Passing the Torch – Earn-outs, MNAV and Scrip-for-Scrip

When a founder sells their business, they’re not always walking away. In many cases, they’re staying on — for 12, 18, even 24 months — to help the buyer transition, retain key staff, and keep the wheels turning. That’s not just goodwill. It’s often baked into the deal through an earn-out: a deferred payment tied to the future performance of the business.

In this way, the seller is literally passing the torch — not just handing over the keys but helping light the path forward. But if the structure isn’t right, that torch can burn both ways.

What is an Earn-out?

An earn-out is a mechanism that defers part of the purchase price, making it contingent on the business hitting agreed performance targets after completion. It’s a way to bridge valuation gaps, align incentives, and manage risk — especially when the seller’s continued involvement is critical to the business’s success.

There are several common structures:

• Traditional Earn-out: A portion of the purchase price is withheld at completion and paid later if performance targets (e.g. EBITDA, revenue) are met. Payment can be in cash or shares and may be made in one or more tranches.
• Reverse Earn-out: The full purchase price is paid upfront (often into escrow), and the seller must refund part of it if targets aren’t met. This structure shifts risk back to the seller and is often used where the buyer wants certainty of ownership but still needs performance protection.
• Tranche-based Earn-out: The deal is split into multiple closings, with each tranche contingent on milestones or financial results.
• Earn-out via Shares: Instead of cash, the seller receives equity in the buyer (or a related entity) as part of the earn-out. This can trigger scrip-for-scrip rollover under Subdivision 124-M of the Income Tax Assessment Act 1997 (ITAA 1997) if structured correctly.

Each structure has different tax, legal and commercial implications — and the traps are easy to fall into.

Tax Implications: Subdivision 118-I and Beyond

The tax treatment of earn-outs depends on whether the arrangement qualifies as a look-through earn-out right under Subdivision 118-I of the ITAA 1997.

If Subdivision 118-I applies:

• The earn-out right is disregarded as a separate CGT asset.
• Any capital gain or loss on the creation of the right is ignored.
• Amounts received under the earn-out are treated as additional capital proceeds for the original CGT event.
• The seller must amend their tax return for the year of the original CGT event when the earn-out crystallises.
• For the Small Business CGT Concessions, the seller may elect to treat the market value of the earn-out right as zero for the Maximum Net Asset Value (MNAV) test — avoiding inflation of net assets.

To qualify, the earn-out must:

• Relate to future financial benefits that are not reasonably ascertainable at the time of the CGT event
• Be contingent on economic performance
• Relate to an active asset
• Be delivered within 5 years of the CGT event

If 118-I does not apply:

• The earn-out right is treated as a separate CGT asset.
• It must be valued upfront, often using probability-weighted scenarios and discounted cash flow methods.
• The value is included in the MNAV test, which may disqualify the seller from accessing small business CGT concessions.
• If the earn-out is satisfied in shares, the scrip-for-scrip rollover under Subdivision 124-M may not apply unless the SPA is carefully drafted to treat those shares as replacement interests under the same arrangement.

Why Drafting Matters

Earn-outs are only as effective as the documents that support them. Poorly drafted clauses can:

• Invalidate 118-I treatment if the earn-out is reasonably ascertainable or lacks performance-based conditions.
• Jeopardise MNAV eligibility if the earn-out is included as an asset without justification.
• Break the 124-M rollover if later-issued shares aren’t clearly linked to the original transaction.

Best practice drafting includes:

• Explicitly acknowledging the earn-out as a look-through earn-out right under Subdivision 118-I.
• Stating that any shares issued under the earn-out are replacement interests under Subdivision 124-M.
• Including a “tax intent & cooperation” clause requiring the buyer to provide timely and complete data for return amendments.
• Documenting the basis for any valuation or election made under MNAV or CGT rules, including the rationale for treating the earn-out as not reasonably ascertainable.

Beyond Tax: Commercial, Legal and Accounting Risks

While tax is a key consideration, earn-outs also carry significant non-tax risks that can derail a deal or sour the post-sale relationship.

Legal Risk: Disputes over Payment Triggers

Earn-out clauses that are vague or silent on key mechanics — such as how performance is measured, what accounting standards apply, or when payments are due — are fertile ground for disputes.

Common flashpoints include:

• Ambiguity in calculation methods (e.g. EBITDA vs net profit, pre- or post-tax).
• Disagreements over adjustments (e.g. normalisation, working capital, one-off costs).
• Lack of clarity on timing (e.g. when is the earn-out measured? When is it payable?).

Fix: Draft with precision. Define the metrics, the measurement period, the calculation method, and the dispute resolution process. Include worked examples if needed.

Commercial Risk: Misaligned Incentives

Earn-outs are meant to align interests — but they can just as easily pull them apart.

• Buyer’s risk: The seller may lose motivation once they’re no longer the owner, especially if the earn-out is hard to achieve or perceived as unfair.
• Seller’s risk: The seller is no longer in control. They may not get the full purchase price if the buyer changes strategy, under-resources the business, or manipulates the accounts.

Fix: Consider transitional roles, governance rights, and information access. Sellers may negotiate observer rights, reporting obligations, or even veto powers over key decisions during the earn-out period.

Accounting Risk: Verifying Performance

For the seller, the biggest challenge is often verifying whether the earn-out threshold has been met. Without access to the buyer’s accounts, they’re left in the dark.

Fix, includes:

• A right to inspect financial records.
• A requirement for audited accounts or certified calculations.
• A dispute resolution mechanism, such as independent expert determination.

Also consider whether the earn-out should be based on gross metrics (e.g. revenue) rather than net metrics (e.g. profit), which are more susceptible to manipulation.

Keep the torch burning.

Earn-outs are more than just a pricing mechanism — they’re a bridge between seller and buyer, past and future. But they’re also a legal and tax minefield.Whether you’re advising on the deal or drafting the documents, make sure the structure supports the commercial intent, preserves the concessions, and keeps the torch burning — not burning out.