Corporate Growth & Ventures Series: Earn-Out and Reverse Earn-Out Provisions

Unlocking value and Realizing Tax Benefits in M&A deals through the use of Earn-Out and Reverse Earn-Out Provisions

In private middle-market mergers and acquisitions (“M&A”) transactions, earn-out clauses within purchase agreements or earn-out agreements are often used to facilitate the sale of a business when the vendor and the purchaser wish to close the valuation gap of the target on closing. While earn-outs are a common mechanism within M&A transactions, tax considerations are causing reverse earn-outs to become increasingly prevalent in Canada in favour of conventional earn-out clauses.

Earn-Outs

Under an earn-out provision, a portion of the business’s sale price is calculated with reference to stipulated performance metrics over a period of time after the sale is completed. The amount received by the vendor will depend on the performance of the company in the agreed-upon metrics. For example, if a target company fails to achieve the required target or milestone, the vendor may not receive any additional payments, while if the company exceeds the target the vendor may receive more payment than initially expected. Purchasers would generally wish to increase the size of the earn-out to reduce the uncertainties of the target’s valuation on closing, while vendors would wish to keep the amount subject to an earn-out as low as possible.

Targets and Milestones

In an earn-out provision, the parties may choose one or more targets to determine the size of subsequent payments. The target metric chosen will largely depend upon the individual circumstances of the company and the negotiations between the parties, and the milestones can be either financial or non-financial. Examples of financial targets include net equity, net income, revenue, earnings per share, and EBITDA (earnings before interest, taxes, depreciation, and amortization). Non-financial targets may include a minimum number of new customers, the approval of a patent, or an advantageous litigation outcome. Regardless of the specific metric chosen, the target, and any constituent elements of the target, should be clearly defined, easy to measure, and compatible with the operations of the business and assumptions in order to avoid disagreements over future payments. To this end, it is often helpful to examine various contingencies which may affect the ability of the company to achieve the target and plan accordingly.

Earn-Out Periods

The duration of an earn-out period will vary with each agreement but will generally last no more than three years. This is because, in the context of a reverse earn-out provision, under the Income Tax Act (“ITA”) net capital losses can only be carried backward three years to offset capital gains. While purchasers and vendors may both wish to reduce risk by keeping the earn-out period short, vendors who continue to manage the business post-sale may seek a longer period to afford them adequate opportunity to meet the earn-out target.

Advantages of Earn-Outs

There are many reasons why parties may agree to an earn-out provision. From a vendor’s perspective, it may be possible to receive a higher price than would have otherwise been possible. Purchasers may be willing to pay a high price up front if there is a guarantee that subsequent payments are contingent upon adequate performance, thereby reducing the risk that they have overpaid for the business and ensuring that incentives with the vendor are aligned. Further, earn-outs may also allow for synergies between the business and the purchaser’s business to manifest during the earn-out period, resulting in a higher sale price, which is especially important in strategic acquisitions that seek to drive growth.

From a purchaser’s perspective, an earn-out provision reduces much of the inherent risk in acquiring a business. If the target company fails to perform as expected, the ultimate purchase price will lower accordingly. Additionally, if the vendor continues to manage the company after closing, an earn-out provision provides them an incentive to operate the business effectively.

Disadvantages of Earn-Outs

The main disadvantage of an earn-out provision is the possibility that disputes may arise concerning earn-out payments. Parties which have failed to clearly set out their targets may disagree as to whether the target has been achieved. Even with clear targets, unforeseen events or market conditions outside of the control of either party can affect the company’s performance, complicating the situation. Additionally, earn-outs require continuous monitoring and accounting controls throughout the earn-out period to be effective, which carries additional costs for all parties involved.

From the vendor’s perspective, an earn-out provision prevents a clean break. It can be difficult for the vendor to move on after the sale because they continue to be materially invested in the business’s success, while at the same time being vulnerable to the purchaser’s actions. Even if the vendor continues to manage the corporation, the purchaser may take certain actions which cause the company to fail to meet earn-out targets.

From the purchaser’s perspective, if the vendor continues to manage the corporation their desire to achieve earn-out targets may cause them to do so in a way which maximizes short-term gain at the expense of long-term performance. Further, out of a desire to secure their earn-out payments, vendor often implements clauses in the earn-out agreement restricting the purchaser’s ability to make significant changes to the corporation until the end of the earn-out period, which may be problematic for certain purchasers.

Tax Consequences of Earn-Out Provisions

Perhaps most significantly, earn-outs may result in negative tax consequences for the vendor. Normally, income derived from disposing of shares in a corporation will be treated as a capital gain under the ITA, meaning that 50% of the income is taxable. Under an earn-out provision, the earn-out payments are taxed as regular income from property under s.12(1)(g) of the ITA, in the year the sum is received. Losing the status of a capital gain means that the amount is fully taxable rather than only 50%. While the CRA has provided some relief through the cost recovery method in IT-426R, this reporting method carries certain restrictions and will not be applicable in all circumstances. Thus, from an income tax perspective implementing an earn-out provision may carry significant tax consequences for the vendor.

Lifetime Capital Gains Exemption

In Canada, owners of qualified small business corporations may take advantage of the lifetime capital gains exemption (“LCGE”). The LCGE operates to allow small business owners to sell their companies in a more tax advantageous manner. Normally, when selling shares in a business, the owner would be subject to tax on 50% of the price received as capital gains. However, the LCGE limit allows vendors to dispose of up to $892,218 of shares tax-free in 2021 (which increases is indexed for inflation). Thus, vendors generally only pay capital gain taxes on the amount of the sale price in excess of $892,218.

When implementing an earn-out provision the original sale price of the business is taxed as a capital gain and thus can be used towards the LCGE limit. However, because subsequent earn-out payments are taxed as regular income, they also cannot be used towards the LCGE limit available to the vendors.

Reverse Earn-outs

Due to the negative tax consequences arising from earn-outs, reverse earn-outs are becoming increasingly prevalent. Under a reverse earn-out provision the vendor receives the entire purchase price at the time of sale. If the company then fails to meet the agreed-upon targets or milestones, the vendor must repay the purchaser part of the original purchase price. It is thus the opposite of a classic earn-out: the vendor is responsible for paying the purchaser to the extent that targets and milestones are not reached rather than being the recipient of payments if the targets or milestones are met.

Under a reverse earn-out provision, the entire purchase price is paid at the time of sale and is thus taxed as a capital gain. This is not only significantly tax advantageous but also permits the entire purchase price to be used towards the LCGE. Further, any payment made by the vendor under a reverse earn-out may be claimed as a capital loss and carried backwards up to three years prior to the closing date to offset any capital gains. If the year of sale is within the previous three years, these capital losses may be used to offset the gain from selling the business itself. However, there are disadvantages of a reverse earn-out provision as it may subject the purchaser to setting aside more funds at the time of closing and result in more tax payable upfront by the seller even though the ultimate amount of taxes paid would likely be less.

Often, the contingent amount of the reverse earn-out payment is held in escrow and only actually paid out to the vendor if the targets are achieved in order to protect the purchaser from the vendor’s credit risk or default on reverse earn-out payments. Regardless, the same advantageous tax treatment applies. The reverse earn-out therefore results in significant tax benefits for the vendor, with very little effect on the purchaser as both methods allow for the purchase price to be adjusted to reflect the actual performance of the business.

Should you contemplate using an earn-out provision in an M&A transaction, you should consult legal counsel and professional advice to avoid uncertainties in its implementation and to maximize its benefits to the parties involved in the deal. Please contact Vincent Ho for more information.