Will sellers lose more than their liberty as a result of Covid-19?

Economic Impact
 
This raises serious problems for sellers who have recently sold a business.  Many business sales (particularly in people-based businesses such as those in the creative sector) are sold on the basis of an “earn-out” – a deal where part of the purchase price is deferred and paid out over a set period after completion.

Earn-out deals often run for three or four years and the deferred payments are usually based on the future financial performance of the business which has been sold.  Sometimes the performance tracks revenue each year (or perhaps the revenue growth rate), but more commonly it tracks the underlying profit of the business.

In ‘normal’ times earn-out deals can work well for both buyers and sellers.  The value of people-based businesses lies in the skills and talents of their workforce, and the business relationships those employees have built up with their clients.

Paying sellers over three or four years therefore allows buyers to prudently reflect the true value of this goodwill in the price paid and, in the process, retain and incentivise key seller-managers and smooth integration.  Sellers benefit as they are given the opportunity to “prove” the value of the business and get paid more for it (a buyer may otherwise discount for risk if asked to pay in full on completion).

But following the government’s recent announcements of stringent new measures to combat the pandemic, many sellers who are either part way through an earn-out deal (or who have perhaps recently signed one) may now be worried about losing more than just their liberty and contemplating the impact on their earn-out payments.

Earn-Out Performance

The first and obvious issue is financial performance. If the deal was based on a multiple of revenues or profits, then the business’ performance for this year will inevitably be hit hard.  It’s too early to say how badly the economy will be affected, but earn-out sellers are likely to face a significantly reduced payment for this year, or the prospect of nothing at all.

This affects both parties. Sellers facing a dramatically reduced payment (or worse, nothing) will be demotivated and disappointed.  They may therefore lack any real incentive to drive the business forward and create sustainable value for the buyer. In extreme circumstances, they may even contemplate resigning.

This may leave a buyer with an underperforming division or subsidiary and, if the seller-managers do leave early, this could have a destabilising effect, not just on the business it has acquired but perhaps throughout its group.

For sellers in this position, it may therefore be worth exploring with the buyer whether it is willing to re-negotiate.  Most share purchase agreements can only be varied in writing and so any change would need to be properly documented, but a buyer may be willing to listen for the reasons noted above.

Earn-out periods could perhaps be extended, excluding this year (or part of this year) from the relevant calculation, on the basis that the pandemic was an exceptional event.  Assuming the business can survive this year (with government assistance if necessary) it may be possible to trade back to (at least partial) strength next year, which would be in both parties’ long-term interests.

Tax Risks

That said, sellers should take professional advice if they are considering this approach as earn-outs are complex from a tax perspective.  Generally speaking, earn-outs (if structured correctly) are taxable as capital receipts, at capital gains tax rates of 10% or 20%.

However, any earn-out deal which does not appear to be a genuine payment for the shares sold, but rather a “bonus” scheme for employees, may be open to challenge by HMRC, with payments subject to income tax at much higher rates (at 40% for higher rate tax payers; and 45% for additional rate tax payers) and additional national insurance costs for both the individual and their employer.  Re-negotiated earn-outs which are primarily motivated by the buyer’s desire to “re-incentivise” the management will be particularly vulnerable.

Although less tax-efficient, a bonus scheme could still be an option though.  If a buyer is unwilling to re-negotiate the original deal, a bonus scheme could be put in place (perhaps just for this year) to mitigate the loss of some or all of the earn-out payment, thereby restoring some motivation for seller-managers.   Some buyers may even see it as critical that seller-managers stay on, at least for the year, to preserve as much as possible of the value of their investment.

Buyer Cash Flow

Finally, there may be some sellers whose most recent (or even last) earn-out period ended on 31 December 2019 and whose business performed well, hitting or perhaps even exceeding its targets.
This may also present problems as buyers may be experiencing their own Covid-19 related issues.  They may have cash flow difficulties and be unable to pay on time (the typical time-frame to agree an earn-out payment is often three or four months from the end of the relevant accounting period).

If so, once again, it may be best for a seller to attempt to negotiate.  If a buyer simply cannot pay on time, then litigating for breach of contract is unlikely to be a sensible commercial move and very unlikely to lead to a fast resolution.  Rather, it is likely to be preferable to try and agree a short extension of time.

If a cash payment is genuinely not an option for the buyer in this current climate, then sellers may be able to consider alternative forms of consideration, such as interest-bearing loan notes or shares in the buyer.  However, both will carry further risk given the economic uncertainty and professional advice should be sought on the implications (and in particular the tax implications) before agreeing to any change to the original deal.

Contact

If you are part way through an earn-out deal (or have recently signed one, or are contemplating one) and would like to discuss any of the issues raised in this article, then please contact any of the authors or your usual Lewis Silkin contact.