Given the continued pricing challenges facing private company transactions and the increasing number of younger, less-proven assets coming to market (for example, in the field of AI), transacting parties are increasingly turning to earn-outs to bridge valuation gaps and manage investment risk.

What is an earn-out?

An earn-out is a contractual provision that entitles a seller to receive additional consideration if certain performance targets or conditions are met post-transaction.

An earn-out is typically used where the parties cannot reach an agreement on valuation (or where much of the value of the business lies in unproven assets), and is a means to bridge the gap.

Earn-out metrics vary but typically track the key value drivers in the business being acquired. Common metrics include revenue, EBITDA/profit, or the achievement of specific milestones, such as bringing a product to market or successfully completing a clinical trial.

Why do earn-outs need to be valued?

As well as allowing the buyer to comply with financial reporting requirements, there are several tax reasons that earn-outs may need to be valued, for example:

• If the earn-out is 'unascertainable' for UK CGT purposes, the value of the earn-out is typically included within the sellers' taxable gain in the tax year of disposal.
• Where non-tax advantaged employee share options are exercised as part of the transaction, the value of the earn-out must be included in the value of shares acquired when calculating option gains for PAYE/NIC purposes.
• The valuable statutory corporation tax deduction claimed on the exercise of employee options (including EMI/CSOP) can be maximised by including the value of the earn-out in the value of shares acquired.
• Depending on the terms, stamp duty may arise on the value of the earn-out alongside the other consideration payable for the shares.

Given the number of places where the value of the earn-out may be reported for tax and financial reporting purposes, it is essential that a consistent approach is adopted by the company, the acquiror and the selling shareholders, in order to reduce the risk of HMRC or auditor challenge.

The Valuation Process

A forward-looking methodology is essential when valuing earn-outs, as it involves assessing the likely timing and quantum of any contingent payments.

Depending on the commercial terms of the earn-out, one of two primary approaches may be suitable:

• the Expected Returns Methodology (ERM) or
• the Option Pricing Methodology (OPM).

These methods have distinct applications, depending on the nature of the earn-out.

Expected Returns Methodology (ERM)

ERM involves estimating future outcomes through scenario analysis or probability-weighted forecasts. This method is particularly effective for linear earn-outs, such as those based on a percentage of revenue or EBITDA, where the payoff does not involve thresholds, caps, or other bespoke features.

The simplicity of ERM makes it appropriate when the risks and outcomes can be reasonably modelled using expected financial projections. For instance, when the earn-out is tied to pro forma financial performance, ERM is a practical choice that provides reliable valuation results without excessive complexity.

Option Pricing Methodology (OPM)

OPM, on the other hand, uses an advanced mathematical framework to incorporate the effects of non-linear payoffs. This method is well-suited for earn-outs involving thresholds, caps, tiers, or path dependencies, as it allows for detailed modelling of the probability distribution of outcomes.

By employing a risk-neutral valuation framework, OPM adjusts for systematic risks inherent in the underlying performance metric, enabling a more precise valuation of complex structures.

For example, OPM is often used in transactions where the earn-out payoff depends on achieving specific milestones or features multiple interdependent metrics.

Summary

Earn-outs are an ever increasingly important component of transactions, especially in sectors like technology and biotechnology, where future performance and milestones are significant value drivers.

From a valuation perspective, earn-outs can be complex and require careful consideration of the underlying assumptions and risks. It is important for buyers and sellers to work with experienced valuation professionals to ensure that the earn-out is structured in a way that is fair and reasonable for both parties.

By considering the key valuation considerations, buyers and sellers can use earn-outs to bridge valuation gaps and reduce the associated tax risks.

Are you navigating an earn-out in your next transaction? Ensure you're on the right path with expert valuation advice. Contact Touchstone Advisory for further details.

Touchstone Advisory is an independent valuations advisory firm comprising a diverse team of skilled professionals with extensive experience across leading 'Big Four' valuations teams.

We specialise in valuing earn-outs for tax and financial reporting purposes, bringing a wealth of expertise across all sectors. Our track record includes successful engagements in technology, healthcare, biotechnology, pharmaceuticals, manufacturing, consumer goods, energy, media and entertainment, and financial services.