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Attorney at Law (Finland)
M&A Vocabulary – Understanding for Experts: “Earn-Out”
In this ongoing series, rotating M&A experts from Rödl’s offices around the world introduce an important term from the English technical language of the transaction business, along with notes on its usage. This is not about academic-legal precision, linguistic nuances, or an exhaustive presentation, but about conveying or refreshing a basic understanding of a term and providing some useful tips from consulting practice.
The basis for Business Valuation and the resulting purchase price determination is usually the planning and forecast-supported expectation of the target company’s future earnings, derived from past business development.
However, sellers are generally unwilling to provide guarantees regarding future business development or to accept discounts on the purchase price for corresponding uncertainties or risks. This is especially true if they can no longer influence the target company’s economic activity after the sale.
For the buyer, on the other hand, there is considerable uncertainty if the assumptions underlying their valuation for future development are highly dependent on factors over which they have little or no control. This uncertainty is amplified if the target company operates in countries where the buyer lacks in-depth market experience.
This is particularly the case when the business success was significantly linked to the seller’s person – for example, because they were involved in the operational business themselves (e.g., as managing director) or the business success in the past depended on them (e.g., through personal customer contact, retention of key employees, integration into a group structure) and may also depend on their actions in the future (promoting actions but also refraining from damaging actions).
An Earn-Out mechanism is a purchase price arrangement in the company purchase agreement, whereby a portion of the purchase price payable to the seller is made in the future. The emergence, due date, and possibly the amount of the claim depend in particular on the achievement of certain metrics within defined periods at the target company.
An Earn-Out arrangement can secure the seller’s support, at least for a certain transition period, and increase their motivation to contribute to a successful continuation and integration. However, care must be taken to ensure that the criteria to be achieved are realistic, as otherwise the positive “reward effect” will be missed, and unattainable targets can be demotivating. However, certain events that significantly influence the fulfillment of earnings forecasts (e.g., the extension of a license, the outcome of pending litigation) can also be secured for the buyer – as an alternative to a direct conditional purchase price retention – indirectly through arrangements that provide for future payments to the buyer depending on the outcome. Earn-Out arrangements are therefore effective actions to hold the seller accountable for statements regarding the expectation of certain planned figures. In return, an Earn-Out arrangement can also be attractive for the seller, as it provides them with the opportunity to additionally benefit from a sustainably successful transaction beyond the individually negotiable purchase price. In negotiations, Earn-Out arrangements are therefore often a suitable means to reconcile seller and buyer positions through the possible distribution of risks and opportunities, and thus to bring about an agreement. However, this solution comes at the cost of increased complexity of the payment mechanism to be designed in the purchase agreement. The structure of a suitable Earn-Out mechanism depends on many factors, such as the industry (seasonality), the buyer’s strategy, and the valuation method used. The simpler and clearer the arrangement, the less likely are later disagreements.
An Earn-Out arrangement can secure the seller’s support, at least for a certain transition period, and increase their motivation to contribute to a successful continuation and integration. However, care must be taken to ensure that the criteria to be achieved are realistic, as otherwise the positive “reward effect” will be missed, and unattainable targets can be demotivating. However, certain events that significantly influence the fulfillment of earnings forecasts (e.g., the extension of a license, the outcome of pending litigation) can also be secured for the buyer – as an alternative to a direct conditional purchase price retention – indirectly through arrangements that provide for future payments to the buyer depending on the outcome. Earn-Out arrangements are therefore effective actions to hold the seller accountable for statements regarding the expectation of certain planned figures. In return, an Earn-Out arrangement can also be attractive for the seller, as it provides them with the opportunity to additionally benefit from a sustainably successful transaction beyond the individually negotiable purchase price. In negotiations, Earn-Out arrangements are therefore often a suitable means to reconcile seller and buyer positions through the possible distribution of risks and opportunities, and thus to bring about an agreement. However, this solution comes at the cost of increased complexity of the payment mechanism to be designed in the purchase agreement. The structure of a suitable Earn-Out mechanism depends on many factors, such as the industry (seasonality), the buyer’s strategy, and the valuation method used. The simpler and clearer the arrangement, the less likely are later disagreements.
In practice, the scope and complexity of Earn-Out clauses quickly increase during negotiations, with the following topics generally being addressed:
- Conditions for the claim to arise (metrics, other conditions, e.g., compliance with a non-compete clause)
- Earn-Out period, basis of assessment, amount, and calculation
- Control and determination of business figures
- Specifications, influences, and restrictions regarding the target company’s future business activities during the Earn-Out period
- Corrections and adjustments in the calculation of the basis of assessment
- Collateral, such as (partial) deposit into an escrow account, bank guarantees, sureties
- Payment procedures and dates
- Review procedures
Typically, Earn-Out periods range from two to three years, although longer periods may be agreed upon in individual cases. The Earn-Out share of the purchase price amounts to 20-40 percent of the purchase price in the majority of cases, with 50 percent or more being agreed upon for specific risks.
Especially in cross-border transactions, additional topics need to be considered, such as:
- Consideration of exchange rate differences/devaluation
- Applicable accounting principles
- Applicable law
- Dispute resolution mechanisms
The cause of the complexity is a conflict of interest between the parties, the balancing of which regularly requires detailed definitions and complex calculation formulas. For example, the trigger for the Earn-Out claim is regularly the achievement of certain planning targets (e.g., cumulative EBITDA or EBIT over a period of three years). The seller thus makes their future claim dependent on factors over which they have no or only limited influence. The buyer, as the new owner, on the other hand, has many ways to shape the result (e.g., through transfer prices, investments, allocations) and thus prevent the fulfillment of the Earn-Out conditions. For this reason, the seller’s intention will be to include as many restrictions as possible for result-relevant actions or corresponding adjustments to the calculation formula.
The buyer, on the other hand, understandably wants as few restrictions as possible to apply to their newly acquired company. A possible approach to simplification would be to agree on the achievement of certain revenue targets instead of EBIT or EBITDA targets. This has the advantage for the seller that manipulation on the cost side by the buyer is less possible.
When appropriately applied in suitable initial situations, Earn-Out arrangements allow for softening entrenched negotiation positions on both sides by providing more security to the skeptical buyer and offering the confident seller the chance to increase the achievable purchase price.
Experienced experts are able to formulate Earn-Out mechanism arrangements in a balanced, transparent, and unambiguous way, without making them unnecessarily complex. This avoids uncertainty and frustration on both sides – during negotiations and beyond the closing of the transaction.
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