What's an Earn-Out When Buying a Business? Jonathan Jay 2023

hi this is Jonathan J from dealmakers.co.uk the number one place for business buying information now this is the second part of a two-part video featuring John Andrews now John Andrews is our resident lawyer at dealmakers and on this video you will see him in front of a mastermind audience giving them his advice on how to buy a business successfully could you explain in a simple terms as possible what an earn out is yes so an earn out is um it's a way of structuring a deal where you don't necessarily you either fix the price for the business overall you say right we'll buy your business for a million pounds we'll pay you 500 000 pounds up front we will pay you the other five hundred thousand pounds over five years so a hundred thousand a year provided the business reaches a particular figure that's one way of having an earn out okay the second way of having to know now is by way of performance of a particular individual so you you can actually say right we will pay you 500 000 pounds for your business and if you as an individual reach certain performance targets we will give you an additional sum for your business what you need to be clear about though is that there is a risk that if you tie it to individual performance that the money they receive is not deemed to be part of the consideration for the sale it's deemed to be income so they get taxed at far less beneficial rate so essentially an earn out is is a way of structuring a deal that's related to the performance of the business or an individual okay so what if the seller doesn't like that deal because it's that they they think possibly that their idea is that they don't know how the how the company is going to perform Under New Management well that that's always a risk if they're not going to stay on and be involved in the process that really that leads to the the finances are going to receive you're absolutely right but they've got a choice not to do the deal uh we didn't get your surname I'm sure Andrews John Andrews yeah John hi um so are we saying what I wanted to clarify is um in terms of you explained the Articles and and that kind of thing and so we're all thinking well if we haven't set up an image company yet well we shouldn't do what you're saying um so what at what point does it make sense to set up that limited company and would we only be able to come to someone such as yourself to do it right well so so you can set you can set your limited company up at any time and you can incorporate it with the model articles if you want and it just sits there but once you start getting to stage at which you're going to start using that company to transact and do deals that's the point in time when you want to change your articles so the articles are really technical documents and unlike some contracts which you know some people might do their own consultancy contracts their own employment agreements articles really need to be done by lawyers or accountants and more lawyers and accountants really because they're the rules of the company that there are public documents so they get published at company's house and they will set the rules by which Shares are issued and shares come back it's probably the most important company document that you will have and and typically what you do is you combine detailed articles with a fairly simple shareholders agreement now some people don't change their articles and just have a complex shareholders agreement um I don't like doing that for two reasons one the articles are far more enforceable against everybody's involved so anybody who takes shares in the company once your articles are registered takes those shares subject to those company rules that are registered company's house whereas with a shareholders agreement if you bring a new shareholder in you either have to have a new agreement drawn up or get them to sign a deed of adherence and if you forget to do that then they're not bound by the rules that are in the shareholders agreement but they are bound by I think it's in the article so that's one good reason to put these complex issues into the into the articles second reason is this if people are going to come in who aren't who aren't complex investors if you present them with a 40 or 50 page shareholders agreement they'll look at it and think what the hell is that I don't think I'll go anywhere near this whereas if you've put all the nasty stuff into the articles most people don't read the articles but they will read the shareholders agreement he gives to them and if you've given them a four or five page shareholder agreement all that's quite straightforward innocuous you're more likely to get the investment that you want if that makes sense so there's a legal reason and there's a practical reason why you put all the nasty and complex stuff into your articles and have a simple shareholders agreement John no no I was convinced by what you said earlier once we find a deal yeah is that too late for us to be setting up a company no no no no absolutely not I'd say do the whole lot for us no absolutely not so it takes it takes a day or two to get your company set up um you probably need to allow a week or two to have a look at the bespoke Articles get produced by your lawyer so you can explain them to you and make sure that what they do is what you want to have happen um and you can usually play around with them we can change the rules that go in there so no some people set up a a an SPV on day one actually a group holding company on day one and just let it sit there for months until they find the right deal other people find their deal and then come to us to say right can we have our group company can we have an SPV and that you know takes a week two weeks maximum to do that okay so last question about that then so how much would it cost to just set up that limited company you can do online yourselves and it costs you 30 I think it's 30 pounds something like that if we do it we probably charge six or seven hundred pounds to do it so the actual setting up the company itself is simple the article is a shareholders agreement typically between three and three and a half thousand pounds so it's not a cheap document but it's a really important document and you only need to do it once and what you can do is once you've done that you can use that document to filter down into your spvs uh hi John yeah um we've got a deal going through at the moment and um we we passed some information between uh solicitor and and the other side and we've also sort of when when some things have come back which uh you know needed a negotiation we've talked directly to the uh seller yeah what's your recommendation on what things should go through you and what things can be discussed so my view on it is it's not our job to tell you commercially what what you should do so the commercial elements of it so how much you're going to pay and when you're going to pay it should really be discussions between between the two parties directly because you both will get comfortable with that and it's not an area that we stray into and in fact when you get an engagement letter from US it actually says clearly that we don't advise on the commercials it's not our job to say that's a good price for a bad price we will say the way that's been structured and the terms on which they want they want this deal done it's not it's not a good deal for you but that's that's on the legal side so anything legal so warranties indemnities charges security that should come through us anything that's to do with the the actual most important part of the deal but the finances of the deal are done better between the parties you know perhaps just some input from their accountants but it's not really a lawyer's job to get involved in that part of it no yeah that's great thank you I'd understood that um but it's more sort of what should we pass so if we've sort of made a decision or got a proposal is it better to pass it backwards and forwards through solicitors or do it sort of yeah so so typically what happens is this is that um if if you've done your due diligence so you might have agreed a price up front you do your due diligence or something comes up you think oh actually you know potentially might be a claim there for twenty thousand pounds what what you would do is you discuss that with us and we say well that is a risk we think it's a small risk or a big risk yeah you might want to renegotiate you would then go back and speak to the speech to the seller and you come back to I said well look what we've agreed to do is is either they've agreed to reduce by twenty thousand pounds or they've agreed through retention so another way to deal with potential claims rather than chip the price is to say we'll hold back the value of that claim for six months or 12 months in an escrow account and provided it doesn't materialize in the next six 12 18 months that will get released so that's that that's all that you need to do is you need to agree the finance of it and tell us what it is that you've agreed but it's better for you both to have agreed out and each of you to go to lawyers to say this is what we've done he's worked for 50 of my Mastermind clients in the last few months alone his name is John Andrews and I've got his details right here in my little black book of contacts you can phone him on zero three four five two four one two four nine four or you can email him on John Andrews dot deallia at jmw.co.uk if you want someone who can get a deal done he is your guy so let's get back to the video I was wondering in terms of um division of work between lawyers and accountants yeah who's kind of responsible in terms of setting up all the companies spvs due diligence who does what okay so in terms of setting up the companies um accounts it's generally tend to be tend to be cheaper than lawyers and setting those up but what they won't do is do the bespoke Articles so so lots of clients come to us with their existing holding companies that their councils have done and that's absolutely fine and then we can change the Articles at that stage if it's appropriate okay um in terms of the division of labor the accountants should be looking at the accounts the management accounts that returns all the finances of the business um all the ledgers um so anything to do with figures the accountant should be doing everything else will be down to it can be a division of labor between us us and you guys actually so um the the documents involved in the processes involved in doing a typical share purchase for example will be heads of terms which we can draw for you although Jonathan's template that I've seen works perfectly fine so that's a one cost saver you can have so header terms the asset or share purchase agreement there will be an information request which is a document that we draft which we send to the sellers lawyers ask them questions about the business about everything employees claims properties everything we set up a data room that they can enter their responses that information request into and they can also upload all the documents we want to see that support those questions that's that's the first part of the process what you guys are going to have to decide is whether you want us to do a full due diligence legal due diligence process for you which would involve us going into the data Room reading those responses reading the documents and doing a full report to you and highlighting any areas of concern that we think we've got so that's a full Duty judgments process some clients don't want that at all so they say look the accountants that looks at all the figures we've read that we've gone into today's through we've looked at it we don't want you to look at it we're quite happy with what we've seen we're going to go ahead so that's no DD on our part and that can cast out three to five thousand pounds of the costs out of your legal fees but what it does do is it raises the risk that there's something legally that you you haven't spotted like a change of control provision or there's a halfway house that you can do with us where you go into the data room you say look I'm comfortable with those parts of data room could you just look at these particular areas and give me a price for looking at those at those areas of concern so the DD process can be a joint a joint venture between your lawyer and yourself you've got to decide how much you're comfortable in doing yourself of that part of the process the next part of the process for all the Ancilla is which would be bold minutes um campus house returns and stuff which again the lawyers need to do so it's a mixture of the lawyers during the legal part the account is doing anything to do with figures and then you deciding how comfortable you are with the due diligence that you've seen do you give sounds a silly question forgive me do accountants I've sent some stuff to my account said have a look over this and he's kind of said what do you want me to look for like I don't know you tell me yeah yeah like like yeah so so for example if there's a contact you say right John that you know in section seven there's a contract I've got a clue what it means should I be concerned we'll go into that we'll read that we'll read that we'll read that contract and we'll give a commentary on it and we'll say right there's a change of control Clause so before you complete the deal we need to know that they're going to consent to that change of control um the prices get reviewed annually by a certain percentage all those sorts of things so you're quite right if you say look you never look at that document that's exactly what we'll do and that's our job to do it yeah cool uh hi I was recently approached by a business owner they need some growth funding and which I will enter the company as a minority shareholder I want to know how my being protected and maximized as a minority shareholder into this position thank you yeah okay so if you're going to minority shareholder are you going to be a director or an employee no just a shareholder okay so if you go as a minority shareholder so if you've got anything if you've got anything less than 50 your minority shareholder then then you're at risk so what you do is you must have a shareholders agreement um and what the shareholders agreement will do is it will give you um a certain number of protections minority protections so typically it will say that no alterations can be made to the Articles without your consent that none of the rights attaching to your shares can be also so they can't take away the right to dividend or your voting rights um it will prevent dilution of your shares so he couldn't bring in other investors and dilute you down unless you consented to it and there would be a number of negative controls that you build into that shareholders agreement so there will be things like you know you can't appoint um other directors without my consent you can't increase your salary or employees salaries Beyond a certain level all sorts of financial controls which are really or borrow money for example all these sorts of financial controls can be put into the shareholders agreement and you will have an equal say in those unless you can censor those happening they can't happen so the shareholders agreement is a mechanism by which you make sure as a minority shareholder your position is protected things bear in mind as well is that if you're gonna if you're going to subscribe for shares rather than make a loan to the business I do so um as a shareholder into the company I will bring money into the company so basically I will loan the money to the company as well with the interest repaid well there's two distinct white there's two there's two different things so a loan to a company doesn't give you shares you literally just put money in you say I'll lend you I'll lend you a million pounds I'll charge you interest at X percent and you will repay me on these terms okay and that loan might be secured or unsecured if that if that loan isn't repaid you if there's a default on those repayments then you can demand that money back from the company and and Sue it and try and get it out of it that's alone subscribing for shares is very different subscribing for shares is an investment into the business so once you buy those shares so if you buy a million pounds of the shares that money goes into the company and in return for that you you get your you get your shares you can't demand that money back the only way you ever get that money ever realize a return on that money is by way of dividends the company pays dividends or if somebody buys your shares off of you which if they're a minority in a private limited company the only person will buy them will be the existing shareholder the majority shareholder or if the business is ever sold so putting money into a company's investment by way of shares is a much bigger risk in many ways than lending money to the company the two different things okay so um the company director want me to enter as a shareholder which um in return you know along the company the money in return with Equity as well as the interest rate paid by the loan so that's a whole right yeah I mean the other way you can structure it is you can do something called a conversible loan note so so you make a loan to the company which says I'll lend you this sum of money and this is the return I will get on it but your option you if you think the business is doing well and you quite like it you say well actually don't pay me the loan back I'm going to convert that loan into shares that's that's another option for you so and that that allows you to hedge your bets it's a better option than the yeah it's kind of halfway house but it gives you the benefit of both so I'll lend you the money and if I think if I don't think the company's doing too well I'll just leave it as a loan if you think actually it's been a good investment you can just say well I'm going to convert that loan into into shares okay so how many legal documents do I need if I go down there you just need actually the low note itself and then you need a board minute from from the company approving that transaction so if I demand a personal guarantee from the director yeah you won't you should certainly ask for that certainly ask for that so that means I need another document for the yeah yeah that can either be a side document or that can be built into there can be a passage to the loan no agreement actually okay thank you is there anything um clever or useful that can be including the including in their sales and purchase agreement to be advantageous to the buyer oh that's that's that's quite a broad question um let's have a thing so so if we're talking about if we talk about protections mostly okay so they're all the obvious things you've got your charges your personal guarantees all those sorts of things in terms of the the structure and the body of the agreement itself um your two principal areas of recourse are going to be warranties and indemnacies and warranties are promises that the seller makes to you about the business um which if they prove to be untrue potentially gives you the right to sue them for breach of contracts okay now that all sounds great but warranty claims are not that straightforward because it's not enough to show there's been a breach of the warranty you have to show that that brief just calls you Financial loss and the loss that you've suffer might not be Financial might be just be some missing records for example which so you know if you buy a lesson Agency for example um and you don't get appropriate warranty section and there are documents missing so you know the gas certificates fire safety certificates the nurses you have to serve when you're entering assured short hold tenancy agreement that's aggravation in trying to reconstruct those and it's time but it's not money okay even if you can find even if you can show there's been a financial loss it's been caused arising from the breach of warranty that still isn't enough what you then have to go you have to go a step further and show that overall that breach of warranty has reduced the value of the shares that you bought in the company it's on the basis we're on the Assumption it's a share purchase so there are those stages that you need to go through they're also really expensive pursue these claims and quite often within the within the share purchase agreement and in asset purchase agreements there'll be a clause that says claims have to have an individual a minimum individual level and there will just be a basket of those claims before you can bring a claim so you might typically say each individual claim has got to be worth more than two three four thousand pounds and there's gonna be a basket worth more than twenty thousand before you pursue that claim um and as I said before in reality unless it's 50 100 Grand it's and even then if you go to court the legal costs far outweigh those sums that they're difficult and expensive to pursue so but the warrant is warranties take up a lot of the time in negotiation in in these deals and they're important but at the end of the day unnecessarily something massively wrong with the business even if you can show a breach you're never going to be pursuing those because it's too expensive to do it um what's of more use are indennesses now indemnities are particular Clauses which say if x y's if a particular event occurs then you will compensate me on a pound-for-pound basis now the most obvious example of this is when you're doing a share purchase a big chunk of the agreement sometimes this is a separate document but not not not commonly you will have what sign is a tax Covenant and basically the tax Covenant is about 10 15 pages long covers all elements attacks it basically says if there is any undisclosed tax or tax that hasn't been paid that should have been paid you will indemnify me for that on a pound-for-pound basis okay and then you can do that with with other areas and these usually come out as part of the due diligence process so if we're doing due diligence and then and we see we see a lessons coming from a client saying we think he breaks the contract our losses are fifteen twenty thousand pounds so the kind of level that if it was a warranty a warranty issue you wouldn't pursue because you couldn't afford to um if it's an Indemnity we can write a clause into the into the spa which basically says if that materializes if that loss materializes it's not a warranty claim you would just simply indemnify us on a power for pound basis and that is a black and white claim if it happens you go to the seller and say right we've had to pay that you have to reimburse it so that's a far more straightforward far easier claim to bring so the way you get protection Beyond personal guarantees and charges is by having warranty protect as best the best warranty protection you can but in 30 years I've had one warranty claim that didn't litigate because it was too expensive or more appropriately you have proper proper indentances and those indemnacies can only really be identified by doing a proper due diligence exercise hi John could you just explain the differences between warranties and indemnities just as a just at a high level Place yeah so an Indemnity is a claim it might it might arise from the same event okay but a warranty is a claim is a claim for breach of contracts and it's it's quite a technical legal legal process but basically if a contract has been breached your your remedy is a claim for damages so you have to prove a financial loss okay that's the first stage but you then have to show that that Financial loss overall reduces the value of the shares so had you known about that warranty issue would that have meant that the shares you bought were worth less in some circumstances it will and it'll be obvious but in other circumstances it won't whereas an indemnity is a particular Financial remedy on a pound-for-pound basis if an event happens so it will be it's always got to be a financial loss but it will say I haven't got to prove that that it's reduced the value of the shares all I've got to prove is that financial event has happened and you have agreed if it happens you will pay you will indemnify me for that on a pound-for-pound basis so it cuts out a whole load of um legal hurdles that you have to overcome with a warranty claim yeah sure thanks hey I have two questions uh indanities um you said has to be an event that has already happened but what happens if you tack on a business and you discover they've been underpaying tax so is that an event that has happened or it doesn't happen until yet tomorrow so you come through the tour what it doesn't have to be an event that's that's happened it just has to be an event that you or I've identified when you've been doing the due diligence process so say for example so tax tax is quite distinct because tax is so important on a share purchase you have a separate Indemnity which runs to a number of pages all to do with tax so generally speaking if if a tax if a if underpayment attacks arises it should have been disclosed and hasn't it will almost invariably be covered by the tax Covenant and you will get you'll be entitled to reimbursement of a powerful power basis even if that only arises post completion so for example if you if if we if you require in a business and we look at it and we suddenly see that there are a load of self-employed Consultants that work in the business so they're not employees but actually when we ask a few questions it turns out they don't work anywhere else they work five days a week for this company and yet they're saying they're self-employed we'd be saying to you there is a potential here that they're going to be deemed to be employees not not contractors which then means there's going to be a big PA where paye liability for the company so we would identify that to you and we would say to you that would be covered by the tax Covenant but we also want a specific clear Indemnity in the Spas saying that if hmrc find that these guys are employees are not are not contractors you would indemnify us on a powerful pound basis for that paye liability so it's not an event that's already happened it's just something a risk that we've identified that we're saying to you that you have Indemnity cover you don't you don't rely on the general tax Covenant or on warranties okay and a second question is what uh legal jurisdictions in the UK do you uh work with so obviously England Wales Scotland available so so so so we we do deals in England and Wales Scotland's a separate jurisdiction but we we have an association with firm in Scotland so anything anything north of the Border we send to them um and Islands separate jurisdiction as well Northern and South so we don't do that so that's a quick question um how much do you uh do you in terms of charging um do you how much do you charge an hour for instance right so so everybody we're quite upfront about this so my charging rate is 500 pounds per hour what what what I would say to you is this that is entirely irrelevant to what we charge for a deal I I would be amazed I would always ask for it but I'd be amazed I mean you guys said yes we'll put you on your hourly rate and tell us what your bill is at the end of it that that just doesn't happen what we do is we generally so I won't give you so quite often guys will ring me up you know if you've been in this seminar I'll say you know what is a typical deal cost okay that's almost an impossible question to ask and it's not us avoiding it but I could say she would like a typical deal would be ten thousand it'll be fifteen thousand be twenty thousand okay the truth of it is until we see your heads of terms we can't really give you an accurate fee estimate because we don't know so there's lots of factors that affect your fees so um are you are you borrowing money so if you're borrowing money you're going to want us quite often to look at the the finance documents the security they want and the lender will want us to act for them in registering their charges so if that element's not involved that there's not that cost but if it's involved we will charge for it um we also need we also need to know is there property involved and if there is property involved is that inside the company outside of the companies does that need to be conveyed across and and what what doesn't do you any favors is we say look I can do a share purchase view for 15 000 pounds and then you say right great and then you strike to say oh by the way um you need to allow nut there's another seven thousand Pounds to transfer the Freehold from from the owners into your company there's another two or three thousand pounds deal with lender documents so it's better for you to know at the outset and for us to know what what the scope of the transaction is and what's involved um to some degree to some degree we we tailor our fields to fees to the value of the deal but small deals can quite often end up being really really complicated um and big deals so say for example you buy a business that's got this small deal but it's got two or three hundred clients and they've all got contracts you want those contracts looked at that's time consuming but you might buy a business of five million pounds that relies on three key clients it's the due diligence on that process is far far less than it is on on the smaller deals we charge more for bigger deals because the risk to us in terms of Indemnity premiums and if things go wrong is is greater so but but we work generally generally speaking we work on a fixed fee basis so so you'll know where you are and we only vary from that fee if something unforeseen happens so we've done a couple of deals with a lawyer on the other side has been really really difficult and unreasonably so and and it's gone on you know for six months rather than three months they've been a lot of phone calls in those circumstances we'll come to you but before but before we've reached that stage where it's gone massively over budget we'll say look if we carry on with this there's going to be an additional fee but hourly rates are immature so in my team we've got we've got three Partners we have five Associates we've got paralegals and what we do is we we work with them to make sure that the work that can be done at the lower fee rate will be done and that's how we Factor our costies in but at the end of the day whatever I charge per hour you guys are not going to be paid what what we charge is it's the fee that we agree with you and that's how most deals are done thank you and I just want another little bit on the back of that in terms of like you'll be doing like um a loan agreement and lending the company money and then like you go for example earlier and it was um you get the money back um with interest or exchange for shares depending on how the company performance typically could I come to you and say you know what would you charge me for that sort of document yeah yeah so so all of these types of documents we we charge most of our world I would say I would say probably 90 of our work is on fixed fee great thank you I think traditionally now if you go to lawyers the only real work that's Charles and hourly basis will be um family so don't get divorced and litigation yeah I've been in yeah I've been divorced and I've done dealt with corporate so you see the words we're quite nice guys compared with that to be honest that's good yeah and that's around you are very nice yeah foreign be deferred if a deal falls through and if so how much right so I'm going to tell you now so this is a true story this is what this is one of the first clients I got for Jonathan I foolishly agreed to that and so so what we will do is this we will we don't require payments to a deal completes and we will offer um a um an abort fee Arrangement so basically the arrangement we will offer is is that if the deal falls through we will charge you the lesser of 50 of the fixed fee that we gave or the actual fees we've incurred but in return for that if it completes we'll charge you 20 more okay um or you can set the straight or you can have the straight fix fee for this so so that that's those are the ranges that we offer um in terms of deferring it's the next it's the next deal the sure answer that is is no we won't do that because I I had a guy who I agreed to do that on his first deal and then his second one his second one aborted and he wanted to defer both those fees I said well hold on the next deal you do you're going to be up to 60 grads of the fees for a deal that might be worth 100 Grand so it just it just doesn't work it's not fair to us and actually it doesn't work for you because when you get to that second deal and you complete it and you're then picking up two lots of fees for one deal it just it doesn't it's not great for anybody great well I think I've got a sore throat now I think I smoked a lot yeah good thank you foreign

Channel: Jonathan Jay

Views: 4,879

Keywords: the dealmakers academy, buying a business, buy a business, distressed business for sale, how to buy a business, how to buy into a business with no money, buying an existing business, buy a business using it’s own cash, buy a business without money, buy a business no money down, business buying accelerator, jonathan jay, business growth, entrepreneur, m&a

Id: vccFV6_j3_Q

Length: 34min 32sec (2072 seconds)

Published: Tue Oct 11 2022