How To Structure an Earn-Out Clause in an M&A Transaction

Earn-out clauses have become one of the most widely used purchase price mechanisms in mergers and acquisitions. By linking part of the purchase price to the future performance of the target company, they help bridge valuation gaps between buyers and sellers and make transactions possible where the parties cannot initially agree on value.

However, an earn-out is only as effective as the contract that governs it. If the performance metrics, calculation methodology or post-closing obligations are not clearly defined, what was intended as a flexible pricing solution may become a source of uncertainty and dispute.

An earn-out differs from a simple deferred payment mechanism. With deferred consideration, the purchase price is fixed and only the payment date is postponed. Under an earn-out, by contrast, the seller’s entitlement to additional consideration depends on whether specified financial, commercial or operational targets are achieved after completion.

For this reason, an earn-out should not be viewed as an isolated pricing provision. It should form part of a comprehensive purchase price mechanism that reflects the commercial objectives of both parties and the structure of the transaction.

The first step is selecting the performance indicator that will determine the additional payment.

Depending on the transaction, the earn-out may be linked to EBITDA, revenue, recurring income, customer retention, operational milestones or other measurable indicators. There is no universally appropriate metric. The choice should reflect the commercial rationale behind the transaction and the specific value that the parties intend to measure.

Revenue-based metrics may reduce the impact of certain accounting decisions but can encourage growth without considering profitability. EBITDA-based mechanisms, on the other hand, better reflect operating performance but generally require more detailed contractual drafting to avoid uncertainty.

The degree of influence retained by the seller during the earn-out period should also be considered. Linking the payment to performance indicators over which the seller has no practical control may significantly alter the allocation of risk agreed by the parties.

Where the earn-out is based on EBITDA, simply referring to “Adjusted EBITDA” or “Normalised EBITDA” is rarely sufficient.

The agreement should specify the accounting standards to be applied, whether historical accounting policies must be maintained and how extraordinary items, one-off expenses, restructuring costs, intra-group charges and integration costs will be treated.

Corporate overhead allocations, transfer pricing policies and shared service charges may also materially affect the final calculation. Rather than leaving these issues to future interpretation, the parties should address them expressly in the Share Purchase Agreement (SPA).

Whenever appropriate, including a worked example can help confirm that both parties understand the calculation methodology in exactly the same way.

The duration of the earn-out should reflect the business cycle of the target company and the objectives being measured.

A period that is too short may fail to capture the company’s actual performance, while an excessively long period exposes both parties to events that could not reasonably have been anticipated when negotiating the transaction.

The agreement should also establish when the measurement period begins and ends, how partial financial years are treated and how any changes to accounting periods or reporting structures will affect the calculation.

The payment formula deserves the same level of attention. Whether the earn-out operates through thresholds, proportional payments or staged milestones should depend on the commercial logic of the transaction rather than on drafting convenience.

Following completion, the buyer will generally assume full control of the business. At the same time, management decisions may directly influence the financial metrics used to calculate the earn-out.

The agreement should therefore strike an appropriate balance between the buyer’s freedom to operate the business and the seller’s legitimate interest in preserving the economic purpose of the earn-out.

Depending on the transaction, the parties may regulate matters such as accounting consistency, business reorganisations, transfers of customers or assets, intra-group transactions or significant changes to the company’s operations.

Rather than imposing a broad obligation on the buyer to maximise the earn-out, it is generally more effective to identify specific actions that should not affect the calculation and to define their contractual consequences.

In many transactions, particularly founder-led businesses, the seller remains involved in the company after completion.

Where this occurs, the agreement should clearly distinguish between consideration paid for the shares and payments linked to continued employment, management responsibilities, restrictive covenants or individual performance.

This distinction may have important contractual, accounting, tax and employment implications and should be assessed in light of the transaction as a whole rather than the terminology used by the parties.

The agreement should also address the consequences of the seller leaving the business before the earn-out period expires, recognising that different circumstances may justify different outcomes.

An earn-out should not be treated as a standalone pricing formula added at the end of an acquisition agreement.

Its effectiveness depends on the consistency between the purchase price mechanism, the accounting methodology, the post-closing governance provisions, the parties’ information rights and the agreed dispute resolution process.

Carefully drafted earn-out provisions cannot eliminate every future disagreement, but they can significantly reduce uncertainty and provide a clearer framework for implementing the commercial agreement reached by the parties.

At ILIA ETL GLOBAL, we advise buyers, sellers, investors and companies throughout every stage of M&A transactions. Our team assists in negotiating and drafting Share Purchase Agreements, designing purchase price mechanisms and structuring earn-out provisions tailored to the commercial, corporate and tax characteristics of each transaction.