In M&A transactions, the determination of the purchase price is often the most significant, and at the same time the most difficult and sensitive, aspect of the negotiations. Where buyer and seller hold divergent views as to the target business’s future performance, an earn-out may serve as an effective mechanism to enable or facilitate the transaction. By making part of the consideration contingent on future performance, the parties create a pricing mechanism under which the final purchase price is determined only once that performance has, or has not, materialised in practice.
An earn-out is particularly well-suited to a number of clearly identifiable situations. This is, first and foremost, the case where there is a material valuation gap between the parties: the seller may be confident that the business will deliver future growth, whereas the buyer will often be reluctant to pay upfront for performance that has yet to be achieved and may never in fact be realised. An earn-out may also be appropriate where future performance is inherently difficult to predict, for example in the case of high-growth businesses, companies with a limited trading history, or businesses that are heavily dependent on particular customers, key contracts or existing management. It may equally be suitable where the seller’s continued involvement following closing is important to the ongoing success of, or an orderly transition for, the business, since it can help align the parties’ incentives.
The effectiveness of an earn-out, however, depends to a considerable extent on the way in which it is contractually structured. A first key consideration is the selection and drafting of the relevant performance criteria (KPIs). Those criteria must not only be objective and measurable, but must also properly reflect the economic reality of the business. In practice, unclear or overly elaborate definitions of financial metrics such as EBITDA or revenue may give rise to competing interpretations, and consequently to disputes between the parties. It is therefore advisable to define such concepts in the acquisition agreement with a high degree of precision, including by specifying the applicable accounting principles and any adjustments or normalisations to be made, and, where possible, by aligning those definitions with the company’s historical financial reporting and other reference data.
An earn-out also requires careful attention to governance during the earn-out period and to the manner in which that governance is reflected in the acquisition agreement. Following closing, the buyer will control the business and, as a matter of principle, enjoy broad discretionary authority over its operation. That discretion may directly affect both the performance ultimately achieved and the calculation of the earn-out. This gives rise not only to an economic tension, but also to a legal issue: absent a sufficiently robust contractual framework setting out clear rights and obligations, it may be difficult to constrain or challenge the buyer’s exercise of that discretion.
In practice, the buyer may influence performance, and therefore the amount of the earn-out, in a variety of ways, including through the allocation of costs (such as management charges or intra-group recharges), changes in accounting policies, or the reorganisation of activities within the group. Strategic decisions, such as accelerating investments or altering commercial strategy, may likewise have a material effect on the relevant KPIs. Although such measures may be entirely legitimate in the ordinary course of business, they may create difficulties for the seller where they affect the earn-out and the transaction documentation does not clearly regulate their permissibility or, where appropriate, the adjustments to be made to neutralise their effect.
To manage that risk from the seller’s perspective, these matters should be addressed expressly and, so far as practicable, with specificity in the acquisition agreement. That said, some degree of grey area will often remain, and it is not always straightforward to strike an appropriate balance between the seller’s interest in preserving the integrity of the earn-out and the buyer’s interest, as the new owner of the business, in retaining sufficient freedom to make strategic decisions. In practice, this will usually result in a combination of covenants governing the conduct of the business during the earn-out period, including both general undertakings (such as an obligation to operate the business in the ordinary course) and more specific restrictions or behavioural obligations imposed on the buyer and the target business. By way of example, the agreement may prohibit the buyer from taking action with the primary purpose of depressing the earn-out, prescribe the continued application of specified accounting principles, or regulate intra-group transactions and cost allocations. The parties may also agree on efforts covenants, including an obligation to use reasonable commercial efforts to achieve the earn-out targets, and may refer to an agreed business plan as a reference point.
Transparency is likewise essential. As noted above, part of the seller’s consideration depends on the post-closing performance of the transferred business, yet the seller will generally no longer have operational control and there will often be a degree of information asymmetry. It is therefore prudent for the transaction documentation to include clear provisions on reporting, information rights and verification mechanisms, so that the seller is able to monitor and, where necessary, test the calculation of the earn-out.
Finally, a clear dispute resolution framework is the last essential component of a well-structured earn-out. Given the technical nature of many disputes, for example those concerning the application of accounting principles or the calculation of particular KPIs, the parties will often provide for such matters to be referred for binding determination to an independent expert, such as a statutory auditor or accountant. More purely legal disputes may, in turn, be submitted to the competent courts or to arbitration. In any event, the acquisition agreement should set out a clear and orderly process, including fixed deadlines, escalation steps and the designation of the decision-making forum. Such an approach materially increases the likelihood that disputes can be resolved promptly and efficiently.
In short, an earn-out can be a valuable tool for bridging valuation gaps, facilitating complex transactions and aligning the parties’ interests. Its success, however, depends on the quality of its drafting: clear definitions, balanced governance arrangements, transparent reporting and a carefully designed dispute resolution mechanism are all essential if the earn-out is to promote legal certainty rather than give rise to fresh uncertainty.