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