When I first learned about the concept of an earn-out mechanism in M&A transactions, I thought it was an absolute good idea. An earn-out bridges the gap between the seller’s and the purchaser’s perception of the value of a target company. If the target company achieves the agreed metrics or milestones, the seller stands to receive more than the initial purchase price.

However, the incentive to be paid more (from the seller’s standpoint) and the desire to avoid paying more (from the purchaser’s standpoint) may sometimes lead to disputes. There are scenarios in which utilising an earn-out mechanism in an M&A deal makes perfect sense, and others where it may not be appropriate.

When to use earn-out

1. An earn-out mechanism is apt when a purchaser acquires a target based on the potential future performance of the target, such as in the cases of start-ups and technology companies. An earn-out allows the seller to be paid more if the target meets the earn-out criteria, while the purchaser has some assurance that the purchase price aligns with the performance of the target company after the acquisition.

2. In cases where the seller will continue to run the business of the target company after closing of the deal, an earn-out provides an incentive to ensure the success of the target company post-closing.

3. If the target company has experienced a temporary decline in its profitability, which does not reflect its usual performance, the purchaser may choose to defer a portion of the payment, contingent on the target company achieving agreed-upon financial performance post-closing.

4. When the purchaser wants to avoid immediate cash flow issues, allocating a portion of the purchase price to be paid post-closing through an earn-out can be a strategic move.

When not to use earn-out

1. If both the seller and purchaser seek a clean break after closing of the deal, an earn-out is not appropriate.

2. When one party is concerned that the other party may manipulate the business of the target company to trigger or avoid earn-out payments, an earn-out mechanism may not be appropriate.

For example, if the purchaser controls the target post-acquisition without appropriate restrictive covenants in the transaction agreements, the purchaser could divert profitable business of the target company to other companies within the purchaser’s group, affecting the seller’s earn-out.

Conversely, the seller may prioritise short-term profitability to meet the earn-out metrics, potentially harming the target company’s long-term interests, such as offering unsustainable discounts to boost sales.

3. When the transaction is a distressed M&A and there is a need to receive the full purchase price upfront, an earn-out mechanism is not practical.

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This post was first posted on LinkedIn on 19 October 2023.