I find that clients and other advisers sometimes confuse the concepts of an earn-out with a performance guarantee. They tell me they want a performance guarantee clause in the sale and purchase agreement, but upon further probing, it becomes clear that what they actually want is an earn-out clause.

Both earn-out and performance guarantee are common mechanisms used in the context of M&A to bridge gaps in valuation and mitigate risks associated with the deal. However, they are distinct concepts.

𝐄𝐚𝐫𝐧-𝐎𝐮𝐭

An earn-out is a contingent payment arrangement in an M&A deal where a portion of the purchase price is based on the future performance of the target company. The purchaser will pay the seller additional payments, known as the earn-out, if the target company meets the performance metrics or milestones after the acquisition, as agreed between the purchaser and seller.

Earn-outs are usually linked to financial or operational targets, such as profits, revenue, or customer retention.

Earn-outs are structured over a defined period, usually 1 to 3 years in my experience.

If the target company does not meet the predefined performance metrics or milestones during the earn-out period, the seller will not receive the additional payments.

𝐏𝐞𝐫𝐟𝐨𝐫𝐦𝐚𝐧𝐜𝐞 𝐆𝐮𝐚𝐫𝐚𝐧𝐭𝐞𝐞

A performance guarantee is an assurance given by the seller to ensure that the target company achieves a specific performance level after the acquisition, as agreed between the seller and purchaser.

Performance guarantees may also be tied to financial or operational targets, but unlike earn-outs, performance guarantees are not contingent payments.

If the target company fails to meet the performance metrics or milestones during the period as agreed between the seller and purchaser, the purchaser will have recourse against the seller, which may include financial compensation or other remedies as specified in the agreement.

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This post was first posted on LinkedIn on 26 October 2023.