Earn-out clause

An earn-out clause is a mechanism utilized in M&A transactions, which allows the seller to receive an additional payment post-closing if the company achieves specified financial targets. Typically, these metrics include revenue or EBITDA. It is crucial that these metrics are clear and easily verifiable to minimize the risk of disputes between the parties.

Mechanism of the Earn-Out Clause

The earn-out clause stipulates an additional payment to the seller if the company meets certain financial targets after the transaction. This mechanism benefits both parties. From the seller’s perspective, they can receive a higher price if their forecasts for the company’s future performance materialize. Conversely, the buyer mitigates the risk of overpaying if the company does not perform as expected by the seller.

Key Elements of the Earn-Out Clause

• Financial Metrics: Precise definition of the financial metrics to be considered in the earn-out calculation, such as revenue levels or EBITDA.
• Catalog of Financial Items: Clear identification of which financial items will be included and which will be excluded from the earn-out calculation.
• Duration: Usually spans from one to several years post-transaction.
• Verification Mechanism: Provisions regarding the role of an external expert or arbitrator to assist in verifying the financial results.
• Buyer’s Obligations: Specification of the buyer’s obligations concerning the continued operation of the business to ensure the company can achieve the agreed targets.
• Prohibitions for the Buyer: Establishment of a list of actions the buyer is prohibited from taking to avoid any negative impact on the company’s performance.

Benefits and Risks Associated with Earn-Outs

For the seller, the additional payment serves as an incentive to remain engaged in the company’s growth, while for the buyer it represents a reduction in financial risk and the possibility of paying the full price only if the company meets the set targets. However, a potential risk in earn-out settlements is the possibility of disputes if the parties disagree on the financial results that form the basis for the earn-out calculation. The seller, by remaining in the company, has greater control over the performance, which may lead to conflicts of interest with the buyer.

Practical Tips

• Precision and Clarity: provisions related to the earn-out should be as precise and clear as possible to avoid potential conflicts.
• Verification Procedures: define clear procedures for verifying financial results and the role of external experts.
• Consult Advisors: it is advisable to consult legal and financial advisors to ensure the earn-out clause is beneficial and protects the interests of both parties.

Conclusion

The earn-out clause is an effective tool in M&A transactions, allowing for an additional payment to the seller based on the future financial performance of the company. Its application, however, requires precise contractual provisions and clear verification procedures to minimize the risk of disputes and ensure that both parties are satisfied with the agreement.

We acknowledge the complexity and demanding nature of this subject. Should you require legal support in this regard, please do not hesitate to contact the Hoogells team.