Earn-out clauses in company purchase agreements - opportunities, risks and legal structure

In view of fluctuating economic data, increasing pressure on the cost of capital and ongoing geopolitical uncertainties, earn-out clauses are currently becoming more topical than the German transaction market last experienced during the financial crisis. Buyers in particular are looking for mechanisms to minimise valuation risks, while sellers want to continue to enforce their price expectations. Earn-outs promise both sides a bridge between current uncertainty and future value potential - they are therefore both an indicator and a valve for the changing market situation.

How an earn-out works

Earn-outs supplement the fixed purchase price with a variable component that only becomes due when the target company achieves defined key figures. Put simply, from the seller's perspective, buyers pay a lower (fixed) purchase price at closing, but this can increase if the target company actually delivers the future economic performance agreed as the basis for the earn-out. Earn-outs are also a means of bridging differences in price expectations between buyers and sellers. If a seller values his company higher than the buyer, an earn-out arrangement offers the seller the opportunity to receive separate compensation for future success if the target achieves its goals. The buyer, on the other hand, only owes an additional purchase price if the target achieves the goals that the seller - in his planning - has promised.

Systematically, earn-outs are typically due in addition to and downstream of a fixed purchase price component (which is already paid upon completion of the transaction) if certain predefined performance indicators are achieved. The period for the consideration of earn-out entitlements is usually limited to a certain period after completion of the transaction (between one and up to five years).

Types of earn-outs

Earn-out models come in many shapes and forms. The most common models are based on EBITDA or sales figures. Otherwise, certain milestones are also regularly taken into account (such as the conclusion of a certain major contract, reaching a certain number of active customers, approval of certain products, etc.).

With EBITDA-based earn-outs, the payment of the earn-out is linked to the achievement of a certain EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation). It is particularly popular as EBITDA is considered a measure of operating profitability and is less distorted by accounting policy measures. From the seller's perspective, however, EBITDA-based models offer risks, as the buyer can influence and reduce the earn-out amount through investments, expenses, cost transfers or intra-group allocations. From the seller's perspective, it is advisable to include clear provisions on corporate governance during the earn-out period in the purchase agreement, particularly in the context of the earn-out covenants (see below). A balance must be struck between the seller's security interest and the entrepreneurial freedom of the buyer as the new owner of the target.

In revenue-orientated models, the earn-out is linked to the revenue generated. This variant is easier to measure, but less meaningful in terms of profitability. From the seller's point of view, the turnover-based approach is often advantageous, as it is generally in the interests of both the seller and the buyer to maximise turnover. Clear advantages are the simple traceability, the low complexity in the determination and the reduced risks of unilateral influence on sales and thus the earn-out payments. From the buyer's point of view, however, caution is required here to ensure that the seller, provided it remains in the management of the target company, does not take any short-term measures to maximise sales that are disadvantageous from the buyer's point of view (such as sales increases through unusual discounts). This issue can be countered, for example, by requirements to conduct business in the ordinary course of business and in accordance with previous practice as well as by rules of procedure and other corporate governance measures (see below).

Less complex methods for determining an earn-out entitlement, which are usually only used in special constellations, include reaching a certain number of customers or a certain market share (especially for start-ups or digital business models) or special milestones, such as the conclusion of certain customer or cooperation agreements, the approval of certain products, the receipt of subsidies, research grants or certifications. This makes it possible to integrate planned but not yet existing circumstances into the purchase price mechanics and fulfil the interests of the parties involved.

Safeguarding the fair handling of earn-out provisions

Securing future earn-out claims is particularly important from the seller's perspective. To this end, comprehensive catalogues of so-called earn-out covenants are usually agreed in the purchase agreement, which regulate certain behaviour during the earn-out period and provide for sanctions in the event of breaches. The point of tension here is the security interest of the seller on the one hand, who generally favours maintaining the status quo (particularly with regard to accounting and contractual practice), and the interest of the buyer in unrestricted and free management of the company on the other.

Particularly in the case of family businesses, the seller often remains in the target company as managing director for a certain period of time and therefore has direct influence on the economic performance of the target and the achievement of the earn-out criteria. In particular, earn-out components such as the achievement of agreed milestones or certain sales targets can be controlled by the seller as managing director. The fulfilment of these criteria is regularly in the interests of both parties. In such cases, the need for comprehensive earn-out covenants is usually limited; however, basic arrangements should of course still be made.

In scenarios involving more complex earn-out models, particularly EBITDA-based models or when the seller leaves the management board, more complex hedging mechanisms within the earn-out covenants are appropriate. From the seller's perspective, clear provisions on bookkeeping, accounting and reporting obligations in particular should be agreed. In addition, aspects such as rights to inspect certain documents by the seller or audit rights, possibly by independent third parties, can also be considered.

Divergences over earn-out claims

In practice, earn-out claims can be prone to disputes as they are based on future developments that can be influenced internally by management and/or shareholder behaviour as well as externally by geopolitical and economic measures. Typical points of dispute are whether a claim has arisen on the merits, how high the seller's earn-out claims actually are (if no fixed earn-out amount has been agreed) and whether the buyer has breached its obligations to co-operate or the earn-out covenants to the detriment of the seller.

Differing views on the earn-out are regularly based on unclear provisions in the purchase agreement, accounting policy measures by the buyer (e.g. by shifting costs with an impact on an EBITDA-based earn-out) or on the breach of information obligations or delays in the payment of the earn-out after the end of the earn-out period.

To avoid or efficiently resolve such conflicts, the following aspects should be taken into account:

• Clearly defined items and calculation formulas (especially for EBITDA-based earn-out models),
• Sample calculations in an annex to the purchase agreement,
• Obligations to co-operate, for example in the form of obligations to provide monthly financial statements, budget plans, forecasting earn-out considerations, etc,
• Restrictions on certain actions (such as mergers, disposals, other actions that could have a negative impact on the earn-out) or how to deal with them,
• Mediation arrangements,
• escalation mechanisms with independent experts for the legally binding determination of an earn-out claim in the event of disagreements.

Conclusion and recommendations for action

Earn-out clauses are a valuable, albeit sometimes complex, instrument for structuring purchase price mechanisms in company purchase agreements. In addition to their complexity, they can harbour a certain potential for conflict. Early advice, ideally as early as the term sheet phase, on legal and, in particular, tax aspects is strongly recommended in order to avoid disputes later on and to optimally utilise the advantages of earn-out models.