Earn-Out Clauses

What is an earn-out clause?

Earn-out clauses are found in M&A agreements as part of the purchase price clause. An earn-out is a subsequent additional and usually variable purchase price component, the payment of which is linked to the occurrence of an uncertain, future and actual event (usually earnings or earnings development of the target company).

Why is an earn-out agreed? 

Incongruent price expectations

The core of every M&A transaction is the valuation of the target company and, derived from this, the determination of the purchase price to be paid for the target company. Understandably, sellers and buyers have different ideas about the valuation of the target company and the determination of the purchase price, which can be attributed to the following reasons in particular:

• Different assessment of the target company’s earnings performance
  Usually, the target company is valued on the basis of the discounted cash flow method, i.e. the discounting of future expected, uncertain cash flows. These can be estimated differently by the seller and the buyer, as they are forecasts of future earnings or cash flows. In addition, further factors contributing to uncertainty may arise, such as (i) the target company is (shortly) on the verge of an economic breakthrough, (ii) the target company is dependent on certain persons, (iii) the economic success of the target company depends on the improvement of certain structural factors (e.g. turn-around cases) or (iv) the economic success of the target company will only arise on the basis of synergies with group companies of the buyer.
• Purchase price financing
  The buyer is not in a position to finance the full purchase price immediately.
• Other irresolvable differences
  In addition, there are cases of other irresolvable differences in the valuation of the target company, e.g. irreconcilable information asymmetries, especially with regard to certain risks.

Earn-out as a possible compromise

With the help of an earn-out, the parties can try to bridge the different expectations that exist with regard to the valuation of the target company and thus avoid a failure of the entire transaction.

Advantages and disadvantages of earn-outs

An earn-out can have various advantages but (at the same time) disadvantages for the parties involved.

Advantages of an earn-out

• Advantages for the seller
  The immanent advantage of an earn-out is that the seller can participate in a positive economic development of the target company after completion of the transaction (to the extent that the earn-out amount cannot become negative in the event of a negative development). This is particularly the case if the economic success is based on the achievement of synergies with the buyer group.
• Advantages for the buyer
  Primarily, an earn-out can reduce the buyer’s risk of paying an excessive purchase price. In addition, a potential earn-out amount, which in principle would be due to the seller, can at the same time also serve as colateral for claims of the buyer against the seller, e.g. for warranty claims under the purchase agreement. Also, the information disadvantage that the buyer has with respect to the target company in the contract negotiations works less to its disadvantage.

Disadvantages of an earn-out

• Disadvantages for the seller
  As already discussed, the question of whether an earn-out is to be paid, and if so, in what amount, depends on the occurrence of future events (see section 4 below for more information on the structuring of earn-outs). This variability gives the parties (primarily the buyer, but under certain circumstances also the seller) structuring options and thus the possibility to influence the occurrence or the amount of the earn-out after the conclusion of the purchase agreement. By its very nature, this harbours potential for abuse. As a rule, the seller can no longer exercise any influence on the target company after the transaction has been consummated. The development of the business thus depends to a large extent on the decision of the buyer (e.g. exercising  influence as a shareholder of a German limited liability company (GmbH) by issuing binding instructions to the management of the target company). By excercising such influence, the buyer could thus deliberately frustrate the achievement of the targets/thresholds for an earn-out. In addition, earn-out targets/thresholds could be impeded by (wrong) decisions of the buyer, although they would have been achievable in principle. However, this disadvantage for the seller can be reduced by drafting the contract accordingly (see section 5.1). Another disadvantage of an earn-out for the seller is that the seller bears the future credit risk of the buyer for the payment of the subsequent purchase price component. However, this risk could be hedged by ensuring that the earn-out amount is secured or financed accordingly (see section 5.2 below).
• Disadvantages for the buyer
  The agreement of an earn-out deprives the buyer of the possibility to make a fixed risk deduction in the company valuation and thus to reduce the purchase price in its favour. In addition, the restriction of freedom of action in relation to the target company associated with the hedging of the earn-out may prove to be disadvantageous (see section 5.1).

Structuring of earn-outs

There are no specific requirements for the structuring of earn-out clauses. They are correspondingly diverse and differentiated, whereby the key points and factors of the typical clauses are outlined below:

Classic structure

The objective of the classic structure of an earn-out clause is to appropriately record the economic success of the target company after completion of the transaction in order to determine a possible subsequent purchase price on this basis depending on this success. The following key points are taken into account in determining whether an earn-out amount arises and, if so, in what amount: Earn-out period, reference or key figures and calculation parameters as well as the specific calculation formula. The earn-out period is the period that is to be decisive for the determination of a subsequent purchase price component. A distinction is made between financial and non-financial performance indicators. Financial performance indicators include, for example, sales/turnover, EBITDA or the operating cash flow of the target company. Non-financial performance indicators are often the achievement of certain milestones (e.g. regulatory approval, granting of a patent, approval of a drug, successful market launch of a product, etc.; however, these in turn can of course also have an influence on the financial performance indicators downstream). In the case of financial performance indicators, it must be specified with regard to the corresponding reference figure from which set of figures the parameters relevant for the earn-out are to be derived. This is often based on the approved and audited annual financial statements of the target company. Once the parties have agreed on the relevant parameters, it must be determined on the basis of which calculation parameters or formula the earn-out amount is to be calculated. It is often determined on the basis of a percentage of the agreed reference/key figures. In addition, certain minimum or maximum amounts are stipulated for the relevant parameters and also for the earn-out amount itself. It should not be forgotten that the procedure for the subsequent determination of the calculation bases is also agreed. As a rule, it essentially corresponds to the regulations for the determination of the final purchase price on the basis of closing accounts (see also below under section 5.3).

Flipping Protection

A special case of an earn-out clause is the flipping protection or anti-embarrassment clause. Here, the buyer undertakes to pay the earn-out in the event of the (re-) sale of the target company. In normal M&A practice, one sees these earn-out clauses when the target company is sold to a turn-around fund, sometimes also in sales to financial investors. With a flipping protection/anti-embarrassment clause, the seller wants to ensure that in the event of a rapid resale of the target company (quick flip - usually within 12 to 18 months after completion of the transaction) and a disproportionately high profit achieved by the buyer, he will participate and cannot be accused of having sold too early and/or at too low price. Similar to the classic earn-out clauses, the contractual form of flipping protection/anti-embarrassment clausevaries, but the key reference value is usually the resale price.

Other cases

In addition to the two structuring options of earn-outs described above, other forms of earn-outs are discussed, such as repayment models (reverse earn-out, i.e. the buyer pays the full earn-out amount at the closing of the transaction, but receives it back (in part) in the event of negative business performance) or option models (i.e. the buyer acquires only part of the target company at the closing and receives the option to acquire the remaining shares at a later date at a price determined on the basis of key economic figures), which, however, rarely occur in practice and will not be discussed further here.

Safeguarding earn-outs

As already described, a major disadvantage of earn-out arrangements for the seller is that it no longer has any influence on the target company after the transaction has been completed and the seller can specifically influence the achievement of earn-out targets. With regard to the different risks and possibilities of exercising influence, the following protective mechanisms can be used in favour of the seller:

Management of the Target Company

The parties usually take a certain economic development of the target company as a basis, which can be based, for example, on a business plan for the earn-out period agreed between the parties. Negative effects on earnings resulting from the deviation of the business plan could then be disregarded for the calculation of the earn-out. In this case, however, questions of causality and proof remain difficult. These can also be solved for significant deviations by a separate approval requirement. For the buyer, however, this has the disadvantage that, in addition to antitrust issues, it may severely restrict the buyer and the target company in their entrepreneurial freedom of action because, in particular, in unforeseen situations or opportunities that arise, it is not possible to act quickly and appropriately enough.

Solvency of the seller

The question of the seller’s solvency with regard to the payment of the subsequent purchase price component depends not least on whether the buyer is an economically independent company or an acquisition vehicle (which will regularly be the case in transactions with financial investors). Especially in the latter case, there is a need for colateral on the part of the seller, which can be solved by means of customary colateral mechanisms (e.g. deposit of a (partial) amount in a trust account, bank guarantee, etc.). However, it is also conceivable that in transactions with financial investors the acquisition vehicle has a corresponding additional credit line available in the acquisition financing loan.

Review of (financial) performance indicators

Especially in the case of classic earn-out clauses, it is particularly important for the seller that the relevant calculation parameters are correctly recorded. In order to counteract possible influence by the buyer, the seller is usually granted information and / or review rights, and possibly even participation rights. In this context, provisions are usually made regarding the treatment of certain business measures or accounting decisions of the target company that are relevant for the earn-out. In this context, it is advisable to supplement abstract calculation formulas with several example calculations.

Structural changes

Structural changes in relation to the target company can also have an influence on the calculation of the earn-out, i.e. change it permanently and / or according to plan. For example, the target company may be the subject of a transformational measure (merger or demerger), sell or acquire subsidiaries or sell a business or material assets. Similarly to the management of the target company, in these cases, a seller’s consent reservation may provide protection. From the buyer’s perspective, this is usually not commercially acceptable. In addition, such reservations of consent must be analysed particularly carefully from an antitrust law perspective, as such constellations may involve the exercise of joint control. Against this background, the parties often agree in cases of structural changes to take into account or exclude the expected economic effect of a structural change when calculating the earn-out. However, it is hardly possible to take into account all conceivable structural changes when drafting the contract. Therefore, the parties usually only agree on general principles, possibly supplemented by the agreement of a pro forma calculation of the financial ratios relevant for the earn-out, which adequately takes into account the structural change.

Alternatives to Earn-Outs

If one considers the reason for agreeing an earn-out, namely the diverging price expectations of the seller and the buyer with regard to the target company, alternative structuring options can also be found. For example, the seller can (indirectly) re-invest in the target company with a minority share. The seller, like the buyer, then benefits proportionately and indefinitely from the further success of the target company (e.g. through dividends or proportionate sales proceeds in the event of a resale). If the reason for the different amount of the purchase price is primarily that the buyer cannot finance the entire purchase price immediately, a vendor loan or the deferral of a part of the purchase price could be considered as an alternative.

Summary

The issues described here - in particular the conflicting interests in securing the earn-out, especially with regard to the target company’s freedom of action - regularly lead in practice to earn-out clauses being discussed intensively, but rarely actually being agreed due to lengthy and difficult negotiations.