Litigation Minute: Earn-Out Provisions

What You Need to Know in a Minute or Less

An earn-out provision is a common provision in an acquisition agreement that makes a portion of the purchase price contingent on satisfaction of certain post-closing targets or other metrics.

In a minute or less, here is what you need to know about earn-out provisions and how to successfully draft them in order to avoid post-closing disputes.

What Is an Earn-Out Provision?

An earn-out provision typically requires the buyer to make one or more contingent payments after closing, which are payable if and when specified targets are satisfied within specified periods. If the target company fails to achieve these targets within the specified periods, the buyer is relieved from making the contingent payments (or, in some cases, only required to pay a lesser amount).

Earn-out provisions are found in nearly 30% of mergers and acquisitions, and are more prevalent in private deals with values under US$250 million.¹

Advantages and Disadvantages of Earn-Out Provisions

An earn-out provision has advantages for both seller and buyer. For the seller, an earn-out provision can provide an opportunity for a higher purchase price. Without an earn-out provision, the price the buyer is willing to pay may be discounted due to buyer doubts or uncertainty about the future success of the target company.

For the buyer, an earn-out provision can protect from overpaying at the time of the deal. With an earn-out provision, the price to acquire the target company is based on actual future performance. 

Earn-out provisions can also present disadvantages if not carefully drafted. A poorly structured earn-out can incentivize a buyer to temporarily operate the company in a manner that suppresses the performance of the newly-acquired business. Additionally, provisions containing ambiguities create material risk of post-transaction litigation between the parties. 

How Best to Structure Earn-Out Provisions to Avoid Litigation

There is no “one size fits all” earn-out provision – provisions must be tailored to suit the parties’ expectations. There are, however, some common considerations that must be addressed with every earn-out provision, including:

• Ensuring the targets are objective, clearly defined, and easy to measure;
• Determining the earn-out period and structure of the payout;
• Determining how the parties will measure performance; and
• Setting up the process for resolving disputes.

Courts are increasingly reluctant to impose any implied contractual obligations for earn-outs when it is clear that the parties have thoroughly negotiated the earn-out provision. Both parties, therefore, should ensure that the plain language and express terms of the earn-out provision carefully describe how the earn-out is to be structured.