When you sell the shares in your business or buy shares in another business the return, or in legal terms the “consideration” that you receive (or if you are the buyer, the price that you pay) for the shares is most likely to be in the form of cash. Indeed, for most sellers and buyers of a business, the preferred consideration is cash. It’s simple and it avoids the uncertainties and risks associated with other forms of consideration. As the saying goes, ‘cash is king’.
However, there may be reasons why a purchase purely for cash (payable either in a lump sum at completion or in instalments at specified dates post completion) may not be possible. The buyer may not want to put the option of cash on the table, for example, because the value of the business cannot be agreed or because the buyer does not have the funds in cash available. Alternatively, the seller may not want cash.
Other than cash, the consideration on a share sale and purchase may include the following or, indeed, a combination of the following:
- 1.Earn outs;
- 2.Share for share exchanges; and
- 3.Loan notes.
In this briefing we consider the advantages and disadvantages of each of these forms of consideration on a share sale and purchase and the commercial and legal issues that are associated with each.
What is an Earn Out?
Earn outs work on the basis that all or, more typically, a portion of the sale price is deferred for a specified period with the amount payable being dependent on how the sold business performs post sale. This period is typically 12 months to 3 years post completion although we have seen shorter or longer earnouts in the market.
Why Use An Earn Out?
An earn out might be the preferred approach for the seller or the buyer. Typical reasons might include:
- The seller thinks the buyer is not giving enough value for the future prospects of the sold business or conversely the buyer thinks the seller is being too bullish about the future prospects of the sold business;
- the seller perceives there is upside to future earnings in being part of the buyer group (perhaps due to economy of scale or other synergies or expertise);
- it helps the buyer to manage its cash flow and may reduce the need to borrow money to finance the purchase; or
- the buyer wishes to motivate any retained sold business management team to maximise the value of the business post sale.
What are the Drawbacks of an Earn Out?
Drawbacks of an earn out include the following:
- The buyer will usually be constrained by post sale undertakings given to the seller to protect its earn out and the seller may retain interest in (and perhaps management of) the sold business i.e., it is not a clean break for either party;
- during the earn out period, the seller is exposed to the credit risk of the buyer;
- calculation of the earn out payments and post completion buyer undertakings increase the risk of disputes between the parties;
- events or fluctuations may happen that the parties have not provided for in the sale and purchase agreement that can result in the earn out being larger or smaller than the parties envisaged when they originally entered into the sale and purchase agreement;
- the business sale transaction costs are likely to be higher and the transaction is likely to take longer to achieve as the earn out provisions will likely result in significant negotiations involving not just the business teams and their legal advisers but also each party’s accountants, financial and tax advisors;
- post completion, the earn out will require actions to be carried out and determinations to be made; this can absorb significant amounts of management time and result in significant external costs for accounting and other advice; and
- there is an inherent conflict between a seller trying to maximise short term performance and a buyer trying to maximise longer term performance.
What Targets Determine the Earn Out?
The proportion that is deferred will depend on what has been agreed between the parties and the payment of the deferred consideration can be triggered by different targets such as:
- Operational – for example, based on customer or sales numbers;
- Financial – for example, based on turnover, profit, EBITDA or other financial performance targets; or
- Event based – for example, obtaining a particular licence or patent filing or expanding operations into a particular geography.
What to Cover in the Sale and Purchase Agreement?
Irrespective of what triggers the earn out payment, what is crucial is that both sides are clear as to when the payment is triggered and for the calculation of any payment to be as objective as possible so as to minimise the risk of disputes later. In addition, the sale and purchase agreement should build in protections for the seller so that the buyer is not able to operate the business post sale to reduce the value of the earn out.
Earn out provisions vary considerably to reflect the particulars of the transaction but common areas that should be considered when drafting earn out provisions include:
- How is the earn out payment calculated;
- is the payment to be made in cash or other forms of consideration (for example, loan notes or the issue of shares);
- how is performance measured against the earn out targets? For example;
- who will calculate the earn out;
- for financial targets what accounts are to be used;
- who will prepare the calculations (usually it is the buyer) and it is clear to both sides how those will be drawn up;
- what principles and policies are to be used; and
- can the party who is not making the calculation (usually the seller) review the calculations and what access to information will they be given?
- is the payment a fixed amount or is it based on a percentage or multiple of another amount?
- is it payable in one lump sum or is it multiple payments? When are payments due;
- how long can the determination of the earn out payment take and once determined when must payment be made;
- when is the earn out calculation to be made;
- is there a cap on the earn out or a minimum amount;
- will the payment be accelerated in any circumstances? Typically, these would include the sold business (or a substantial part of its assets) being sold, the buyer or the sold business going insolvent or breach of any post-completion undertakings given by the buyer relating to how the sold business will be operated post-sale;
- where the earn out is paid in several tranches each dependent on targets being met, can the seller accelerate payment if the targets are achieved earlier or catch up if a target is missed but achieved late;
- what undertakings are required from the buyer during the earn out period to preserve the value of the earn out post completion? Undertakings might include:
- carry on the sold business in the ordinary course and not to materially change the scope of the business or to amalgamate it with the buyer’s business;
- support the sold business to facilitate the earn out being achieved/maximised;
- conduct the sold business on arm’s length terms;
- not to divert business from the sold business to other parts of the buyer’s group;
- the buying group will not compete with the sold business;
- share the financial books and records of the sold business with the seller;
- veto rights for the seller in relation to major decisions affecting the sold business such as settling major litigation, changes to the level of gearing;
- not to sell or grant security over the sold business or a material part of it;
- not to wind up the sold business;
- not to take any action where the purpose is to avoid or reduce the value of the earn out; and
- other miscellaneous provisions to retain certain staff (such as the existing management team), to restrict capital expenditure and to maintain a certain level of working capital.
- during the earn out period what matters will require the seller’s consent? For example:
- changes to the business plan;
- borrowings outside the ordinary course of business;
- taking out specified loans;
- giving of guarantees;
- significant capital expenditure;
- post completion acquisitions;
- changes to the terms of employment of key staff; and
- declaring dividends.
- who will resolve disputes and how? Typically, disputes relating to the earn out are referred to an independent expert and the scope of their appointment is set out in the sale and purchase agreement. The sale and purchase agreement should also specify the time frame for dispute resolution, costs and the right to challenge any determination by the expert;
- what is the financial status of the buyer? Depending on the answer to this question, a well-advised seller may seek security for the earn out payment obligations of the buyer through either an escrow arrangement, a third party or parent company guarantee or a charge over the assets of the buyer or the sold business;
- is it appropriate to allow the buyer to set off amounts it owes to the seller in relation to the earn out against amounts owning to the buyer from the seller (such as under indemnities, any tax covenant or warranty claims);
- whether there are acceleration rights which allow: (i) the buyer to exercise a buyout option by paying out a specified sum instead of waiting until the end of the earn out period (this can be useful if, for example, the buyer wishes to sell the business prior to the end of the earn out period); or (ii) the seller to require early payment of the earn out amounts in specified circumstances (for example, if the buyer breaches the post completion undertakings, the buyer becomes insolvent, change of control of the buyer, termination of the employment of retained seller management).
2.Share for Share Exchange
What is a Share for Share Exchange?
Another form of consideration for the sold business is the issue by the buyer of its share capital in return for the transfer to it of the shares in the sold business. This note assumes that the buyer is a private limited company as there are additional considerations if the buyer is a public limited company.
Why Use a Share for Share Exchange?
Offering shares in its share capital to a seller is attractive to a buyer in the following scenarios:
- the buyer does not have cash on hand or is not able to raise cash from existing shareholders or through loans;
- to incentivise seller managers if they are to be retained to run the sold business; and
- to avail itself of other advantages such as merger relief under the Companies Act 2006.
When considering whether a share for share exchange is appropriate, a seller should consider the following matters:
- where the consideration shares amount only to a minority stake in the buyer, what protections does the seller have and absent adequate protections what protections does it wish to build into a shareholders’ agreement or through amending the articles of association? Protections might include veto rights, tag along rights, non-dilution provisions and right to appoint a director;
- how liquid are the consideration shares? If there is no ready market for the consideration shares, does the seller wish to include put or call options to allow it to exit;
- if the buyer’s capital is divided into different classes of shares, what are the rights attaching to the consideration shares? For example, what rights to vote and receive dividends attach to the consideration shares;
- does the seller require tax clearances to be obtained prior to completion to ensure it obtains the tax treatment it expects;
- does the seller have the resources to fund its transaction costs (for example, capital tax liabilities that crystallise on completion);
- does the buyer have the authority to allot the shares;
- what shareholder approvals does the buyer need? For example, are there any restrictions on the issue by the buyer of shares in its share capital in its articles of association or any shareholders agreement; and
- are the consideration shares subject to pre-emption rights?
What is a Loan Note?
A loan note is a type of financial instrument issued by an issuer (the buyer) to a noteholder (the seller) under which the issuer promises to pay a certain amount to the noteholder; it is evidence of a debt the terms of which are agreed between the issuer and the noteholder. It is effectively an ‘I owe you’ from the buyer to the seller.
Why Use Loan Notes?
A seller may prefer to receive loan notes as opposed to shares in the buyer for many reasons including:
- The value of the loan note does not alter with the fortunes of the buyer as it is a fixed amount. This does of course mean that the seller does not get to participate in any increase in value of the buyer;
- loan notes usually have a fixed date for repayment so the seller has certainty as to when its exit will complete;
- loan notes do not have the same issues with liquidity as shares in a private company; and
- As a noteholder, the seller is a creditor of the buyer which usually means it ranks ahead of shareholders in the event of an insolvency event affecting the buyer.
What to Cover in a Loan Note?
When agreeing the terms of the loan note, the following areas, amongst others, should be considered:
- What rate of interest will apply to the loan note and how often will it be paid;
- when will the loan note be repaid? Can repayment be accelerated in certain circumstances such as an insolvency event involving the buyer;
- Is the seller restricted in transferring the loan note;
- will there be any restrictions on the buyer issuing other loan notes/indebtedness especially if that debt will rank ahead of the seller’s loan note or is otherwise secured;
- how does the loan note rank against existing debt of the buyer; and
- can the loan notes be converted into shares of the buyer? If so, what are the terms of the conversion; and
- Is repayment of the loan note secured or guaranteed in any way?
Other Issues to Consider with loan notes.
Other issues to consider with loan notes include:
- Is the buyer able under it articles of association or shareholders’ agreement to issue the loan notes;
- does the buyer need shareholder consent to issue the loan notes;
- if the loan note is convertible into shares, authority to allot the buyer shares will be needed under the Companies Act 2006 and pre-emption rights may need to be disapplied; and
- Is the buyer restricted by any third-party funding from issuing the loan notes?
4.The Need for Tax Advice
The different forms of consideration set out in this note will have different tax implications (both in terms of amount of taxation and when it is due) for both the buyer and the seller. In order to optimise value and to manage cash flow, it is therefore important for tax advice to be taken when structuring the sale and the way in which the consideration will be paid.
Through the use of earn outs, share for share exchanges and loan notes (or a combination of all three) sellers and buyers of businesses are able to structure the consideration payable by the buyer for a business in a way that allows them to optimise their commercial needs and constraints.
However, once an element of non-cash consideration is introduced, the complexity increases exponentially. The matters which both sides will need to consider in structuring non-cash consideration are numerous and require both parties to anticipate what might happen in the future. Such crystal ball gazing becomes inherently more difficult where the consideration is not payable for a significant period of time. For some parties what is seemingly commercially straightforward becomes incredibly complex once the specialist advisers (who will all need to spend significant time (and therefore expense) documenting the deal) are involved. For this reason, early engagement of the right legal, tax and accountancy teams is advised (before the point of no return is reached at a commercial level) in order to structure the consideration in a way which meets the commercial needs of both parties whilst trying to mitigate complexity and risk.
Garfield Smith Solicitors has experience of working collaboratively on these types of transactions (both in the UK and cross-border) not only on the legal side but, using its contacts, by bringing to bear cost efficient and timely advice from accountants, tax and other business advisers. Please get in touch if you would like to discuss your plans.
12 May 2023