DealMakers AFRICA Q2 2021
Earn-outs ensure emerging market deals can carve out the unknowns
by De Wet De Villiers
Earn-outs are gaining ground in Africa and other emerging markets as a popular mechanism to structure and secure deals in the face of ongoing COVID-induced uncertainty.
These arrangements – which typically entail a seller of a business or part of an entity only receiving future earnings if certain financial goals are achieved – are giving buyers and sellers much needed certainty and peace of mind.
The World Bank says in its 2021 Global Economic Prospects reports that per capita income losses will not be unwound by 2022 for about two-thirds of emerging market and developing economies. Fortunately, this need not signal the death knell for deals. In fact, AJM is experiencing close to a doubling in demand for earn-outs.
Lower value deals are, of course, going to be with us for some time, but in our experience, the flexibility provided by carefully planned earn-out provisions, together with tailored structured financing solutions and careful tax management strategies, are seeing many successful deals still being done. This is helping keep emerging market economies healthy and on track for more upside once vaccine rollouts improve.
It is, however, very important to remember that the timing of the various stages of an earn-out transaction becomes important when determining tax consequences. The full purchase consideration is not known and so the payment of each earn-out tranche needs to be assessed for its respective tax consequences. A tax loss can also potentially be created when earn-outs are involved.
Let’s use a simple example to explain: Let’s assume the base cost of shares being sold at the time of the transaction is R100, but only R50 is paid up front. The ultimate purchase price could be as high as R200 if certain conditions are met. Clearly, there is a tax loss at the initial stage, but each completed earn-out tranche becomes very important to ultimately determine the overall tax liability of the transaction, keeping in mind a completed earn-out can take up to three years in certain instances.
These amounts impact capital gains tax. In year one, the base cost is used (resulting in the tax loss), but as the earn-out provisions are met, the proceeds will likely have no base cost against which to be offset, which would result in capital gains being realised in subsequent years. In cases where the future is unknown, it may, therefore, make more sense to spread the deal over multiple years.
Other taxes to factor in would then be provisional tax and securities transfer tax. Managing tax risks includes determining value very carefully, which is a complex calculation entailing multiples of profit after tax, historic and future earnings and cash flow, among others
However, with all these elements in place, uncertainty is reduced substantially and in the current volatile world, this is the way to go.
Earn-outs are not just beneficial for large businesses, as they are helping smaller deals get out of the blocks too, accelerating growth opportunities for buyers and sellers. What we are finding is that earn-outs are proving to be a good way to get through any lingering “deal fatigue”, or reluctance to pull the trigger by an owner who, at the final hurdle, does not want to give up his “baby”.
A well-structured clause will also help buyers when things go wrong, and this leads to a smooth handover, especially as buyers often don’t know the business well enough in the initial stages. We are, therefore, seeing these structures helping with transitions, especially as most of the existing executives are likely to have had an equity stake in the business prior to the sale – and it is often good to ensure that good people with skin in the game are retained for as long as possible.
These structures are also proving important when specific COVID “carve outs” are required – for instance, a condition could be inserted that a store remains open for the deal to be completed. These carve-outs do lead to inevitable delays in the final conclusions of deals, but they are ensuring that buyers are not left in the lurch when lockdowns happen.
It is true that Africa, as a whole, remains frontier territory, with risks for business. AJM has advised on many transactions where earn-outs are being used to factor in these uncertainties, to ensure that deals happen. We have, for instance, found that our clauses which include a carve-out period for election violence are proving popular and necessary. We have found that clients like the certainty that this creates prior to them taking the leap into doing business in Africa.
On the whole, a properly structured earn-out leads to better planning, sustainability and prospects down the line.
While we are faced with an uneven COVID-19 recovery, earn-outs are helping to ensure that economies can keep ticking, with deals still very much on the agenda.
De Villiers is a Director: Private Clients | AJM Tax