Securities Options: earn-outs: what are they?
An ‘earn-out’ will often occur when a business is sold and there is difficulty in agreeing a value fair to both vendor and purchaser. In such circumstances, an earn-out represents part of the consideration for the purchase of the business, being that part which, following negotiations between the parties, is unascertainable. Typically, the vendor will receive a cash sum, or an initial issue of securities, plus an “earn-out” consisting of one or more of the following:
- a right to receive an amount of deferred cash consideration dependent on the performance of the newly-acquired business over a defined period following the purchase, payable at the end of the period or at various stages during the period, or
- a right to receive loan notes (issued by the purchaser) after a certain period has elapsed and dependent on the performance of the newly-acquired business. The loan notes would be redeemable after a certain period or periods, or
- a right to receive securities in the purchaser or its parent company after a certain period has elapsed and dependent on the performance of the newly-acquired business. These may or may not have restrictions placed on them.
Earn-outs could also be constructed using:
- restricted (forfeitable) securities (shares or loan notes) issued by the purchaser and which vest after certain performance targets have been reached, or
- convertible securities, issued by the purchaser and which convert into a more valuable security after certain performance targets have been reached.
Where the earn-out arrangements do not involve the acquisition of securities or securities options, the application of the general earnings legislation in Part 2 of ITEPA will normally need to be considered rather than Part 7.