When you ask a mergers and acquisitions (M&A) lawyer about an earn-out, the reaction will likely be mixed. Some will focus on the ability of an earn-out to be an effective M&A mechanism, and others will focus on its complexity and the likelihood of a dispute arising related to whether or not an earn-out will be paid. Both are accurate reactions. My experience is that when crafted and implemented well, earn-outs are a powerful solution to close deals that might otherwise stall.

Why Use an Earn-Out

Earn-outs can be an especially successful tool in M&A to:

  • Bridge valuation gaps.
  • Share risk through linking consideration to post-closing results (rather than forecasts).
  • Align incentives by rewarding sellers (often continuing in management) if the business achieves certain milestones.

Common Earn-Out Metrics

Selecting the right metric on which to base the earn-out is critical. Some common metrics include:

  • Revenue or gross sales.
  • Profits, EBITDA or adjusted EBITDA.
  • Operational achievements such as the number of units sold, active or new users, bookings, qualified sales pipeline, regulatory approvals, product launches, entering new territories, or integration milestones.

What Sellers Want

In an earn-out, sellers often try to negotiate for some of the following:

  • Covenant not to frustrate. Sellers tend to seek an express obligation that a buyer will not take actions with the primary intent to avoid payment of an earn-out.
  • Visibility and access. The deferment of payment means that sellers want robust reporting or audit rights and data access to verify performance.
  • Control and resources. To the extent possible, sellers ask that buyers commit to budgets, staffing, and commercial support levels.
  • Payment backstops. Sellers might seek an escrow or holdback to facilitate payment, as well as interest on late payments, limits on set‑off, and remedies for material breach.
  • Acceleration triggers. Sellers often attempt to negotiate a deemed achievement of an earn-out or a fair value payment upon the occurrence of a specified breach(es) or a change‑of‑control.

What Buyers Want

On the other hand, in an earn-out, buyers often try to negotiate for some of the following:

  • Operational flexibility. Buyers require the ability to manage the business in the best interests of the combined group, in their sole discretion, subject only to narrow anti‑frustration language.
  • Clear metrics and caps. Buyers seek certainty with hard caps on the earn-out, along with a floor or tiering to manage downside and avoid windfalls.
  • Integrity of financials. Buyers will attempt to negotiate consistent accounting with buyer‑wide policies where appropriate or exclusions for extraordinary or non‑recurring items.
  • Alignment. Buyers will seek non‑competition, non‑solicitation, and retention arrangements to keep key personnel engaged.
  • Set‑off rights. Buyers will seek the ability to make net indemnity claims against unpaid earn‑out amounts.

The Earn-Out Clause

As you might appreciate from the non-exhaustive seller and the buyer wish lists above, earn-outs are heavily negotiated. They are tailored to the specific business, the industry, the parties, and the transaction. Clear and concise language is a given. In my experience a well drafted earn-out clearly sets out the term and cap for an earn-out, the targets and milestones to be achieved, any adjustments or addbacks, accounting and metric measurement standards, sample calculations, and a dispute resolution mechanism that involves the buyer and seller first using good faith efforts to settle any dispute before any referral to a binding solution from a third-party (such as an accountant or arbitrator).

Next Steps

If you are contemplating an earn‑out, consider:

  1. Selecting metrics that are clearly defined with examples.
  2. Stress‑testing the metrics, formulas and covenants against realistic scenarios.
  3. Designing practical reporting and dispute‑resolution terms.

If you are considering an earn-out or structuring an M&A transaction, let’s discuss how to design an approach that works for your deal:

Brant Harvey

Partner

204.956.3572

[email protected]