What Is an Earn-Out and Why Do Agencies Use Them?

An earn-out is a deferred payment structure in an acquisition. You sell your agency today, but part of the purchase price depends on performance over the next two or three years. The buyer pays you more if the agency hits agreed targets, usually revenue, profit, or client retention metrics.

For agency acquisitions, earn-outs are standard. Buyers want protection against the risk that the founder leaves and the business drops off. You want a higher price than the buyer will pay upfront. An earn-out bridges that gap.

But here is where it gets complicated. The tax treatment of your earn-out payments depends entirely on how the deal is structured. Get it wrong and you could pay 45% income tax on money you thought was a capital gain taxed at 14%. That difference, tens or hundreds of thousands of pounds, matters.

The Core Tax Distinction: Capital vs Income

HMRC looks at earn-out payments and asks one question: is this consideration for the shares you sold, or is it payment for ongoing services you provide after the sale?

If it is consideration for shares, you pay Capital Gains Tax (CGT) on the gain. If you qualify for Business Asset Disposal Relief (BADR), that rate is 14% on the first £1m of lifetime gains. Above that, the standard CGT rate for residential property is 24% and for other assets including shares it is 20%.

If HMRC recharacterises your earn-out as employment income, you pay income tax at your marginal rate, 40% or 45%, plus Class 1 National Insurance at 2% (employee) and 13.8% (employer). The total tax burden can exceed 50%.

This is not a theoretical risk. I have seen it happen to agency founders who signed standard buyer-drafted earn-out agreements without taking separate tax advice.

The Two Common Structures

1. Deferred consideration for shares. The earn-out is a contractual right to receive additional cash if certain targets are met. You sell your shares on completion. The earn-out is treated as part of the sale proceeds. CGT applies. This is usually the most tax-efficient route.

2. Post-completion employment income. The earn-out is structured as a bonus, consultancy fee, or dividend stream paid to you after the sale. You remain employed or engaged by the buyer. The earn-out is taxed as earnings. This is almost always worse for you.

Some deals mix both. You sell 70% of your shares upfront and stay on as a director with a bonus linked to performance. That bonus is employment income. The share sale is capital. You need to separate them clearly in the documentation.

BADR and the Two-Year Rule

To qualify for Business Asset Disposal Relief (formerly Entrepreneurs' Relief) on your share sale, you must meet three conditions:

  • You held at least 5% of the shares and voting rights
  • You were an employee or officer of the company
  • Both conditions were met for at least two years before the date of disposal

Here is the trap. If your earn-out is structured as deferred consideration, the date of disposal for CGT purposes is the date you sell the shares, not the date you receive each earn-out payment. That means you must have held the shares for two years by completion. If you incorporated your agency 18 months ago and sell today with a three-year earn-out, you do not qualify for BADR on the deferred element.

There is a statutory rule that helps. Under TCGA 1992, s 280, if you receive deferred consideration, you can elect to pay CGT on the instalment basis, paying tax as you receive each payment. But the BADR qualification is tested at the point of disposal, not when cash lands in your account.

If you have been a director for four years and hold 100% of the shares, you satisfy the two-year rule easily. But check the exact dates. If you transferred shares to a spouse or trust within the last two years, that can reset the clock.

How HMRC Views Earn-Outs: The Key Factors

HMRC publishes guidance in the Capital Gains Manual at CG12600 onwards. They look at several factors to decide whether an earn-out is capital or income:

  • Is the earn-out linked to your ongoing employment? If you must stay employed to receive it, HMRC will argue it is employment income.
  • Is the earn-out calculated on your personal performance? If it depends on your individual billable hours or new business targets, it looks like remuneration.
  • Does the buyer have discretion? If the buyer can reduce or cancel the earn-out at will, it is harder to argue it is fixed consideration for shares.
  • Is the earn-out paid as a dividend? Dividends are distributions of profit, not consideration for shares. They are taxed at dividend rates (8.75%, 33.75%, or 39.35%) but do not qualify for BADR.

A clean structure looks like this: you sell your shares on day one. The buyer issues a loan note or deferred consideration agreement that pays out on specified dates, conditional only on the agency's financial performance, not on your continued employment. You can leave the business the next day and still receive the earn-out.

That is the gold standard for tax treatment as capital gain.

Worked Example: Two Agency Founders, Two Outcomes

Founder A sells his 12-person digital agency for £1.2 million. The deal is structured as £700,000 upfront and £500,000 earn-out over three years, based on EBITDA targets. He sells his shares on completion. The earn-out is a contractual right attached to the shares. He resigns as director the same day.

His total gain (after base cost and annual exemption) is £1.15 million. He qualifies for BADR on the full amount because he held the shares for four years. tax at 14%: £115,000. Net proceeds: £1,085,000.

Founder B sells a similar agency for the same price. But the buyer requires him to stay as managing director for three years. The earn-out is structured as a bonus: 20% of annual net profit above £200,000. He receives £150,000 in year one, £180,000 in year two, and £170,000 in year three.

HMRC treats the earn-out as employment income. He pays 40% income tax plus 2% NI on each payment. Total tax on the earn-out: approximately £210,000. On the upfront £700,000 share sale, he pays 14% BADR: £70,000. Combined tax: £280,000. Net proceeds: £920,000.

Founder B pays £165,000 more tax than Founder A, on the same total deal value. That is the cost of a poorly structured earn-out.

Negotiating the Earn-Out: What to Push For

You can improve the tax outcome through negotiation. Here is what to prioritise:

Make the earn-out unconditional on employment. If the buyer insists you stay, negotiate a separate service agreement with a market-rate salary. Keep the earn-out purely linked to company performance, not your personal role.

Cap the earn-out period at two years. Shorter periods reduce the risk of HMRC arguing the payments are disguised remuneration. They also get you your money faster.

Use a loan note structure. The buyer issues you a loan note on completion. The note pays interest and principal on set dates. This is clearly capital consideration. It also defers your tax liability until you receive the cash, if you elect under s 280.

Get a tax indemnity from the buyer. If the buyer insists on a structure that creates income tax risk, ask them to indemnify you for any additional tax you incur. Some buyers will agree. Most will not. But asking signals that you understand the risk.

Separate the earn-out from any post-completion consultancy fees. If you provide ongoing services, agree a separate consultancy agreement at a commercial rate. Do not bundle it into the earn-out calculation.

What Happens If the Earn-Out Fails?

If the agency does not hit its targets, you receive less or nothing. That is the commercial risk you accepted. But there is a tax angle here too.

If you paid CGT upfront on the full estimated earn-out value (because you elected to treat the entire consideration as fixed at completion), and then the earn-out pays less, you can claim a loss. That loss can be carried back or set against other gains in the same tax year.

If you used the instalment basis (paying tax as you receive cash), you simply pay less tax because you receive less cash. No loss claim needed.

Most agency founders prefer the instalment basis for this reason. It matches cash flow to tax liability and avoids overpaying HMRC upfront.

Employment Taxes on Earn-Outs: The Hidden Risk

If HMRC successfully argues that your earn-out is employment income, the consequences go beyond your personal tax bill. The buyer (your former agency, now owned by the acquirer) is liable for employer NI at 13.8% on the earn-out payments. They also need to operate PAYE and report the payments on your P60.

Most buyers will resist this because it increases their costs. But if the earn-out is written as a bonus or profit share linked to your personal performance, they have no choice. HMRC can and does audit these arrangements.

If the buyer refuses to operate PAYE and HMRC later determines the earn-out is employment income, HMRC will pursue the buyer for the unpaid employer NI plus interest and penalties. The buyer will then likely pursue you under the indemnity clauses in the sale agreement.

This is why you need the earn-out documented as consideration for shares, not as a bonus. It protects both you and the buyer.

Dividend Earn-Outs: A Common But Risky Structure

Some buyers propose a dividend earn-out. You retain a small shareholding post-completion. The buyer declares dividends each year, and your share of those dividends forms the earn-out.

On the surface, this looks attractive. Dividends are taxed at lower rates than employment income. You pay 33.75% at the higher rate, compared to 40% income tax plus NI.

But there are problems. First, dividends do not qualify for BADR. You pay CGT on the share sale at 10% (if eligible) but the dividend earn-out is taxed as dividend income. Second, dividends can only be paid from distributable profits. If the agency has a bad year, there may be no profits to distribute, and you receive nothing, even if the underlying business is performing well on an EBITDA basis.

Third, HMRC can challenge dividend earn-outs under the settlements legislation (ITTOIA 2005, Part 5). If the dividend arrangement is designed to avoid tax, HMRC can recharacterise it as employment income anyway.

Dividend earn-outs work best where the buyer is a larger group and you retain a genuine minority shareholding with real rights. They are risky as a pure tax planning device.

Practical Steps Before You Sign

If you are considering an offer that includes an earn-out, do this before you instruct lawyers:

  • Get tax advice on the draft structure. Ask your accountant, ideally one who understands agency exits, to review the term sheet. Our ICAEW qualified team at Agency Founder Finance sees these structures regularly and can flag issues early.
  • Model the post-tax outcome. Work out what you actually keep after tax under different earn-out scenarios. Use real numbers, not round figures. A £500,000 earn-out taxed at 14% is £450,000 net. The same earn-out taxed at 42% (40% income tax plus 2% NI) is £290,000. That £160,000 difference is real money.
  • Negotiate the earn-out terms before you agree the headline price. Once the price is fixed, buyers have less incentive to improve the structure. Push for capital treatment as part of the initial negotiation.
  • Check the two-year BADR holding period. If you are close to the threshold, delay completion or restructure the deal to qualify.
  • Consider a share-for-share exchange. If the buyer is a company, you can exchange your shares for shares in the acquirer. This defers CGT entirely until you sell the new shares. Earn-outs can be structured within this framework.

Final Thought

An earn-out is a commercial tool. It lets you sell your agency for a higher price than a buyer will pay upfront. But the tax treatment is not automatic. It depends on how the deal is documented.

The difference between capital treatment and income treatment can be hundreds of thousands of pounds. That is worth getting right before you sign.

If you are planning an exit and want to understand how earn-out structures affect your tax position, speak to an accountant who works with agency founders. Get in touch with us if you want to run through your specific situation.