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Earnout agreements

Earnout agreements in M&A

June 7, 2022

2039

This article is written by Shubham Bhatnagar a student of 2nd year-3 year llb- Faculty of Law, DU pursuing a Diploma in M&A, Institutional Finance and Investment Laws. This article has been edited by Ojuswi (Associate Lawsikho).

This article has been published by Sneha Mahawar.

Table of Contents

Introduction

An earnout is a contingent value payment that is made typically by a buyer of a company to a seller of a company. It is a mechanism that is typically used to bridge value gaps that exist typically in M&A deals. The seller views that the future potential of the company could create a lot more value than the buyer is probably willing to pay today and the buyer also recognizes the future value potential of the company. Therefore, it is a kind of consideration that the buyer contractually binds itself to pay the seller based on future performance metrics of the business. It is a tool to bridge the valuation gap between buyers and sellers and is a commitment that a buyer makes to pay the seller based on future metrics.

Earnouts are an important device used in M&A Transactions to deal with future uncertainty in the performance of the acquired business. Earnouts are of importance to both parties in an M&A transaction, they are important to buyers because they mitigate the risk of uncertain business performance. They are important to sellers because they provide an opportunity to maximise the sale consideration a bit conditionally in this way earn-outs are the potential bridge between buyers and sellers.

The article shall be focusing on the pros and cons of earnouts, key taxation issues, regulatory issues, factors and benchmarks one should be mindful of while structuring earnouts and the impact of Covid on earnouts clauses in M&A transactions.

Pros and cons of earnouts

There are both advantages and disadvantages for buyer and seller in an earnout. It is a great tool to bridge expectation gaps on valuation. One of the big reasons for using earnouts is to bridge the gap between valuation arising out of high growth scenarios. In a business where the intellectual property resides with the management team or the founders, these become a way to retain them and keep them excited about the business and the growth. It helps in bridging the gap in management capability with the incoming founder team by integrating them effectively with the management team going forward.

From a seller’s perspective, no seller wants earnouts, they want all the money upfront if they are looking to capture the full value of the future potential of the business. This is why they are very reluctant to agree to earnouts and performance metrics, thereby making it a relatively long and arduous process. When a business tries to boost sales, they set up very large aggressive business plans about how bright the future is. However, earnouts as well as putting a value associated with the performance, result in reasonably long cycles of negotiations. An earnout makes post-acquisition operations more complex irrespective of integration strategy. Whether it is full integration, or, partial integration, or, standalone operations trying to agree on operating covenants and operating principles in the business for the future, it is a big challenge when substantive value is associated with future performance. People talk about control and their rights, and at the same time buyers that once invested significant capital into the business, also want control of that business. Thus, establishing a structure for earnouts that fits most of the requirements is essential.

Tax considerations

Key taxation issues one should be mindful of while structuring earnouts

In any structuring tax considerations play a pivotal role and structuring earnouts is no exception.

Taxation of earnouts in M&A is complex not just from a seller’s perspective who earns income and is therefore required to pay taxes on it but also from a buyer’s perspective who makes payments.

S.no	There are mainly 2 tax issues	FROM SELLER’S PERSPECTIVE	FROM BUYER’S PERSPECTIVE
1	Nature of earnouts	From a tax perspective is it additional capital gain income that the seller earns or is it just an employment linked incentive or performance-linked incentive that the seller earns and of course taxability would change substantially depending on how earnouts are viewed from tax perspective	How should the buyer be treating these payments in its hands? Is it an additional cost basis that the buyer gets in shares or is it just the sunk cost for the buyer?
2	When is it taxable	Is it taxable upfront when the shares are sold by the seller or is it taxable when the deferred payments are based on going earnouts is actually received by the seller? On this particular issue, there have been contradictory rulings as per one ruling the payments are taxable upfront and as per another ruling, the payments should be taxable in the year in which the seller is actually receiving them because the court appreciated the fact that these payments could be conditional and until those conditions are satisfied the seller cannot be considered as having earned that income.	If the share sale transaction is subject to withholding taxes, is the buyer required to withhold tax on the total consideration upfront plus deferred or just the upfront consideration?

Solution to the above-mentioned issues from buyer’s and seller’s perspective answered jointly

When looking at applicable tax provisions there are no specific provisions dealing with these tax issues. Therefore, there are these grey areas both for the seller as well as the buyer. For buyers, the issue is that there are no judicial precedents as of yet which clarify some of the aspects of issues. Given these tax issues and concerns, it makes sense to look at structures that could help mitigate these issues to some extent, which could essentially help to deal with earnouts based payments from the upfront share sale. Some of the examples of such a structure could be:

Where instead of selling all the shares upfront, the seller sells the shares in tranches and whatever is paid for a particular tranche is then taxable at the time when the tranche is sold and not at the time of the first upfront sale itself. From the buyer’s perspective as well, the structure should work better because it will have clarity concerning the buyer’s cost basis (is it an additional cost basis that the buyer gets in shares or is it just the sunk cost for the buyer), and whatever the buyer pays for a particular tranche, should be available to the buyers as cost basis and shares. The other structure could be, let’s say the seller sells all the shares upfront but subscribes to a new instrument, for instance, a redeemable preference share instrument in the company at the nominal consideration and then the deferred component is structured as part of the redemption premium on redemption of preference shares. This also helps to deal with earnout based payments from the upfront share sale.Another structure could be, let’s say earnout based payments are identified and recorded as employment linked incentives payable to the seller when parties report this income as salary income linked to the employment exercised by the seller, when these payments are offered to tax as salary income, of course, the tax rate will be higher because employment income is taxable as. Ordinary income at higher rates compared to capital gains income but still, this structure will have that clarity that the seller won’t have to go out of pocket to pay taxes without having earned that income and will be paying taxes only when there is clarity that seller is going to earn that income now when we track about structures of this nature, of course, there could be other nuances each structure may have even in terms of other tax issues, for example, taxation of redemption premium on preference shares is an issue in itself that needs a closer look and evaluation. Employment structure whether it makes sense to structure it as a consultancy instead of an employment model is also something that could be looked at in detail.

While there could be these nuances and even the legal aspects would need attention, broadly structures like this could help mitigate the tax issue for the seller where the seller won’t have to go out of pocket at the time of share sale upfront, where the subsequent payments may be uncertain but he will be paying taxes upfront without having the ability to recover those taxes later on.

There are 3 important related structuring elements for an exercise of this nature:

1. Substance
Given that tax laws have an anti-abuse regime now it’s important that whatever the structure is finalised and can pass muster under the general Anti-Abuse Rules.

2. Documentation
Whatever structure is finalised needs to be adequately and properly documented in the transaction documents because documents will be key in any defence proceeding before the tax authority.

3. Valuations
Share deals are required to satisfy certain tax specific valuation report requirements therefore those would also require attention.

However, a word of caution that there is no one-size-fits-all when it comes to structuring agreements an M&A earnout, what may work in one deal may not be appropriate in another and therefore optimum tax earns structure needs to be bespoke from the transaction every deal may have different commercial drivers, different requirements, different circumstances even the legal and other tax considerations may vary depending on those circumstances.

Regulatory issues

What are the regulatory issues that are relevant to structuring earnouts and how should they be dealt with.

Listed companies

Where we see fewer earnouts but there are SEBI norms that regulate incentives or upside sharing arrangements where board and shareholder approval of people who are not interested is required.

Sub-regulation (6) to Regulation 26 (which pertains to obligations with respect to directors and senior management) to provide on the following lines:

“No employee, including key managerial personnel, director or promoter of a listed entity shall enter into any agreement with any individual shareholder(s) or any other third party with regard to compensation or profit-sharing unless prior approval has been obtained from the Board as well as shareholders by way of an ordinary resolution”.

“Provided that all such existing agreements entered into prior to the date of notification and which may continue beyond such date shall be informed to the stock exchanges for public dissemination and approval obtained from shareholders by way of an ordinary resolution in the forthcoming general meeting. Provided further that in case approval from shareholders is not received, all such agreements shall be discontinued.”

Unlisted public companies

The Securities Contracts (Regulation) Act, 1956 also known as SCRA is an Act of the Parliament of India enacted to prevent undesirable exchanges in securities and to control the working of stock exchange in India

Where SCRA needs transactions to close on the date when the share is transferred to the next day, therefore, a purchase price cannot be deferred in a public company situation often it is ignored as normally people associate SCRA with listed companies but unlisted public companies are also governed by SCRA.

Private companies

The challenge is primarily when there is a non-resident shareholder and the challenge stems from the fact that the foreign exchange norms require that as a non-resident one cannot hold back more than 25% of the purchase price for a duration of 18 months from the date of signing of the agreement that leaves a non-resident who is looking to structure earnout perhaps arguably with not enough adequate time for an earnout to play out as generally it takes at least some a couple of years to do justice to the earnout construct.

Structuring of earnouts

So how do earnouts need to be structured in such a case?

Defer the purchase price along with the acquisition of shares so one acquires the shares in tranches. For instance, 75% in one and balance 25% when the earnout is payable although this has some issues since one does not get a clean break as a seller and as a buyer, they also don’t get full control and a shareholders’ agreement needs to be drafted which has its own challenges. Given these tax issues and concerns, it makes sense to look at structures which could help mitigate these issues to some extent, which could essentially help to deal with earnouts based payments from the upfront share sale and some of the examples of such structures could be challenging.
Employment model, where part of the earnout is paid through the employment or consultancy fee model and odds for transitional services agreement model that has some taxation ramifications which it was alluding to which needs to be born into mind.
Issue of non-voting security to the promoter who is sought to be paid the earnout amount. promoter subscribes to redeemable preference shares at a nominal amount.If the earnout thresholds are milestones are met the promoter will then be paid against the redemption of those renewable preference shares at a premium. There will be taxation consequences, which have to be taken into account.

However, the larger picture is that the regulatory hurdle of foreign exchange law is not insurmountable and like any other structure it has to be often a blended amalgamation of 3-to 4 models and not one size fits all approach which never works in life. For instance, when one goes to buy a car not all cars will have every feature oftentimes a mix of 2-3 options we have to go for same is restructuring where we have to be mindful of options that may be part of the money can be done to share within the foreign exchange law limited part of it through employment model, part of it through escrows.

Factors to be considered

Key factors that ought to be considered in organising an earnout in an M&A exchange

Organising an earnout is vital, as it includes how the business will run, who will have what sort of command over the business, and other key components. A blend of every one of these concludes what the organisation accomplishes concerning income, EBITDA, commitment from top clients, and so on, which thus chooses the pay-out for the dealer. The following are a couple of contemplations for organising earnouts:

Key executives

An organisation doesn’t develop in light of only one individual; it requires the work of a total group. Consequently, it turns out to be vital for the merchant to remember key chiefs for his/her arrangement, as they can be a distinct advantage to drive income and accomplish projected EBITDA edges.

Length of the Contract

The dealer dislikes to work for extremely lengthy as per the standards set somewhere around the new purchaser and might need to stay away from future contrasts. Remembering that, it definitely should keep the agreement time frame short and plan out the earnouts in that period as it were. In the case everything goes fine, then, at that point, the merchant and the purchaser can continuously restore the agreements and reconsider the terms of work.

Control

It’s out of line to cut the earnings of the vendor if an objective isn’t met while he doesn’t control the business. To keep away from such a circumstance, the purchaser and the merchant should settle on the strategy and the sort of control the vendor will practice post-securing. The vendor might wish to supervise the tasks, advertising, and different regions that can drive income and margins. If the acquirer maintains an aware separation and is by all accounts giving the control, it ought to be viewed as a decent sign.

Monetary Metrics

Common monetary measurements incorporate income, EBITDA, net income, and profit per share (EPS). Dealers like to put together the earnouts concerning income, which is hard for the purchaser to control yet simple to accomplish. There may likewise be a circumstance where the vendors of the business take up projects with low edges only for income. Remembering this, purchasers generally really like to accomplish a mix of income and edges for earnouts.

Innovation and administration organisations with high development potential are a portion of the organisations that are generally attached to earnouts in an M&A bargain.

One brilliant rule applies to earn-outs, and that is to keep it simple. The objective of any earn-out is to give motivation to the vendor to augment the deal cost by keeping up the company’s performance. The more intricate the earn-out formulae are, the more potential there is for disputes.

Benchmark

Benchmark to be considered while calculating earnouts

Earnouts typically emanate from uncertainty in target valuation, so to that extent what benchmarks are added depends and flows from what the target’s business is and the nature of the business that one is looking to acquire as a buyer.

In the case of private companies, it is a lot more difficult at times to structure and although less prevalent in listed companies where there is a significant amount of comprehensive financial disclosure in the public eye where there is market prevalent pricing etc. Therefore, earnouts are less prevalent and easier to structure to that extent regulatory aspects aside. Therefore, in the context of private companies ultimately one would have to focus on outcomes rather than milestones and it depends on the nature of business one is buying if it’s structured to multiple group companies versus a single.

Covid and earnouts

How has Covid impacted earnout clauses in M&A transactions?

During Covid, there arose a necessity of a risk mitigant tool, value mitigant tool like earnout has come to the forefront increasingly more deals are witnessing this during Covid times. Parties are not able to absolutely ascertain if the forecast which is laid out by the seller will be met or not because of Covid. Nobody could have anticipated such a devastating phase two which surpassed phase one and severely crippled many businesses not only their performance but how the market sentiments will go. For instance, will consumer goods have demands or will the demands plummet, and will the customers pay on time all of this needs to be tested because of that uncertainty so if the target’s fundamentals are good both parties are mature enough and being advised by sophisticated advisories instead of tanking their deal they can do an earnout model also earnout periods have become more protracted it’s not a one year quick 18 months window because that may not be good enough for riding over the tide of Covid 19 so people are going for slightly longer period 24 months or 36 months waiting for much of course what they are doing in the process is making staggered payments so it’s not all or nothing or everything to be paid at the back end they are releasing payments as certain milestones are hit let’s say after 12 months so that the seller is enthused and the earnout period doesn’t seem like an eternity for the seller.

Conclusion

Risk allotment

It designates the gamble impartially between the parties and in my view no negotiation is unbalanced, any exchange where one party leaves feeling excessively certain is truly not a fair exchange.Therefore, for a fair negotiation parties really must apportion the gamble similarly and earnouts make an astounding showing, particularly in the present day and age.

Watertight contractual provisions

Ironclad agreements are the key to carrying out the idea into a written codified document if the understanding is loosely worded, a generally excellent idea can go for a toss and parties could be entangled over the long-haul disputes and further decaying their relationships for eternity.

Expert legal, tax and accounting guidance ought to be taken to guarantee that the arrangements meet the regulatory necessities as well as are painstakingly thoroughly examined to safeguard the interest of executing parties. Each of the three stakeholders ought to work indispensably in a closely aligned manner to deliver an item that truly gets the parties over the line with a mutually beneficial arrangement to stay away from any equivocalness and limit any possible disputes.

References

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