What is an earn-out in an agency sale?
In an earn-out, the buyer pays some of the price at settlement and agrees to pay more later if the agency performs. The ATO describes a standard earnout as one where the buyer pays additional amounts if performance thresholds are met within a set time, and a reverse earnout as one where the seller repays amounts if thresholds are not met.
Buyers propose earn-outs in agency sales because so much of the value depends on clients staying after the owner changes. Two related terms work differently. A rent roll retention clause adjusts the price for managements lost in a set period after settlement. Vendor finance is a fixed amount the buyer owes the seller, whatever the business does.
Why is an earn-out not worth its face value?
A promise of up to a certain amount later is worth less than the same amount at settlement, for four reasons:
- ·Probability: the targets may not be met, in full or in part.
- ·Time: money received in two or three years is worth less than money today.
- ·Control: after settlement the buyer runs the agency, sets prices, staffing and costs, and may merge it into its own business.
- ·Credit: the buyer has to be able and willing to pay when the time comes.
Hypothetical illustration: how do two offers compare?
Invented figures, not market data, and simplified. Offer A is $1.6 million at settlement. Offer B is $1.3 million at settlement plus up to $500,000 over two years, based on gross profit retained from existing clients.
Suppose a valuer, after reviewing the client base, retention history and the buyer's plans, assesses that about 60% of the earn-out is likely to be paid. That is $300,000 expected. Discounted for an average wait of around 18 months and for the risk of dispute or non-payment, it might be worth roughly $240,000 to $250,000 today. On that view Offer B is worth about $1.54 million to $1.55 million, a little less than Offer A, despite its $1.8 million headline. Different assumptions give different answers, which is why the report sets them out.
Which earn-out targets suit an agency?
The target decides how much of the earn-out the seller can influence after settlement:
- ·Revenue: simple to measure, but silent on margin; a buyer can discount fees to hold revenue.
- ·Gross profit or EBITDA: closer to what the seller sold, but exposed to the buyer's cost allocations and accounting choices.
- ·Retained recurring income: suits books, such as management income on a rent roll, renewal income on an insurance book or trail on a loan book; harder to manipulate, but affected by how the buyer services clients.
- ·Named accounts retained: direct, but sensitive to decisions the seller no longer controls.
- ·New business targets: depend heavily on the seller staying involved, so read the employment or consulting terms that go with them.
What protections should sellers raise with their lawyer?
An earn-out without protections relies on the buyer's goodwill. Sellers commonly ask their lawyer about fixing the definitions and accounting policies at completion; information and audit rights over the figures; operating covenants that keep the agency running substantially as before; independent expert determination of disputes; acceleration if the buyer resells the agency or ends the seller's role without cause; and limits on the buyer setting off other claims against the earn-out. This is general information, not legal advice; the right protections depend on the deal.
How are earn-outs taxed?
Subdivision 118-I of the Income Tax Assessment Act 1997 gives look-through treatment to a look-through earnout right. Broadly, the right must be to future financial benefits that are not reasonably ascertainable when it is created; it must arise from a disposal that is CGT event A1 of an asset that was an active asset just before the disposal; all benefits must be provided within five years after the end of the income year of the CGT event; the benefits must be contingent on the economic performance of the asset or the business and reasonably relate to it in value; and the parties must deal at arm's length.
Where those conditions are met, the ATO explains that the capital gain or loss on the earnout right is disregarded, and payments the seller receives later increase the capital proceeds for the asset sold. An option to extend, or a variation that lets benefits run past the five-year limit, means that condition is treated as never having been met. Where the conditions are not met, the ATO says the approach in TR 2007/D10 applies, under which the earnout right itself can need a market value at the time of the sale. This is general information; your tax adviser applies it to your contract.
What do we need from you?
To value an offer that includes an earn-out, we usually ask for:
- ·The offer, term sheet or draft sale agreement, including the earn-out definitions
- ·Three years of financial statements and year-to-date accounts
- ·Revenue by client and retention history for the book
- ·The buyer's stated plans for the agency, if known
- ·Any forecast prepared for the sale
What does an earn-out valuation cost?
Valuing the agency and the deferred portion of an offer is a fixed fee, agreed in writing before work starts. If an earn-out calculation is later disputed, an expert report is $4,495 + GST. The band is set by the annual revenue, excluding GST, of what is valued: a rent roll's annual management income, an insurance or mortgage book's annual recurring income, or the agency's total annual turnover where the whole agency or shares or units in it are valued. Delivery time starts once payment and all required information have been received.
- ·Small Business Valuation: $1,495 + GST where the revenue of what is valued is under $2 million, delivered in 2 business days
- ·Medium Business Valuation: $2,495 + GST from $2 million to $3 million, delivered in 3 business days
- ·Large Business Valuation: $3,495 + GST above $3 million up to $10 million, delivered in 3 business days
- ·Above $10 million: quoted in writing before work starts, with the delivery date agreed before commencement
- ·Expert report for a dispute or court: $4,495 + GST, with the delivery date agreed before commencement
- ·Add-ons: +$495 per retrospective (past) valuation date and +$795 per additional entity