Here at Claritas, we often see Earn-Out provisions incorporated into M&A transactions. Transactions normally involve initial upfront cash, and/or equity, and deferred consideration.
The deferred element of the consideration may be quantified at a later date, typically using a formula based on two to three years’ post-acquisition revenue or profits. These arrangements are known as ‘earn-outs’ and are popular because they benefit both parties: The seller has the potential to guarantee and maximise their sale price post-transaction, and the buyer can lock in the seller to help ease the merger process and protect themselves against a downturn in results.
Further detail regarding the tax treatment of Earn-Outs can be found on our website, here. The focus of this article is, therefore, not to repeat the tax considerations, but to focus on the valuation exercise that is required where an earn-out forms part of the consideration in a transaction.
Purpose of valuation
The main reason for preparing a valuation of the Earn-Out is to establish a value for Capital Gains Tax (“CGT”) purposes. The disposal of the business is reportable to HMRC via the individual’s self-assessment tax return. The valuation of an Earn-Out is required where it represents unascertainable consideration (explained in the link above). The value of this separable Earn-Out asset, i.e. the right to receive future payments, will form part of the sales proceeds on completion of the sale.
The consequence of mis-valuing an earn-out is likely to be an under or overpaid CGT liability. If HMRC were determined that the mis-valuing of the earn-out was done carelessly or deliberately, then penalties and interest could be applied to the underpaid CGT.
How is an Earn-Out valued for CGT purposes?
Earn-Out mechanisms are normally a function of the revenues or profits in one or more post-completion periods. Therefore, a typical approach to valuing an Earn-Out will require an analysis of the budgets and forecasts for the expected future financial performance of the business post-sale and how this would translate into payments under the Earn-Out equation in the SPA.
The future revenues or profits are then discounted to reflect the likelihood of achieving those targets, taking into account the wider macro and micro industry/business-specific economic factors that could impact the business’ ability to achieve those targets.
Forecasts are, by definition, subjective in their nature, therefore, discounts will need to be discussed with the business owners/stakeholders as they are likely to have an accurate picture of any future changes that could impact the business.
The tax basis of the valuation
The valuation is determined in accordance with Part 8 Taxation of Chargeable Gains Act 1992 (“TCGA 1992”). S.272 (1) of that Act specifies that ‘market value’ is the price that a security might reasonably be expected to fetch on a sale in the open market.
There is a substantial amount of case law regarding tax valuations, which has led to a number of assumptions, including (but not limited to):
- The sale is hypothetical;
- The seller is a hypothetical, prudent and willing party to the transaction;
- The buyer is a hypothetical, prudent and willing party to the transaction (unless considered a ‘special purchaser’);
In order to carry out the valuation financial information needs to be readily available including the vendor’s financial statements up to the date of the transaction and any forecasts.
Clearly, it is important that when an Earn-out valuation is required as part of a transaction, the valuation is carried out by experienced advisors who understand the tax legislation and relevant case law.
Valuation approach
As referred to above, Earn-Out valuations are typically based on future turnover or profits. Once the forecast figures have been calculated, high, medium, and low cases are established through the application of discounts. These discounts are arrived at through valuation experience and discussions with the sellers, and then either the high, medium or law cases are included in the valuation.
The Earn-Out mechanism can vary from one deal to another, typically these deferred consideration payments are made in tranches over several years, which means inflation will need to be taken into account.
The impact of inflation on the Earn-Out valuation is also known as net present value (“NPV”) calculation, whereby each of the deferred consideration payments is reduced by the expected UK inflation rate at the time the installments are to be made. Details of the instalments are usually set out in the share purchase agreement (“SPA”) or, in a transaction where no company is involved, the detail can be found in the asset purchase agreement (“APA”).
Final thoughts
Earn-out valuations are becoming increasingly relevant in the world of M&A. It is important that Earn-outs are identified as early as possible in the transaction process so seeking formal advice is critical, otherwise, an unexpected tax liability could significantly impact a vendor’s net cash position further down the line.
Disclaimer
The matters covered in this article should not be taken as providing formal advice as each matter should be considered on its on facts. The matters set out in this article are for general awareness only.
