Introduction
Earn-out clauses are increasingly popular in share sale and purchase agreements. An earn-out clause is a contractual provision in a share purchase transaction where the buyer agrees to pay the seller an additional purchase price—referred to as the earn-out—if the target company meets certain predetermined financial benchmarks within a defined period after the closing. Essentially, the earn-out serves as a conditional supplementary payment, contingent on the target’s future financial performance.
Type of earn-out clauses
There are typically two types of earn-out clauses:
Single transaction earn-out – This applies when all shares of the target company are sold in a single transaction.
Tranche-based earn-out – This occurs when the shares are sold in stages over time.
Single Transaction Earn Out
In the first type, which is the most common, the buyer initially pays the seller a base purchase price, determined based on the target’s current value at the closing date. Subsequently, after a specified earn-out period, the buyer makes an additional payment, calculated based on the future value of the target. This payment is contingent upon the target meeting predefined financial milestones during the agreed reference period
Tranche-based Earn Out
For this type of earn-out clause, the buyer acquires the target's shares in stages, rather than all at once. This means that multiple purchase price payments are made, corresponding to each tranche of shares transferred under the agreement. The price for the first tranche is final and determined based on the target's current value at closing. However, subsequent payments for the remaining tranches are contingent upon the target meeting specific financial milestones over one or more post-closing earn-out periods.
Practical purpose of earn-out clauses
The use of an earn-out mechanism allows for the reconciliation of the differing valuation perspectives of the seller and the buyer in a share transaction. Typically, sellers adopt a forward-looking pricing approach, valuing the target based on its anticipated financial performance and overall growth potential. In contrast, buyers tend to take a backward-looking approach, relying on historical financial data and being cautious about factoring in uncertain future projections. An earn-out serves as a compromise by allowing part of the purchase price to be contingent on the target achieving specified financial milestones, thereby bridging the valuation gap between the parties.
This differing approach stems, in part, from the information asymmetry inherent in any transaction. The seller possesses an in-depth understanding of the business, having first-hand knowledge of its operations, prospects, and potential. In contrast, the buyer's knowledge is limited to the findings of a due diligence process, which may vary in scope and depth, leading to a natural divergence in how each party assesses the value of the target company.
In some cases, the seller and buyer successfully negotiate a purchase price that fairly balances both perspectives on valuation. However, there are instances where they struggle to reach common ground. This is where an earn-out mechanism can serve as a practical solution, helping to break the deadlock by allowing part of the purchase price to be contingent on the target's future performance. By incorporating an earn-out, the parties can move past their valuation impasse and ultimately secure the transaction.
Specific Advantages and Disadvantages
Seller’s Perspective
An earn-out mechanism offers both benefits and drawbacks for both the seller and the buyer. For the seller, it provides an opportunity to remain financially involved in the target's growth post-closing. This allows the seller to potentially reap the rewards of the business’s continued success, effectively benefiting from the value they helped create.
Buyer’s Perspective
From the buyer’s perspective, an earn-out mechanism can offer several strategic advantages:
It allows the buyer to pay an initial purchase price at closing that aligns with its own valuation of the target’s financial potential at the time of signing. At the same time, the buyer can accommodate the seller’s higher price expectations by making additional payments contingent on the target achieving the projected financial performance;
It serves as an effective incentive for the seller to remain involved in managing the business during a transition or handover period, ensuring continuity and stability;
It helps preserve the buyer’s cash flow, unless the earn-out amount is required to be placed in escrow or backed by a bank guarantee at the seller’s request;
It can facilitate smoother financing of the acquisition, as the buyer may have the flexibility to use future dividends from the target to fund the earn-out payments;
an earn-out can also serve as a security measure for the buyer in relation to the seller’s indemnification obligations. If the seller breaches any representations and warranties, the buyer can offset any amounts payable under the earn-out clause against the seller’s liability under the indemnification provisions of the share sale and purchase agreement. This provides the buyer with an additional layer of financial protection in the transaction.
Key Considerations when Drafting Earn-out Clauses
When drafting or negotiating earn-out clauses, it may be prudent to consider the following, among others:
(a) First and foremost, the parties must carefully determine the financial milestone(s) that will trigger the earn-out payment. There is no fixed rule for this selection, giving both parties complete flexibility in choosing their preferred metric. In our experience, EBIT/EBITDA is the most commonly used benchmark, particularly in mid-sized transactions.
(b) the parties must determine an appropriate earn-out reference period, considering factors such as the nature of the target's business and any handover period involving the seller, if applicable.
Currently, typical earn-out reference periods fall within the following ranges:
(i) 18 to 24 months for small and mid-sized transactions;
(ii) 6 to 24 months for larger deals.
A shorter earn-out period increases the risk that the target's financial performance may be influenced—positively or negatively—by unexpected events. It may also lead to conflicts of interest if the seller remains involved in management, as they might prioritize short-term results over the company's long-term success.
Conversely, a longer earn-out period provides greater assurance that the financial performance measured is a more accurate reflection of the target’s true growth potential.
Additionally, the parties should consider whether certain predefined events should accelerate or terminate the seller’s right to receive earn-out payments.
(c) The parties must exercise particular caution when the target company has subsidiaries or affiliated entities, ensuring that the legal and accounting scope used to calculate the financial metrics for the earn-out is clearly defined. Additionally, they must explicitly agree on the accounting principles to be applied post-closing when preparing the (pro forma) consolidated accounts used for these calculations.
To protect the seller’s interests, it is common to include restrictive covenants preventing the buyer from making structural changes that could negatively impact the earn-out metrics during the reference period. These protections may include restrictions on selling subsidiaries or merging the target with another company, as such actions could directly or indirectly affect the target’s financial performance and, consequently, the earn-out calculation.
Furthermore, the parties must establish:
(i) The process for preparing and verifying the (consolidated) accounts used to assess whether the earn-out milestones have been met.
(ii) A dispute resolution mechanism to address disagreements regarding the preparation of these accounts, the calculation of financial milestones, or the final earn-out amount.
(d) The parties should establish clear guidelines regarding the management of the target during the earn-out period. This includes defining specific actions that the buyer cannot undertake without first obtaining the seller’s consent. These restrictions help ensure that the target's operations remain stable and that its financial performance is not unduly influenced in a way that could impact the earn-out calculation.
The primary principle is ensuring that the seller (or their representatives) remains involved in managing the target during the earn-out period. These management-related provisions are primarily designed to protect the seller from any actions by the buyer that could unfairly manipulate the earn-out metrics to the seller’s disadvantage. Additionally, they serve to prevent the buyer from making decisions that could indirectly harm the target’s financial performance during this period.
(e) The parties should consider whether to establish a minimum (floor) and/or maximum (cap) for the earn-out payments. Buyers typically seek to cap the total earn-out amount, often limiting it to 10% to 25% of the estimated target value. In transactions involving tranche-based transfers, sellers often negotiate for a minimum earn-out to ensure they receive a guaranteed portion of the additional purchase price.
Additionally, the seller must carefully assess any potential adverse interactions between the representations and warranties mechanism and the earn-out provisions. This helps avoid situations where the seller could be penalized twice for the same event, which could otherwise result in an unfair financial impact.
(f) Sellers may occasionally seek to secure the earn-out payments by negotiating a guarantee from the buyer, such as a first-demand bank guarantee, an escrow arrangement, or a pledge over a portion of the target's shares. However, such requests can diminish the buyer’s incentive to agree to an earn-out, as they undermine its flexibility and financial benefits. If the parties fail to find a mutually acceptable solution, these negotiations could ultimately lead them back to a deadlock, jeopardizing the transaction.
Conclusion
Earn-out clauses, which provide flexibility and align incentives, are essential in bridging value disparities between buyers and sellers in M&A transactions. Parties can design earn-out agreements that defend their interests and promote a seamless transaction process by precisely specifying financial measures, putting in place suitable safeguards, and foreseeing possible disputes. Earn-out procedures, however, should be handled strategically and legally given the complexity involved in order to prevent disagreements and guarantee a just result for all parties.
The above content presented in this article is meant solely for offering general information and should not be considered as legal opinion or professional advice. If you would like to speak with our expert on structuring your next acquisition, drop us a text/call us up to schedule a consultation
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