by Barrie Pearson - Wednesday, 29th August 2007 -

Vendors hate earn-outs. So do acquirers. Most professional advisers hate them, too. So why do over 50 per cent of all private company deals involve them?

Because they are the only way that acquirers can deliver an attractive price and still have adequate protection if the business declines after the acquisition.

You may not fancy an earn-out, but without one, you may not be able to sell your business.

So how do you ensure a successful earn-out?

If you're a vendor, define profit pedantically. Typically, the acquirer's accounting policies will be used to calculate the profit before tax on which the earn-out payments will be made. So vendors must calculate what effect this will have on their profits, and ensure that the profit targets for earn-out payments are set accordingly.

Pay rigorous attention to detail. It will help to maximise the earn-out payment. The acquirer may insist on providing certain services such as treasury and legal advice, internal audit, tax and pension administration.

This could make good sense for the vendors - and it should be cheaper - but I always insist that an annual lump sum is agreed at the outset to avoid nasty surprises later.

Equally, the acquirer may be able to provide warehousing, transportation, desk-top publishing and similar services, but charging rates must be agreed.

It should be possible to obtain a cheaper overdraft by using the rate negotiated by the acquirer with their bank. If the acquirer transfers out any cash in the current account every night and deposits it overnight in a group account, make sure the vendors will be credited with the notional interest.

In virtually every single earn-out there is a cap. If you're a vendor, your advisers must negotiate to make sure it does not fit too tightly: if you then deliver better profits than expected, you will still gain proper reward for your efforts.

And watch out for capital gains tax. If the earn-out payments are to be paid in cash - or the vendor has the right to choose cash - there is a real risk that the Inland Revenue will assess the potential capital gain and tax will have to be paid on it at the same time as you do the deal. Clearly, you will want to avoid this. Fortunately there is a simple solution.

Ask the acquirer to make the earn-out payable by a loan note, so that no tax arises until the loan note is surrendered for cash at the end of the earn-out period. To play safe, however, I always press for a bank guarantee to make sure the vendor can get the cash when it's due for payment.

Finally, there is the length of the earn-out period. Vendors normally want to receive their earn-out cash as soon as possible.

Two years should provide enough continuity and comfort for the acquirers. I like to negotiate service contracts for the vendors until about three months after the end of the earn-out period, so they are still employed in the business when the final accounts are prepared, which will determine the size of the earn-out cheque.

But I always negotiate the maximum payment at the time of the original deal, just in case the business declines post-acquisition.

First published in July 1998. You can read more of Barrie's wise advice in our fully searchable archive.