Recalling what we saw in the article “M&A in family-owned companies: Tensions in negotiations”, there are multiple factors that make it difficult to reach an agreement on the valuation of the company being sold. Fortunately, there are tools, such as the earn-out clause, that provide solutions to such disagreements.
The earn-out is a provision in the company’s transaction agreement in which the buyer agrees to pay an additional amount to the seller if the company achieves certain performance targets after the transaction. Thus, this clause helps to bridge the gap between the valuations of both parties.
Earn-outs are especially useful to protect the buyer when there are valuation risks in the face of extraordinary situations. A very clear example: the Covid-19 pandemic. In the months following the start of the pandemic, there was great political, economic and social uncertainty around the world. All of this fundamentally changed the valuation landscape that had been in place prior to the event. As earn-outs are mechanisms to protect against valuation gaps, they become important to prevent losses in situations like these.
In order to fulfill its purpose, an earn-out clause must essentially contain the following:
- The variable to be taken into account to measure the company’s performance. For example, earnings.
- Will there be exclusions to the performance measures?
- The specific formula for determining the amount the buyer will pay if the targets are met.
- Will the seller participate in any way in post-sale operations to achieve the target?
- Will the earn-out payment include interests?
- Will there be any guarantee or way to ensure payment of the earn-out clause?
Ultimately, all of these factors make earn-out provisions a significant challenge for M&A lawyers. Especially if we consider that earn-outs are future events and, therefore, there is a risk that they will be outdated by the time they take effect. Thus, the mergers and acquisitions specialist should be as attentive as possible to details that will help to look forward the future of the company.