What is an “earnout” clause in a business acquisition?

The term “earnout arrangement” (Earnout) has been defined by the Australian Taxation Office (ATO) as any transaction in which an income-earning asset is sold for consideration that includes the creation of an ‘earnout right’ (Earnout Right) for the seller of the asset, according to TR 2007/D10.   An Earnout Right is further defined as:

“a right to an amount calculated by reference to the earnings generated by the asset for a defined period following the sale (generally a period of between one and five years) as defined at paragraph 3 of TR 2007/D10.”

What is the purpose of an Earnout?

The purpose of an Earnout is to delay the payment of consideration until the point in time when financial goals are realised.  It allows the purchaser to minimise uncertainty over the future performance of a business by linking a portion of the sale price to the future performance of the company.  The percentage of the total consideration that is subject to an Earnout is always subject to negotiation with the seller wanting less by way of Earnout and the buyer wanting more.  Generally, the better the business, the lower the percentage of the sale price that is to be paid by way of an Earnout.

What is an example of an Earnout?

The Walt Disney Company (Disney) purchased the massively multiplayer online game (MMO) Club Penguin for US$350M on 1 August 2023, in fixed remuneration and the contingent payment of US$350M in the form of two (2) further payments based on undisclosed growth thresholds.  This deal protected Disney from the possibility of a downturn in future revenue and profitability from the MMO.  This possibility was soon realised after the MMO suffered a significant economic downturn, eventually closing on 30 March 2017. (Walt Disney’s Statement)

What are common complications sellers should be aware of when negotiating Earnouts?

Sellers should be aware of some of the issues associated with Earnouts as there is a chance that Earnout consideration can become illusory.  We commonly see:

• unforeseen barriers placed in front of the seller so that the Earnout targets cannot be met;
• loosely defined terms which results in debate about the amount of consideration payable from the Earnout; uncertain terms; and
• management and operation differences after the buyer takes over, leaving the targets associated with the Earnout unable to be unmet.

Legal complexities with Earnout clauses

In the case of Metalicus Pty Ltd v Metwholesale Pty Ltd [2011] VSC 2, one of the issues to be determined surrounded the interpretation and purpose of the Earnout clause given its wording.

The contract provided, that during the Earnout period, the business must be conducted in accordance with the following:

• the 2008 budget; and
• a manner consistent with how the business had been conducted by the vendors in the preceding twelve (12) months.

This clause ended up frustrating the contract of sale, as the seller argued that all business expenses were to be in strict compliance with the 2008 budget (Budget), while the purchaser argued that the Earnout clause only required regard to the Budget when read as a whole.

The result was that Croft J made a declaration that on a proper construction of the amended agreement, the obligation to conduct business in accordance with the 2008 Budget only required the purchaser to endeavour to follow the Budget, not be strictly bound by it.  In this decision, Croft J held that it was impossible for the Purchaser to fulfill their obligations under both limbs following strict compliance with the Budget.

Standard Earnout Arrangements and Reverse Earnouts

1. A Standard Earnout Arrangement (Standard Earnout Arrangement) is defined by the ATO in TR 2007/D10 as:

“Any transaction in which an income-earning asset is sold for consideration that includes the creation of an ‘earnout right’ (Earnout Right) in the seller of the asset.”

For example, a seller wishes to dispose of a business in which they own and operate.  A purchaser buys the business for A$5M that is split between A$2.5M in fixed remuneration and A$2.5M in conditional payments to the seller over two (2) years based on the performance of the business.

The seller is being granted an Earnout Right to the conditional payments being generated by the performance of the business in this simplified scenario.  This is referred to as a Standard Earnout Arrangement.

2. A Reverse Earnout Arrangement (Reverse Earnout Arrangement) is defined by the ATO as:

“A reverse earnout arrangement is a contract for the sale of an asset in which the seller of an asset accepts a nominated sum by way of consideration but undertakes to pay an amount or amounts (post-sale payments) to the buyer calculated by reference to the earnings generated by the asset during a specified period after completion of the sale.”

For example, a seller wishes to dispose of its interest in a business that could be done by way of a share sale or an asset sale.  The assets of the business are sold for A$5M on the condition that the seller agrees to pay 50% of the consideration if the business fails to achieve a turnover of $2,500,000 in each of the two (2) years following the acquisition.

The purchaser is being granted the Earnout Right to the conditional payment being generated by the performance of the business in this simplified scenario.  This is known as a Reverse Earnout Arrangement.

Capital gains tax implications

The ATO insiders Earnout arrangements liable for Capital Gains Tax (CGT):

“For the purposes of Capital Gains Tax (CGT) a business consists of a number of CGT assets (including the business’s goodwill, debts and contractual rights as well as the physical assets of the business).”

The ATO will generally adopt a look through approach to Earnout Rights (LTER) for CGT purposes under the Income Tax Assessment Act 1997 Division 166 Capital proceeds.  This approach separates the financial benefit of the Earnout Right from the underlying asset (business assets or shares), disregarding the capital gains or losses arising from the right until the benefits are either fully realised or extinguished.  The capital gain or loss is then calculated considering the cost base of the asset during the relevant tax year.

Links and further references

Legislation

Corporation Act 2001 (Cth)

Guide-to-capital-gains-tax-2022

TR 2007/D10 – Income tax consequences from earnout arrangements

Cases

Metalicus Pty Ltd v Metwholesale Pty Ltd [2011] VSC 2

Further information about earnout clauses and commercial law

If you need advice on earnout clauses or commercial law, contact us for a confidential and obligation-free discussion:

Disclaimer

This article contains general commentary only.  You should not rely on the commentary as legal advice.  Specific legal advice should be obtained to ascertain how the law applies to your particular circumstances.

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