The earn-out: tying the price to results

When buyer and seller cannot agree on the price of a company, the problem is often the future: the seller is convinced the company will grow, the buyer does not want to pay today for results not yet achieved. The earn-out is the bridge between the two positions. Part of the price is paid immediately, another part is deferred and conditional on the achievement of agreed objectives in the years following the closing. Who is right will be told by the income statement.

How it works

The price is split into two components:

• a fixed part, paid at closing;
• a variable part (the earn-out), paid in the following financial years only if the company reaches certain parameters.

If the results come, the seller collects the top-up; if they do not, the buyer does not pay for growth that never happened. In theory it is an elegant mechanism that aligns interests. In practice, everything depends on how the clause is written.

Which parameters to link it to

The choice of parameter is the most delicate decision. The typical options:

• Revenues (turnover): easy to measure and hard to manipulate, but they say nothing about profitability — the seller could “buy” turnover at negative margins.
• EBITDA or operating profit: they reflect real profitability, but they are sensitive to accounting choices and to the buyer’s cost allocation.
• Non-financial objectives: the acquisition of key clients, the launch of a product, the renewal of strategic contracts, the retention of key people.

Rule of thumb: the closer the parameter is to cash and the simpler it is to verify, the less room it leaves for conflict. An EBITDA is “fairer” than turnover but much more litigable.

The real risk: the post-closing conflict

After the closing, control of the company passes to the buyer. But the outcome of the earn-out depends precisely on how the company is run in those years. This is where the typical tension arises:

• the buyer integrates the company, shifts costs, changes commercial priorities — and the relevant EBITDA suffers;
• the seller, who often stays on as a manager, wants to maximise the short-term result to collect the earn-out, perhaps sacrificing long-term investments.

For this reason the clause must establish not only what is measured, but also how the company is managed during the earn-out period.

What a well-drafted clause must provide for

• A precise accounting definition: which principles apply, how group costs, management fees, extraordinary items and intra-group allocations are treated.
• Management protections: commitments by the buyer not to hollow out the business, to maintain resources and product lines, not to shift revenues or costs artificially towards other group companies.
• A contained duration: one or two financial years are generally sufficient; long periods multiply the opportunities for conflict.
• A calculation and verification mechanism: who prepares the calculation, by when, with what right of review for the seller.
• Dispute resolution: appointing an independent expert (auditor) as arbitrator for accounting disagreements avoids lengthy lawsuits.
• Acceleration: what happens if the buyer resells the company, dismisses the seller-manager or transfers the business unit during the earn-out period.

Tax and accounting aspects

The earn-out collected by the seller is part of the sale price and must be treated consistently from a tax standpoint, carefully distinguishing it from any employment remuneration if the seller stays on operationally — an incorrect qualification can turn a capital gain into taxable income and generate social-security charges. On the buyer’s side, the earn-out affects the accounting of the acquisition. These points must be defined from the outset in the contract.

In summary

The earn-out is useful when there is genuine uncertainty about future value and enough mutual trust to collaborate for a few years. It is not a way to postpone a disagreement: if the parties are far apart on the price and distrustful, the earn-out merely shifts the conflict from the negotiating table to the litigation one. The difference between a bridge and a trap lies entirely in the drafting of the clause.

How we help you

The Capital division of SIH ONE structures and negotiates earn-out clauses: the choice of parameters, accounting definitions, management protections and verification mechanisms, within a solid sale and purchase agreement. Talk to the team.