Key Considerations In Earn-Out Provisions In Private M&A

• Published date: 15 January 2025
• Law Firm: SkyLaw
• Author: Miss Andrea Hill, Kevin West and Priya Ratti

An earn-out is a mechanism whereby the parties in an M&A transaction link a portion of the purchase price to the future performance of the target business after closing.

In a mergers and acquisitions transaction, earn-outs can be a double-edged tool for purchasers and sellers when negotiating their purchase agreement. A purchaser and seller may choose to include earn-out provisions when they cannot agree in advance on the value of the target business. This is often done with the intent of bridging the gap between what the purchaser is willing to pay to purchase the business and what the seller agrees to charge as a purchase price.

A similar, but inverse, concept is called a "reverse earn-out", whereby the purchase price is reduced after closing to the extent the target company fails to achieve a certain performance threshold.

There are several challenges underlying earn-outs that can add to the complexity of the negotiations between purchasers and sellers. If not drafted clearly and with intention, earn-out provisions can be a source of costly and stressful disputes between the parties.

Understanding Earn-Out Provisions

An earn-out is typically structured as one or more conditional payments of a purchase price which are payable after closing when certain specified thresholds or targets are satisfied within pre-determined periods of time.

Such specified targets may be financial, non-financial, or a combination of the two. Financial targets may be based on projected revenues, EBITDA, net equity, earnings per share, or other achievements.

Non-financial targets may be based on objectives such as attracting a minimum number of new customers, or getting listed in the public market. They may also be based on sales volumes or the business obtaining a certain patent, license, or a regulatory approval.

In a well-drafted purchase agreement, if the specified targets are met by the acquired business, the purchaser must make the agreed-upon payments to the seller at the specified points in time. If, however, the acquired business fails to achieve such targets during the required time periods, the purchaser is relieved from making the conditional payments, or in some instances, is only required to pay a reduced amount.

Earn-Out Considerations in Deal Structuring

Earn-outs carry various pros and cons for both purchaser and seller, and each party should carefully undertake a cost-benefit analysis during the negotiation process. In some instances where the disadvantages outweigh the advantages, it may be impractical or inadvisable to...