Introduction
Earn-out clauses play a crucial role in business sale agreements by bridging valuation gaps between buyers and sellers. These clauses link a portion of the purchase price to the future performance of the business, ensuring that both parties have aligned interests.
For sellers, earn-outs provide an opportunity to achieve a higher sale price if the business meets specified targets, while buyers can mitigate the risk of overpaying for underperforming assets. This balanced approach makes earn-out clauses a valuable tool in facilitating successful transactions.
What is an Earn-Out?
Definition and Purpose
An earn-out is a contractual provision in a purchase agreement where a portion of the purchase price is contingent upon the future performance of the acquired business. This mechanism allows buyers and sellers to bridge valuation gaps by tying additional payments to specific performance targets, such as revenue, EBITDA, or net income.
Key Components of an Earn-Out
Earn-outs consist of several critical components that define their structure and execution in a purchase agreement.
- Performance Metrics: Define how business success is measured (e.g., revenue growth, EBITDA, customer retention). Metrics must be clear, objective, and resistant to manipulation. They may also include non-financial targets like milestones or customer acquisition goals.
- Timeframes: Typically 1–5 years, with defined assessment frequency (quarterly or annually).
- Payment Terms: Specifies how and when payments are made (lump sum or periodic) and the form (cash, stock, or both). Clear disbursement conditions ensure transparency.
- Calculation Methodology: Outlines how earn-outs are calculated, including accounting principles, formulas, and treatment of extraordinary items to prevent disputes.
- Control & Management: Since buyers control the business post-sale, provisions may require fair operation to maximise earn-outs. Sellers may have veto rights or be incentivised to cooperate during transition.
- Dispute Resolution: Mechanisms should be in place for handling disagreements, often through independent accountants or arbitration.
Additional Considerations
- Earn-outs should be clearly defined to avoid ambiguity and disputes.
- Agreements should anticipate unforeseen circumstances, as earn-outs can be complex.
- Tax implications must be considered for both buyer and seller.
- The purpose of the earn-out (incentivization vs. risk mitigation) influences its design and structure.
A well-structured earn-out ensures fairness, enforceability, and alignment of interests between both parties.
Pros and Cons of an Earn-Out Clause
Advantages for buyers and sellers
Earn-out clauses benefit both parties by fostering collaboration and addressing valuation uncertainties.
- Alignment of Interests: By linking part of the purchase price to future business performance, earn-outs keep both buyer and seller invested post-sale. This is especially useful during the transition period, where seller involvement ensures a smooth transfer.
- Risk Mitigation: Buyers reduce the risk of overpaying by deferring part of the payment until performance targets are met, ensuring they invest in a business that meets expectations.
- Bridging Valuation Gaps: When buyers and sellers disagree on valuation, earn-outs allow sellers to achieve a higher price if the business performs well, while buyers commit additional funds only upon meeting targets.
- Performance Incentives: Earn-outs motivate sellers to drive growth and profitability post-sale, benefiting buyers if the seller remains involved.
- Deferred Tax Liability: Since earn-out payments are contingent, sellers can defer tax liabilities until the amounts are received, providing financial advantages.
Earn-outs balance risk and reward, allowing sellers to be compensated for potential growth while ensuring buyers only pay for actual success. They help manage uncertainty, bridge valuation gaps, and facilitate deal closures that might not otherwise occur.
Advantages for buyers and sellers
Common Issues and How to Avoid Them
Ambiguous Performance Metrics
Ambiguous performance metrics in earn-out clauses can lead to significant disputes between buyers and sellers, as unclear targets make it difficult to determine when earn-out payments are owed. Vaguely defined metrics allow either party to interpret results in their favour, leading to disagreements. For example, if the earn-out is tied to “profit” without a clear definition (e.g., EBITDA, net income, or a specified accounting method), disputes are likely to arise. To prevent such conflicts, it is crucial to establish clear and measurable criteria for performance targets.
Strategies to Avoid Ambiguous Metrics:
Define Specific Targets: Clearly outline the financial or operational goals necessary for earn-out payments, such as specific revenue numbers, EBITDA figures, or net income calculations, using consistent accounting practices. Sellers often prefer earn-outs based on revenue, while buyers often prefer profits. If using profit metrics, define profit clearly and establish rules that ensure the business is run to maximise the value of the earn-out.
Use Objective Measurements: Ensure that the metrics are based on verifiable data and standardised definitions to minimise subjective interpretations. Metrics should be precisely defined; for example, if the target is “customer retention,” specify what constitutes a retained customer (e.g., an active contract, a purchase within a defined timeframe).
Provide Detailed Calculation Methods: Include a step-by-step explanation of how the earn-out will be calculated, and provide worked examples within the agreement, to ensure mutual understanding and transparency.
Consider Non-Financial Metrics: Earn-outs can also be based on non-financial metrics, such as the retention of key customers or employees, a successful product launch, or obtaining a patent.
Control Over Business Operations
Control over business operations post-closing is another common issue that can impact the effectiveness of earn-out agreements. When the buyer assumes control, they may have the ability to influence business performance in ways that could minimise earn-out payment. For instance, buyers could reallocate resources, overspend on R&D, make excessive salary payments to “insiders”, or integrate the target business in a way that diminishes its stand-alone performance. The seller can also manipulate the business to prioritise short-term profits over long-term goals, so this risk should be mitigated.
Strategies to Mitigate Control-Related Issues:
Define Control Rights Clearly: Specify the extent to which the seller retains oversight over key business decisions, including strategic and financial matters, during the earn-out period to ensure that operations are managed in a way that maximises earn-out payouts.
Include Covenants: Incorporate covenants that require the buyer to operate the business in a manner that does not adversely affect earned-out metrics, potentially by adhering to an agreed-upon business plan or budget, and obligating the buyer to maximise the earn-out payment.
Grant Veto Rights: Allow the seller to have veto power over significant changes to business operations that could impact the earn-out, ensuring that critical aspects of the business are maintained according to the original agreement. Specify that no material changes will be made to the business model without both parties’ consent.
Implement Oversight Mechanisms: Establish mechanisms for regular monitoring and reporting of business performance to maintain transparency and alignment between both parties. Grant the seller access to accounting and financial information, sometimes known as audit rights.
Additional Considerations
Dispute Resolution: Include robust dispute resolution mechanisms within the earn-out provisions. A common approach is to provide for the appointment of an independent accountant to resolve disagreements over financial calculations, and stipulate whether the decisions of third parties are binding.
Integration Issues: Earn-outs are best used when the acquired business remains a stand-alone entity post-closing; integration with another business can make it difficult to monitor the earn-out and achieve synergies.
Timeframes: The earn-out period, typically ranging from one to three years, and the frequency of performance assessments should be explicitly defined. Longer earn-out periods should be considered with caution.
Tax Implications: The tax treatment of earn-outs is a major consideration for both buyer and seller, particularly regarding whether payments will be treated as capital gains or ordinary income.
Trust: Trust between the buyer and seller is essential, as even the most carefully drafted agreement cannot prevent all disputes.
By addressing these common issues proactively and incorporating these nuances, both buyers and sellers can create more effective and harmonious earn-out agreements that align interests and reduce the likelihood of disputes.
Speak to a Lawyer Today
We call back within 24 hours.
Drafting Precise Earn-Out Clauses
Earn-out clauses must be carefully structured to ensure clarity, fairness, and enforceability while minimising disputes.
Key Components
- Performance Metrics: Define measurable, objective, and achievable criteria such as revenue targets or EBITDA benchmarks to ensure transparency and prevent manipulation.
- Timeframes: Typically 1–3 years, with a clearly defined evaluation frequency (quarterly or annually). Longer periods require caution.
- Payment Terms: Specify when, how, and in what form (cash, shares, or a combination) payments will be made to ensure predictability.
- Accounting Principles: Clearly state whether GAAP, modified GAAP, cash-basis, or accrual-basis methods will apply, along with how revenue, expenses, and extraordinary items are handled.
Dispute Resolution Mechanisms
- Independent Accountant: Appointing an independent third-party to resolve financial calculation disputes ensures fairness. Specify whether their decisions are binding.
- Mediation & Arbitration: Mediation is the first step to resolving disputes. If unresolved, arbitration offers a faster, cheaper alternative to litigation, allowing industry-specific expertise.
- Buyer Conduct Post-Sale: Clauses should prevent buyers from manipulating performance metrics. This can include veto rights for the seller on significant decisions or requiring adherence to a pre-agreed business plan.
Additional Considerations
- Clarity & Simplicity: Ensure the agreement is clear and concise to minimise disputes.
- Control: Define who controls the business post-sale, as the controlling party can influence earn-out results.
- Stand-Alone Business: Earn-outs work best when the business remains independent post-sale.
- Tax Implications: Early involvement of tax advisors helps navigate tax treatment complexities.
- Legal Counsel: Precise legal drafting is essential—small errors can be costly. Close collaboration between lawyers and accountants is crucial.
- Trust: A well-drafted earn-out cannot eliminate risks, so mutual trust between parties helps prevent disputes and manipulation.
By addressing these factors, earn-out agreements can be structured to protect both parties, align interests, and ensure fair execution.
Need Answers Fast?
Contact us today.
Case Studies
Case Studies
SSABR Pty Ltd v AMA Group Ltd
Background: The plaintiffs sold two smash repair businesses to AMA Group Ltd for $4.8 million, plus an earn-out based on EBIT over a two-year period. The dispute centred on whether EBIT should be aggregated over two years (plaintiffs’ argument) or averaged annually (AMA Group’s argument).
Court Ruling: The court ruled in favour of AMA Group, determining that average annual EBIT should apply, citing:
- A binding heads of agreement referenced average EBIT.
- Extensive negotiation history supported AMA Group’s interpretation.
- The absence of a recorded agreement change that would effectively double the agreed multiple.
The court also considered rectification under equitable principles, but found no convincing proof of a mutual intention differing from the written contract. As a result, no earn-out was payable. The case is currently under appeal.
Grant Reid Wilson atf G&L Wilson Family Trust v QBT Pty Limited
Background: The target company held a 40% stake in a joint venture (JV). A $4 million earn-out was contingent on either:
- Written consent from the JV partner to the change of control, or
- Payment by the JV partner for the target’s shares.
Due to COVID-19, the JV partner went into administration and transferred its shares to the vendors. The buyer argued that, since neither specific condition was met, no earn-out payment was due.
Court Ruling: The court ruled in favour of the vendors, determining that the retention of JV shares warranted the earn-out. The court found that:
- The buyer’s interpretation led to an absurd commercial outcome.
- The intent of the agreement was to compensate vendors for the JV stake, regardless of written consent.
- The share transfer itself amounted to implicit consent to the change of control.
The court concluded that contract terms must be interpreted as a whole, prioritising commercial intent over rigid wording. The case is also under appeal.
Conclusion
Earn-out clauses help bridge valuation gaps by linking part of the purchase price to the business’s future performance, aligning interests and mitigating risk.
However, they present challenges, including disputes over performance metrics and complex legal structuring. By understanding both benefits and risks, and analysing case studies, buyers, and sellers can use earn-outs to facilitate successful transactions.
If you’re considering a business sale agreement, our expert legal team can help structure clear, enforceable earn-out clauses that protect your interests. Contact us today for trusted legal guidance.
