the original earn-out formula – the metrics that drove it and the time period agreed.
If a purchaser is unwilling to vary the terms of the original earn-out, they might consider different methods of incentivisation to ensure selling shareholders remain engaged with the business. One option is special bonus arrangements, although they may not be as tax-efficient as earn-out payments.
Tax consequences
Any alteration to earn-outs or any replacement arrangement will have tax consequences. If the earn-out is to be abandoned, as the targets are not achievable, a few issues may arise.
If part of the earn-out has already been taxed on its value at the point of sale, relief should be given for non–payment and any tax elections made at the time should be reviewed.
A replacement standalone arrangement is not going to be a payment for the shares – as they have already been sold – and is likely to have income tax and NIC consequences. In certain cases, a form of share incentive (perhaps EMI options) is one way to keep this within the capital gains tax regime rather than income tax. However, it is not always possible.
For businesses who are part way through an earn-out deal, have recently signed one or are contemplating one, getting professional advice sooner rather than later is essential.