M&A Vocabulary – Explained by the experts: Earn-Out

In this ongoing series, a number of different M&A experts from the global offices of Rödl & Partner each present an important term from the English specialist language of the mergers and acquisitions world, combined with some comments on how it is used. We are not attempting to provide expert legal precision, review linguistic nuances or present an exhaustive definition, but rather to give a basic understanding or refresher of a term and some useful tips from our consultancy practice.

The basis for a company’s valuation and the purchase price determination based on this is generally the expectation of future income of the target company, based on budgets and forecasts extrapolated from past trends.

However, vendors are generally not willing to provide guarantees of future business trends, nor to accept discounts on the purchase price for any related uncertainties or risks. This applies all the more once they are no longer able to influence the target company’s economic activity after the sale.

On the other hand, for the buyer there is substantial uncertainty, if the assumptions underlying their assessment of future development depend strongly on factors which they themselves cannot influence or only to a limited extent. This uncertainty increases if the target company operates in countries where the buyer does not have any in-depth market experience.

This is especially the case when the success of the business was materially linked to the person of the vendor – for example, because they were personally involved in the business operations (e.g. as managing director) or where past success depended on them (e.g. personal customer contacts, loyalty of key employees, integration within a group structure) and will potentially continue to depend on their actions also in the future (providing support, but also refraining from damaging actions).

An earnout mechanism is a purchase price adjustment in the company acquisition contract, under which part of the purchase price due to the vendor will be paid in the future. The existence, timing, and possibly also the level of the payment due will depend specifically on the target company achieving certain target figures within defined time limits.

Using an earnout arrangement can ensure support from the vendor for at least a defined transitional period, as well as motivating them to contribute to successful continuation and integration. However, care must be taken that the criteria to be achieved are realistic, otherwise the positive “carrot effect” will not be reached and unachievable targets can have a demotivating effect.

For certain events that may have a significant impact on achieving earnings forecasts (e.g. the extension of a license, the outcome of a pending legal dispute), the interests of the buyer can also be insured indirectly – rather than using a straightforward conditional purchase price retention – by providing for future payments to the buyer depending on the outcomes.

Earnout arrangements are therefore effective ways of holding the vendor responsible for information about the expectation of specific planned figures. In return, an earnout arrangement can also be attractive for the vendor, as it is gives them the possibility of benefiting from a longer-term successful transaction beyond the currently negotiable purchase price. During negotiations, earnout arrangements have therefore often proved to be a means of bridging the gap on how to share potential risks and opportunities between vendor and buyer, and thus reaching an agreement.

However, this solution is “purchased” at the cost of increased complexity in the payment mechanism written into the purchase contract. The structure of a suitable earnout mechanism depends on many factors, such as the sector (seasonality), the buyer’s strategy, and the valuation method used. Rule of thumb: the simpler and clearer the arrangement, the less likely there will be differences of opinion later on.

In practice, when negotiating earnout clauses, the arrangements quickly grow in scope and complexity, with the following topics being covered: 

• preconditions for a claim to materialise (reference figures, other conditions, e.g. compliance with a non-competition clause)
• earnout time period, how it is measured, value and calculation
• checking and calculating business numbers
• stipulations, impacts and restrictions relating to the future business activity of the target company during the earnout period
• corrections and adjustments when calculating the basis for measurement
• securities, such as. a (partial) deposit in an escrow account, bank guarantees, sureties
  payment procedures and dates
• verification procedure

Earnout periods usually run for two to three years, but in individual cases, longer periods may also be agreed. The earnout portion of the purchase price in most cases is about 20-40 percent of the purchase price, although 50 percent or more are may be agreed where specific risks exist.

For cross-border transactions in particular, additional areas need to be considered, such as:

• allowance for fluctuations in exchange rates/devaluation
• applicable accounting standards
• applicable law
• dispute resolution mechanisms

The root cause of this complexity is a conflict of interest between the parties, which usually demands detailed definitions and complex calculation formulae to reach a balance. Thus, the starting point for triggering the earnout claim is usually the achievement of certain budget targets (e.g. cumulative EBITDA or EBIT over a three year period). The vendor therefore makes his future claim dependent on factors over which he has no or only limited influence. On the other hand, as the new owner, the buyer has a variety of options to manipulate the result (e.g. via transfer prices, investments, cost allocations) and so prevent the earnout conditions being achieved. For this reason, the vendor will be attempting to include as many limitations as possible on measures relating to earnings and/or corresponding adjustments in the calculation formula.

On the other hand, the buyer would understandably like to have as few restrictions as possible applying to his newly acquired company. A possible simplifying approach would be to agree to achieve certain turnover targets instead of using EBIT or EBITDA target values. For the vendor this has the advantage that the buyer has less possibility to manipulate the costs.

With an appropriate starting point, and sensible application, earnout arrangements allow you to soften entrenched negotiating positions on both sides, by giving the sceptical buyer more security and offering the cautious vendor the opportunity to increase the potential purchase price.

Experienced experts have the skills to formulate arrangements for an earnout mechanism that is balanced, transparent and unambiguously defined, without making them unnecessarily complex. This avoids uncertainty and frustration on both sides – both during the negotiations and after the conclusion of the transaction.