We’re now past the halfway point of our merger and acquisition [M+A] blog series, having already unpacked how to structure an acquisition deal, the importance of the parties then entering a non-disclosure agreement, completing due diligence, and getting the contract right before signing.

The next key aspect to be unpacked in a merger and acquisition transaction is earnouts and working capital adjustments, and why they must be considered in every merger and acquisition transaction.


what is an earnout?

An earnout is a payment that the seller ‘earns’ from the buyer when specific performance targets are met during the transaction.

If an earnout strategy is adopted, the milestones that trigger an earnout payment must be clearly negotiated and specified in the contract. It is crucial to clarify the mechanics of this strategy so it is clear whether the performance criteria has been met or not.

As an example, an M+A contract may place an obligation on the buyer to pay the seller an earnout payment if the company achieves a profit number above a certain target. Here, the parties would need to consider the following when drafting an earnout clause in the contract:

  • Accounting standards. It is necessary to ensure that the accounting standards that were used in the company in the lead-up to settlement are still applied post-completion in calculating profits for the earnout.
  • Impact of head office / related part costs. On acquisition, some companies may incur additional costs that impact profit. Such buyer-related charges should be excluded from any calculation with respect to the earnout.
  • The buyer’s decision to vary the material nature of the company.
  • What happens to the portion of the earnout if the target is not met?

Valid earnout payments are not considered ‘deferred consideration’ and to determine when capital gains tax [CGT] will apply to the earnout payments, careful consideration of the earnout terms is required.

Where the earnout payments meet the look-through earnout rules, the CGT provisions have a mechanism that allows you to amend your original capital gain buy including the amount of the earnout received when the earnout is achieved [i.e. you will only pay CGT where the earnout components are met and financial benefits received].

However, in the event the earnout does not meet the look-through earnout right rules, the market value of the earnout is included in the initial capital gain and you pay CGT upfront. Inability to meet the look-through earnout rules can have adverse tax implications, as the market value of the earnout is taxed upfront.

In the event you do not reach the specific targets of the earnout, and the earnout right expires, you have a capital loss in the year the earnout expires. Obviously, this is not a desired outcome as you have paid CGT upfront on the market value of an earnout that you may never achieve.

If an earnout strategy is proposed for your transaction, it is strongly recommended that your accountant provides advice about the tax impact of the earnout payments.


complications with earnout clauses

The drafting of earnout clauses can be quite a contentious process. Common problems with the adoption of an earnout [in addition to the above example] are:

  • Disputes over metrics, the period of time or methodology used for the earnout formula.
  • Disputes as to whether or not the buyer [who is now the owner of the company] caused unforeseen events which made performing the contract radically different to the original intentions between the parties, which still results in obtaining the earnout.
  • The seller being denied financial access so they can ascertain the position.

Earnout clauses also need to be specifically tailored to the transaction, and whilst they can help negotiations, it is essential that all concerns be addressed so that there is no confusion as to the calculation of the metrics going forward.


what is a working capital adjustment?

A working capital adjustment is when the purchase price of a merger and acquisition transaction is adjusted based on an agreed working capital target of the company to be acquired.

It is therefore vital to consider in any M+A transaction what financial position will the company be in at the closing of a transaction.

As part of the purchase price negotiations, the buyer and seller should discuss the working capital position of the company when the transaction is finalised. If you do not negotiate a fair and reasonable working capital position, the ultimate purchase price can be severely impacted by a working capital adjustment calculation.

During negotiations, buyers should therefore negotiate a target net working capital of the company. It is expected that the target net working capital should be equal to a sum of money that is sufficient to cover the company’s short-term obligations.

Common examples negotiated include:

  • Cash free / debt free. When the M+A transaction is finalised, the contracted position is that the seller will pay off all debts and extract all excess cash.
  • Cash target / debt free. When the M+A transaction is finalised, the contracted position is that the seller will pay off all debts and would contain a minimum cash at bank value.
  • Net working capital target. Net working capital is simply the difference between the company’s current assets [such as cash, unpaid invoices and inventory] and its current liability [such as accounts payable and debts].
  • Settlement. If at settlement a seller delivers more working capital than a pre-agreed target working capital value, the seller will receive a positive adjustment to the purchase price. Conversely, if the seller delivers the company at closing with less working capital than the target working capital, the seller will owe money to the buyer, which will be a deduction of the purchase price.


overall considerations

Unfortunately, net working capital targets are commonly misunderstood. In negotiating a net working capital target, the buyer must convince the seller that the buyer requires the company to leave behind a defined minimum amount of working capital necessary to fund the ongoing operation of the company. From a buyer’s perspective, current assets such as accounts receivable, inventory and prepaid expenses are necessary to maintain the ongoing operation of the company.

Net working capital can be a strongly negotiated aspect of the transaction. Please also be aware that the target net working capital is substantially dependent upon the nature of the specific business and its historical operating cash flows.

It is vital that you seek legal and accounting advice while in the stages of negotiating the terms of your M+A transaction to determine whether earnouts and working capital adjustments apply to your transaction.


we’re here to help!

If you are considering purchasing a business, business assets or shares in a company, give the team at businessDEPOT Legal a buzz on 1300BDEPOT or get in touch via legal@businessdepot.com.au to discuss how we can help you.

In Part 6 of our merger and acquisition series we cover approvals and consents. You can check out our full merger and acquisition blog series here.


general advice disclaimer

The information provided on this website is a brief overview and does not constitute any type of advice. We endeavour to ensure that the information provided is accurate however information may become outdated as legislation, policies, regulations and other considerations constantly change. Individuals must not rely on this information to make a financial, investment or legal decision. Please consult with an appropriate professional before making any decision.