In Mergers and Acquisitions (M&A), achieving a mutually satisfactory purchase price when selling your business is often the most significant hurdle. When a buyer’s conservative valuation clashes with a seller’s optimistic projection of future growth, the deal can easily stall. This is where earn-out clauses—a contractual provision in a Share Purchase Agreement (SPA)—become an invaluable tool for bridging the valuation gap and aligning the interests of both parties.
What is an Earn-Out?
An earn-out is a mechanism where a portion of the purchase price is made contingent upon the target company achieving specific financial or operational performance targets after the transaction has closed.
Instead of the buyer paying the entire consideration as a lump sum at closing, the total sale price is typically split into two components:
Initial Payment (Cash-at-Close)
This is the guaranteed amount paid to the seller when the transaction is completed.
Earn-Out Payments (Contingent Consideration)
These are additional payments made over a specified future period (the Earn-Out Period) if the business meets the pre-agreed targets.
This structure allows the seller to receive additional compensation if their optimistic view of the business’s potential proves true, while simultaneously protecting the buyer from overpaying for uncertain future performance.
Why Use an Earn-Out? The Shared Success Model
Earn-outs are most frequently used to resolve two key issues in M&A transactions:
1. Bridging Valuation Gaps
This is the primary driver. If a seller believes their high-growth startup is worth £50 million, but the buyer’s due diligence only supports an immediate valuation of £40 million, an earn-out can cover the £10 million difference. The buyer pays $40 million upfront, and the seller has the opportunity to “earn out” the remaining £10 million by delivering the projected performance. This transforms a disagreement over price into an opportunity for shared success, with payment tied directly to proven results.
2. Risk Mitigation and Incentive Alignment
For the Buyer: An earn-out mitigates risk by ensuring they only pay top dollar if the business actually delivers the projected growth and performance. It also helps retain key talent, as sellers (often the founders) are incentivized to stay with the company during the Earn-Out Period to ensure the targets are met, driving a smoother transition.
For the Seller: The seller is compensated for the future potential they have built into the business and, in high-growth companies, may achieve a significantly higher total valuation than an all-cash upfront deal would have allowed.
Structuring the Earn-Out: Key Elements
A well-drafted earn-out clause in the SPA must clearly define several core elements to avoid costly disputes down the line.
1. The Earn-Out Period
This is the defined timeframe over which performance will be measured. It typically ranges from one to three years, though shorter or longer periods are used depending on the industry and the nature of the milestones (e.g., regulatory approval in biotech may require a longer timeline).
2. Performance Metrics
The metrics must be objective, measurable, and relevant to the business’s value drivers. Common metrics include:
- Revenue: Often used for early-stage or high-growth businesses where top-line expansion is the main focus. It is generally easier to calculate and less susceptible to buyer manipulation than profit metrics.
- EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) / Net Profit: More common for stable, mature businesses, as it reflects profitability. However, these metrics are more vulnerable to the buyer’s post-acquisition operational decisions.
- Operational Milestones (Non-Financial KPIs): Used in specific sectors like tech, pharma, or manufacturing. Examples include securing a key patent, achieving FDA approval, launching a new product, or reaching a specific customer retention rate (e.g., Annual Recurring Revenue (ARR) for SaaS companies).
3. Calculation and Payment Structure
The agreement must clearly detail the formula for calculating the payment. It can be a simple, flat-fee payment upon hitting a target, or a more complex ratchet or multiplier structure.
Example of a Multiplier Structure: The seller receives £5 for every £1 of EBITDA above a £2 million baseline in year one, up to a £5 million cap.
Earn-out payments are usually made in cash but can also be paid in buyer shares (equity), which further aligns the seller’s long-term interest with the buyer’s entity.
The Risks and Pitfalls
While earn-outs are great for facilitating a deal, they are often a source of post-acquisition conflict. As one Delaware Court of Chancery judge famously remarked, “an earn-out often converts today’s disagreement over price into tomorrow’s litigation over the outcome.”
For the Seller: Loss of Control
The greatest risk for the seller is that they lose operational control over the business. The buyer, now the owner, makes the decisions that impact the earn-out metric. The buyer might:
- Integrate the acquired company too quickly, disrupting operations.
- Cut costs (like marketing or R&D) to boost short-term profit, potentially hitting a profit-based earn-out but harming long-term value.
- Direct sales opportunities to a different entity within the buyer’s larger group.
Sellers must negotiate robust buyer covenants in the SPA, limiting the buyer’s ability to take actions that deliberately impair the earn-out’s achievement (e.g., a promise to “operate the target company consistent with past practice”).
For the Buyer: Misaligned Incentives
The buyer’s main risk is that a seller who stays on may focus excessively on short-term behavior (e.g., aggressive sales at low margins) to hit the earn-out target, even if it is detrimental to the business’s long-term health post-Earn-Out Period. Conversely, if the relationship sours, a disgruntled seller may intentionally underperform.
Buyers need to establish clear post-closing conduct rules and reporting lines to maintain adequate operational control while acknowledging the seller’s need to hit the metric.
Best Practices for Successful Earn-Out Deals
A successful earn-out structure is built on precision, transparency, and trust:
1. Be Precise with Definitions
Use exact and unambiguous definitions for the performance metrics. If using “Adjusted EBITDA,” define every single adjustment in detail. Accounting policies should be clearly specified and applied consistently (e.g., using the target company’s pre-closing accounting standards).
2. Align Incentives (Role Clarity)
If the seller remains involved, clearly define their post-closing role, responsibilities, and reporting structure in a separate employment or consultancy agreement, aligning their new compensation with the earn-out goals.
3. Specify “Buyer Anti-Avoidance”
Include clauses that restrict the buyer from taking actions designed to depress the earn-out metric (e.g., preventing the buyer from shifting revenues or costs away from the target company).
4. Define Dispute Resolution
The SPA should include a clear, binding mechanism for resolving disagreements over the earn-out calculation, often involving a neutral third-party accounting expert, to avoid costly litigation.
Earn-outs are a testament to the fact that deal-making often requires creativity. When implemented carefully and with a focus on clear, measurable terms, they transform a potential deal-breaker into a powerful vehicle for shared risk and reward, ultimately leading to a more equitable and successful transaction for both buyer and seller.
