Legal Flash - Earn-out clauses: a strategic tool, but with key risks

What is an earn-out?

An earn-out is a contractual provision in an M&A agreement that ties part of the purchase price to the future performance of the target company. The seller receives additional payments after the deal closes, depending on the company’s financial performance, specific milestones, or other agreed-upon criteria. These clauses are often used when there is uncertainty about the target's future earnings or when the buyer and seller cannot agree on an immediate valuation.

Why use earn-outs?

• Bridging the valuation gap: In cases where the buyer and seller have different views on the target company's value, an earn-out can help align their interests. The buyer can pay a lower initial price, with additional payments contingent on the target’s performance post-closing.
• Retaining key management: Earn-out provisions can incentivize the seller to remain with the business and ensure continuity in management. This is especially useful when key management will play an important role in the post-transaction integration process.
• Risk mitigation for buyers: The buyer can mitigate the risk of overpaying for the business by tying part of the purchase price to future performance. If the company does not perform as expected, the buyer will pay less.

Risks and challenges of earn-outs

• Measurement disputes: One of the main challenges with earn-out clauses is the potential for disputes over how performance is measured. Different interpretations of financial metrics or business performance can lead to disagreements. Clear and precise definitions of performance criteria are critical to avoid future conflicts.
• Management control: After the transaction, the seller may have limited control over the company’s operations, which can affect the ability to meet the performance targets. The buyer’s decisions and actions post-acquisition may significantly influence the outcome of the earn-out, creating tension between the parties.
• Integration risks: The post-merger integration process can impact the target's ability to meet the earn-out targets. Merging operations, cultures, and strategies may create unforeseen challenges that hinder performance.

Best practices for structuring earn-out clauses

• Clear performance metrics: To avoid disputes, it is essential to define clear, measurable performance targets. These should be based on objective criteria such as revenue, EBITDA, or other financial metrics, and should take into account both short-term and long-term goals.
• Time frame and caps: The duration of the earn-out period should be specified, typically ranging from one to three years, and caps on the earn-out amount can help provide a clear limit on the buyer’s exposure.
• Governance and reporting: To ensure that both parties are aligned, establish clear reporting mechanisms and transparency regarding performance tracking. The seller should have access to the necessary financial information to monitor progress.
• Dispute resolution: Including a dispute resolution mechanism in the agreement is key. Consider mediation or arbitration to resolve potential conflicts efficiently and avoid costly litigation.

Why legal counsel is crucial in earn-out transactions

• Tailored contractual drafting: Specialized M&A lawyers can draft clear, effective earn-out provisions that align the interests of both the buyer and seller, reducing the potential for future disputes.
• Risk assessment: Legal counsel can help assess the risks associated with earn-outs, advising on the best approach to ensure that both parties are protected.
• Mediation and dispute resolution: If disagreements arise, experienced lawyers can assist in resolving disputes quickly, whether through negotiation or alternative dispute resolution methods.