The purchase price, including how and when that purchase price will be paid, is arguably the most fundamental term of any business sale agreement. Even where there is a keen purchaser and an eager vendor, the parties can often reach a roadblock when trying to reach an agreement. While a purchaser, especially one with limited financial backing, will obviously want to value the asset or business being acquired as low as possible, a vendor will, understandably, want to get as much of a return as possible on their disposal, especially in a situation where the vendor has invested their entire life into building up the goodwill of that business.
One way of reconciling the expectations of both vendor and purchaser is to provide for a form of contingent consideration or ‘earn-out’ within the purchase contract, be it an asset purchase agreement where assets such as a business contracts or plant and machinery are being acquired, or a share purchase agreement where shares in a company are being acquired. Such a clause will commonly provide for a lump sum payment on completion, with provision for additional payments to the vendor on the occurrence of a certain event (for example, if the company’s product begins to sell in another country) or where the business meets or exceeds certain agreed post-closing targets (for example, if the turnover of the company in the next financial year exceeds a certain level).
The inclusion of an earn-out clause can potentially benefit both parties to the contract. The purchaser can benefit from a cash flow point of view (as well as by keeping the services and know-how of the vendor for a period after the purchase is completed where this is desired). The vendor can benefit by making his business a more commercially attractive prospect for possible purchasers as well as increasing the likelihood that he will get a higher price in the long run for the sale of his business.
ADVANTAGES TO A PURCHASER
One clear benefit of a contingent consideration arrangement for the purchaser is that they will not be required to raise as much financing at the outset – this is undoubtedly beneficial where the purchaser is facing difficulties raising the required funding. A further benefit to the purchaser is the possibility of financing the deferred element of the consideration out of the company’s future profits.
By providing for contingent consideration in a purchase agreement, the buyer can limit the risk of paying too much for the company. A carefully drafted clause can provide a more accurate mechanism for valuing the target company based on several factors over a period of time.
With any company, be it an up-and-coming company which hasn’t posted strong profits, an established company which is struggling in the current environment or even a well-known successful enterprise, an earn-out clause can be particularly useful for the purchaser where the vendor is himself a valuable business asset. If, for example, future consideration is dependent on turnover, the vendor will be more likely to remain as an employee of the company allowing the purchaser to benefit from the seller’s knowledge and experience. The continued involvement of a vendor who is himself a key asset of the company can help ensure continuity of key contracts (which may include a change of control clause) while enabling the purchaser to familiarise themselves with how the business is run. It is possible that an earn-out can help tie the seller to the target company by providing that he will become dis-entitled to any future contingent consideration payments should they cease to be employed by the target company.
One further advantage to a purchaser is that a well drafted earn-out clause can allow for a right of set-off if any unknown liabilities arise post-closing which the purchaser had not accounted for.
ADVANTAGES TO A VENDOR
While there may be a delay in receiving all of the consideration with an earn-out structure in place, there is the potential for the vendor to earn significantly more consideration than would otherwise have been payable if the parties were forced to agree a once off payment at the outset.
By accepting an element of deferred consideration, a vendor may be able to sell a business that would otherwise be unsellable where that vendor is unable to agree a business valuation with potential purchasers or where purchasers are unable to raise sufficient finance.
A potential risk to the vendor is that the purchaser may do something which will adversely affect the turnover of the business. For example, the purchaser may terminate key contracts in a conscious attempt to keep profits down so as to avoid paying any additional consideration over and above what was paid upon the signing of contracts. It is possible however to incorporate protections for the benefit of the vendor providing for legal redress against the purchaser where that purchaser breaches covenants in relation to the way the company is run from the date of completion.
It is often the case that the buyer will be able to continue working with the company and can play an active role in the company maximising its potential thus increasing the likelihood of him benefiting from the deferred element of the consideration. The company’s potential may be maximised even further due to the economies of scale or strategic alliances which may arise as a result of having the purchaser on board, especially if that purchaser is already in the same marketplace.
CALCULATION OF THE CONTINGENT CONSIDERATION
Clear and simple works best when it comes to drafting an earn-out clause. Any uncertainty or ambiguity in terms of how the consideration will be calculated can often lead to costly litigation – a cost which both parties will want to avoid.
The value of the deferred consideration can be dependent on as many or as few financial or non-financial variables as the vendor and purchaser may agree, for example, turnover, number of sales, net profit, EBITDA (earnings before interest, taxes, depreciation, and amortization) or the occurrence of a specific event such as the company subsequently being sold, or there being additional investment in the company from a third party. However, both parties should be certain at the outset how exactly these performance milestones will be measured and should agree the specific accounting principles to be employed when calculating the deferred element of the consideration. Both parties may also want to give consideration as to whether a lower or upper limit should be set for an earn-out.
Where accounting mechanisms or variables cannot be agreed between the parties, the business sale agreement or share purchase agreement (as the case may be) can provide for an independent third party to provide an expert valuation in relation to the consideration to be paid.
By the very nature of ‘contingent’ consideration, there is no guarantee that it will ever become payable as it will be conditional upon the occurrence of a future event. While expert tax advice should be sought by each party in relation to their specific tax liabilities, it is clear that the tax treatment of contingent consideration can depend on the way in which the clause is drafted.
Where there is a specified cap on the amount of contingent consideration that may become payable, or where the consideration is simply paid in instalments over a certain period of time, section 563(1)(a) of the Taxes Consolidation Act, 1997 (“TCA”) provides that the vendor will be subject to CGT on the maximum amount of consideration payable notwithstanding the fact that receipt of the consideration is entirely dependent on some future event which is not guaranteed, or the fact that part of the consideration may prove irrecoverable. Furthermore, no discount is permitted to reflect the delay in receiving the proceeds. If any part of the proceeds proves irrecoverable on a later date, the GCT can be re-calculated and a refund can be sought from the Revenue Commissioners, if appropriate.
For example, if the consideration clause of a share purchase agreement is drafted in such a way that a price of €500,000 will be payable for the entire issued share capital of a company, in five equal instalments over 5 years, the vendor must calculate their CGT liability as if they received the entire €500,000 on day one. This may potentially mean that a very significant portion of their cheque in year 1 will go straight to Revenue. A similar CGT calculation will arise where the consideration clause is drafted in such a way that €300,000 is payable on closing plus a certain percentage of all net profits in the subsequent two years, up to a maximum of €200,000 i.e. your gain for GCT purposes will be calculated as if you were paid €500,000 up front. Where however the company makes a loss in the next two years, the vendor can seek to adjust their CGT computation and may apply to Revenue for a refund of CGT paid.
Where the clause is drafted in such a way that the value of the earn-out or contingent element of the consideration is not ascertainable, the tax treatment will differ to that outlined above. Current Revenue practice in these circumstances is to apply the principle in the UK case of Marren v Ingles (even though that case hasn’t been challenged in the Irish Courts). Accordingly, section 563(1)(a) of the TCA will not apply. Instead, a valuation is placed on the value of the earn-out i.e. a value is placed on what a third party would pay for the right to be the beneficiary of the contingent element of the consideration on a future date, taking into account the risk that it might never become payable. This is then treated as a separate asset for CGT purposes. A CGT liability will initially arise on disposal of the assets or shares (as the case may be) with the sales proceeds being the up-front consideration paid plus the value placed on the earn-out. A second charge to CGT will then arise when the contingent consideration is paid with the base cost of that ‘asset’ being the value placed on the earn-out at the time of the sale.
In the Marren v Ingles case, the taxpayers sold shares in consideration of a lump sum upon signing the contract plus the right to receive an additional amount if the shares were quoted on a stock exchange. On flotation, the additional amounts were paid and the taxpayers were taxed on the basis that the right to receive the sum was an asset which had been acquired at the date of sale of the shares and disposed of on receipt of the payment. The House of Lords agreed that this was the correct approach to take. Their rationale was that an ‘asset’ when defined in the widest terms, includes all forms of property including an incorporeal right to money. The House of Lords stated that it would be possible for the vendor to dispose of the right to receive the money at any time by selling it or giving it away and if they had done so, there would have been an actual disposal of an asset and the vendors would have been liable for CGT. Although in this case they did not dispose of the asset, they did hold it until it matured and, if the right is considered an asset, then the sum which the vendors received on that date was derived from that asset. The sum was paid to satisfy or extinguish the right to receive a future sum and not as any part of the consideration for the shares.
An example of how this principle may arise in practice may be where a purchaser agrees to pay a lump sum of €300,000 plus a further payment which will be related to the level of investment, if any, that a company attracts from a third party. Similarly, the clause may be drafted in such a way that a lump sum of €300,000 is paid on closing, plus a certain percentage of future profits without limitation. In both cases, the initial CGT liability will be calculated based on sales proceeds of €300,000 plus the value placed on the earn-out at the time of closing. This will often require an expert valuation. If the company does attract further investment, or if the company makes a profit, additional CGT may become payable depending on the valuation placed on the earn-out at the time of closing. If not, an entitlement to a refund of CGT which has been overpaid may arise for the vendor.
As can be seen, the Marren v Ingles principle can ease the burden on the vendor to pay tax before actually receiving all of the consideration. However, it can also result in an increase in tax liability where the rate of CGT increases between closing and the date on which the contingent element of the consideration becomes payable.
A potential benefit of the Marren v Ingles principle may arise for non-resident and non-ordinarily resident vendors who are normally only liable to CGT in respect of the disposal of ‘specified assets’ in Ireland (such as land, assets used for the purposes of a trade, or shares in a company deriving a greater part of their value from property or mineral rights in the State). It is possible that the Marren v Ingles principle may exempt that vendor from any gain arising on the ‘second’ (deemed) disposal of the earn-out. It is likely however that such a vendor will remain within the CGT net in relation to the ‘first’ disposal of the specified asset. For example, say a USA resident vendor sells shares in an Irish based company in consideration of €200,000 which is payable now plus a certain percentage of future sales proceeds if that Irish based company is sold again in the next 2 years. Applying the Marren v Ingles logic, that vendor will make 2 ‘disposals’ for CGT purposes (assuming the company is in fact sold within the next 2 years). The first disposal will be the disposal of the shares which is a disposal of a ‘specified asset’ for CGT purposes and so CGT will be payable. The second disposal is the disposal of the right to possibly receive the future consideration. This will not fall within the definition of specified asset for CGT purposes and so it is arguable that CGT should not be paid on this second disposal.
One final consideration that a vendor may want to bear in mind from a CGT point of view are the CGT compliance dates i.e. when must the CGT be paid? Current rules state that where a disposal takes place between 1 January and 30 November, the CGT must be paid to Revenue on or before the 15 December of that same year. Where the disposal takes place between the 1 December and 31 December, the CGT must be paid on or before 31 January of the following year. The date of disposal is considered to be the date on which an unconditional contract is entered into (and not the date on which the consideration is paid), even though the proceeds of the sale may not be paid until a much later date. Revenue has confirmed that the deadlines will be strictly enforced. They have stated that ‘delays in closing contracts for whatever reason cannot be put forward as a basis for not paying Capital Gains Tax on time. Any such late payment is subject to the statutory interest charge’. It is clear that Revenue’s strict approach in this regard has the potential to cause hardship. For example, where a contract is entered into on 30 November the due date for payment of CGT will be 15 December, irrespective of when the sales proceeds are received by the vendor. This will be particularly burdensome for a vendor who is not in a position to borrow money and who may have no choice but to pay the CGT late and incur interest charges for late payment.
The TCA does however provide for an exception to the above which a vendor may wish to consider before selling their business. Section 981 of the TCA provides that where the consideration is payable in instalments over a period of 18 months or more then, if the vendor satisfies Revenue that they would otherwise suffer undue hardship, Revenue may permit that vendor to pay the CGT in instalments over a period of up to 5 years, or the date of receipt of the final instalment (whichever is the shorter). Although it is generally the case in practice that in applying section 981 Revenue will charge interest on the tax not paid by the due date, the ability to pay by instalments may be of benefit to the vendor from a cash flow point of view.
From the point of view of the purchaser, the Stamp Duties Consolidation Act, 1999 provides that where the total consideration payable in relation to the acquisition of assets or shares cannot be ascertained on the date of execution of the transfer instrument, the stamp duty payable shall be calculated based on the market value of the asset being transferred. This may require the purchaser having a professional valuation carried out in relation to the acquired property and paying stamp duty based on that valuation. This professional valuation may bear no resemblance whatsoever to the value of the contingent consideration to be paid.
For example, imagine a purchaser offers to buy the entire issued share capital of a company, ABC Ltd. ABC Ltd. has traded successfully for a number of years under the management of the vendor (who also owns all of the issued shares). The consideration to be paid for the shares is to be based on the performance of the company over the next 5 years, during which time the vendor will remain on as manager. Stamp duty will be paid on the market value of the shares being transferred even though only a fraction of this amount may in fact be paid to the vendor over the next 5 years.
Alternatively, the purchaser may consider making an application to Revenue to stamp the transfer instrument based on the initial cash paid on completion and request the Revenue’s consent to have the transfer instrument re-submitted for additional stamping once the actual value of the contingent element of the consideration has been ascertained. Such consent will be entirely at the discretion of the Revenue Commissioners. A further consideration in this regard may be that the actual contingent consideration earned may be significantly more than anticipated which would operate to increase the stamp duty liability of the purchaser. Additionally, the Revenue may decide not to issue a stamp duty certificate until such time as the final consideration has been ascertained in which case the purchaser of shares in a company will not be able to update the share register of their newly acquired business. Where the business is being acquired by way of asset purchase, the purchaser will have a problem if they try to sell the assets in future if Revenue has not issued their stamp duty certificate.
The provision of some form of contingent consideration is often seen as the most practical way of valuing a business as the purchaser is able to pay a conservative price based on the historical performance of the company, while simultaneously allowing flexibility so that if the company meets or exceeds the forecasts of the vendor in terms of, for example, future profits, the deferred element of the consideration can reflect this.
An earn-out period may run from a number of months to a number of years and may include several earn-out payments at different stages during that time. Due to the uncertainty of contingent consideration, there is a possibility that the purchaser may be incapable or unwilling to pay the contingent element of the consideration which may give rise to litigation. Disputes in the context of contingent consideration payments are most common where one or both parties fail to consider the many variables that can have an impact of the amount and method of payment of the consideration. A detailed and carefully drafted share/asset purchase agreement or business sale agreement can minimise the risk of this occurring.
The advantages and disadvantages of deferred consideration should be considered carefully when negotiating the sale or acquisition of a business and may not be appropriate in all cases. Where an element of deferred consideration is suitable however, good professional advice and a carefully drafted share/asset purchase agreement can accurately reflect all of the relevant complex legal and commercial considerations to provide an appropriate mechanism that meets the expectations of both vendor and purchaser.
The above is a very general and simplified summary of the law on the subject matter. As such you should obtain professional advice before taking any actions as regards you or your company’s affairs. Should you wish to make enquiries in relation to any of the areas touched on by this article please contact Adrian Burke & Associates.