Earn outs in business sales

An earn-out is a contractual provision in a business sale where part of the purchase price is contingent on future performance. Earn outs bridge valuation gaps and retain key management post-sale. Earn outs are increasingly common in our experience; they are especially common for :-

• Service businesses heavily dependent on key individuals

• Companies with unproven growth projections

• Tech startups with potential but limited track record

• Professional practices where client retention is crucial

• High-growth businesses with uncertain trajectories

Earn-outs can be structured around any measurable target: financial metrics (EBITDA, revenue, gross profit), operational goals (customer retention, product launches), or specific milestones (regulatory approvals, contracts won).

Payment mechanisms vary from simple thresholds to complex sliding scales. The earnout period can range from months to years, with payments made in stages or as lump sums

Performance metrics in more detail

• EBITDA targets - financial performance excluding non-operational factors.

• Revenue thresholds - pure sales targets, often used for growth businesses.

• Gross profit measures - focus on operational efficiency.

• Customer retention - critical for service businesses.

• Product development milestones - common in tech and R&D companies.

Payment mechanisms for earn outs

Options include :-

• Fixed threshold payments - specific amounts triggered by hitting targets.

• Sliding scale arrangements - proportional payments based on performance.

• Capped or uncapped - limiting maximum additional consideration.

Change control can be a problematic area

Change control can create conflicts in earn-outs because the buyer's operational decisions directly impact the performance metrics that determine the seller's payout. Key issues include:

• Cost allocations and accounting policies that affect reported profits

• Strategic decisions like pricing, marketing spend, or product development that influence revenue/growth

• Integration choices that could reduce the acquired business's standalone performance

• Resource allocation between the acquired unit and existing operations

Tax aspects

The key tax implications of an earn-out in a UK private company sale are:

• Risk of earn-out payments being treated as employment income (subject to income tax and NICs) rather than capital gain (potentially eligible for Business Asset Disposal Relief) if too closely linked to continued employment

• Timing of tax payment - CGT may be payable upfront on an estimated value of the earn-out right, or sellers can elect to defer until actual receipt but risk losing BADR

• Structure matters - earn-outs can be structured as either deferred consideration (taxed when the right arises) or as contingent consideration (taxed when received) with different implications

• Valuation challenges - if paying CGT upfront, need to agree value of earn-out rights with HMRC which can be complex and may lead to paying tax on amounts never received

The key is careful structuring to maintain capital treatment while managing cash flow for tax payments.

Common areas of dispute about earn outs

• Accounting policies - need for consistency with pre-sale practices.

• Extraordinary items - treatment of one-off events or costs.

• Group allocations - fair attribution of shared costs.

• Control Disputes and business direction - tension between short-term earn-out and long-term value.

• Resource allocation - access to group resources and support.

• Investment decisions - impact of capital expenditure on metrics.

Safeguards for sellers

Essential safeguards include:

• Security - A business seller agreeing to an earn-out typically seeks security through legal charges or debentures over company assets, parent company or bank guarantees, and ring-fencing protections to prevent manipulation of earn-out metrics. They often want escrow or retention accounts with specific release mechanisms, plus rights to monitor and audit the business during the earn-out period. Acceleration clauses are also common to trigger immediate payment if the buyer sells the business. The exact security package depends heavily on the buyer's financial strength, group structure and relative negotiating power.

• Operation covenants - requiring business to be run consistently.

• Information rights - access to relevant financial data.

• Anti-manipulation provisions - prevention of artificial performance impact.

Safeguards For buyers

Key protections cover :-

• Management obligations - securing continued engagement.

• Integration flexibility - preserving operational freedom.

• Set-off rights - against warranty or indemnity claims.

Trends with earn outs

Every business sale transaction is unique. It's true to say that in our experience more buyers are demanding risk sharing in the form of an earn out element. The following trends reflect our experience :-

• Average duration: 2-3 years

• Typical range: 15-30% of total value

• Most common metric: EBITDA

• Growing use of multiple metrics

• Increased focus on ESG targets

• Focus on vital drafting of earn out clauses and a comprehensive yet practical dispute resolution mechanism.