Earn-outs as part of a transaction
Earn-outs as part of a transaction – how do you structure an effective earn-out clause?
The M&A market has clearly picked up over the past year, with an exceptionally high number of new deals being concluded. Despite this activity, purchase price negotiations often remain the most challenging stage of a transaction, and the differing views between the buyer and seller regarding the target company’s value are one of the most common reasons why deals are delayed or fall through entirely. The seller may emphasise growth potential and future prospects, whilst the buyer wants to see evidence of these before being prepared to pay on the basis of such prospects. When this gap between the parties’ views cannot be bridged directly through price negotiations, an earn-out often provides a solution that ultimately enables the deal to go ahead.
The tightening of the financing environment has also contributed to widening the gap between the buyer’s and seller’s price expectations. In such cases, an earn-out links the financing of the transaction to the determination of the price, as the buyer does not commit to the full purchase price in advance without evidence of business performance, whilst the seller is given the opportunity to demonstrate the growth potential even after the transaction has been completed. This approach therefore provides flexibility for both parties to the transaction.
What is an earn-out?
An earn-out, or conditional additional purchase price, refers to that part of the purchase price for which the obligation to pay and/or the amount depends on the target company’s future performance following the transaction. Part of the purchase price is paid upon completion of the transaction, and the remainder is determined by whether the target company achieves, for example, an agreed level of turnover or EBITDA during a specific monitoring period. In practice, for example, 70–80% of the purchase price may be paid upon completion of the transaction, with the remaining 20–30% is payable at a later date, provided the agreed targets are met. The monitoring period typically lasts from one to three years following the transaction, but its duration always depends on the industry and the nature of the deal.
At its best, an earn-out encourages the seller to remain committed to the company’s success even after the transaction and provides the buyer with security in the event that the business’s performance does not meet the seller’s expectations. On the other hand, an earn-out is not risk-free for either party: from the seller’s perspective, the realisation of the additional purchase price often depends on factors over which they no longer have control after the transaction, and from the buyer’s perspective, the arrangement may complicate the integration of the target company into the rest of the business if operations have to be restricted during the monitoring period to safeguard the earn-out.
It is also worth distinguishing an earn-out from a seller’s reinvestment, even though they are often used in parallel. An earn-out refers to a portion of the purchase price that is paid in cash upon the fulfilment of targets, whereas in a reinvestment, the seller reinvests part of the purchase price and thus remains a shareholder in the buyer’s company. In both cases, the aim is to align the seller’s interests with the company’s success even after the transaction, but the methods and risks differ.
What should you look out for in an earn-out clause?
To ensure that the earn-out clause serves the interests of both parties even after the transaction, here are a few practical tips to bear in mind when drafting an earn-out clause:
Define the metric precisely. Choose a metric, such as turnover, EBITDA or customer retention, that genuinely reflects the value for which the additional purchase price is paid. The method for calculating the metric should be set out in such detail that there is no room for interpretation. The more clearly the metric is defined, the lower the risk of a dispute arising over its calculation after the transaction.
Agree on the structure and limits of the additional purchase price. The payment structure directly affects both the parties’ incentives and the risk of dispute, so it is advisable to agree on this during the negotiation phase. Decide whether the additional purchase price will be paid on a sliding scale based on the degree to which the target is achieved, or only once a specific threshold has been exceeded. A sliding-scale model is typically more balanced, whereas an “all or nothing” threshold exacerbates a situation where a deviation of just a few per cent from the target results in the loss of the entire additional purchase price, thereby increasing the risk of dispute. If multiple monitoring periods are used, it is also advisable to agree whether, for example, falling short in one period can be offset by exceeding the target in the next, so that a single poor year does not automatically result in the loss of the entire additional purchase price.
Agree on the accounting principles in advance. It is advisable to define the accounting and calculation principles to be used in detail, as these will determine how the previously selected metric is monitored. It is also necessary to agree on whether adjustments will be made to the accounting principles, for example, in respect of intra-group items, non-recurring expenses, transaction costs, group contributions, exceptional investments or changes in accounting practices. If these principles have not been agreed in advance, they often have to be renegotiated only after the observation period has ended and that is, precisely at the stage when the parties’ interests are furthest apart.
Restrict the buyer’s freedom of action during the monitoring period. Following the transaction, the buyer typically gains full control over the target company, which may directly affect the metrics used to determine the additional purchase price, for example through the discontinuation of a product line, changes to pricing, investment decisions, changes to key personnel or the consolidation of business operations. It is particularly important from the seller’s perspective to agree in advance to what extent the buyer undertakes to continue business operations in a manner that does not unduly undermine the seller’s genuine prospects of realising the additional purchase price. It is also advisable to agree that the obligation to pay the additional purchase price will pass to any new owner if the buyer has the right to transfer ownership of the target company during the monitoring period.
Agree on the seller’s access to information during the monitoring period. Following the transaction, the seller will no longer have access to the target company’s financial reports if the seller sells their entire ownership in the target company to the buyer. In such cases, it is advisable to set out in the share purchase agreement how and on what schedule the buyer will report on the development of the metric. At the same time, it is advisable to agree on the seller’s right to review the calculation of the additional purchase price and the information on which it is based, as well as the time limit within which the seller must submit any objections.
Set out the dispute resolution procedure for the additional purchase price in advance. It is advisable to agree in the share purchase agreement in advance how any disagreements regarding the fulfilment of the metric will be resolved, for example by appointing an independent expert or auditor whose decision is binding on the parties. This is a considerably quicker and more cost-effective route than litigation or arbitration. Often, a procedure agreed in advance also reduces the likelihood of disputes arising in the first place.
Determine the right of set-off. The buyer typically wishes to have the right to set off claims for which the seller is liable, such as compensation based on a breach of the warranties in the share purchase agreement, against the additional purchase price. From the seller’s perspective, it is important to limit set-off to claims that have been finally confirmed and are undisputed, so that a single disputed claim does not delay payment of the entire additional purchase price.
Take note of the tax timetable. A change to the taxation of the additional purchase price came into force at the start of 2026, which affects the year in which the additional purchase price is taxed as part of the seller’s income tax. Under the Finnish Income Tax Act, an additional purchase price is taxed as a capital gain in the tax year in which the obligation to pay and the amount are finally confirmed, if this occurs only after the actual year of the transaction. In such cases, the capital gain is recalculated and, where necessary, any previously confirmed capital loss is adjusted accordingly. It is advisable to take this new provision into account when planning the length of the monitoring period and the payment schedule, so that any tax consequences fall at the correct time for the seller.
Consider the necessary security arrangements. When drafting the share purchase agreement, it is advisable to consider in advance how payment of the additional purchase price will be secured should the buyer’s financial situation change during the monitoring period. Security may take the form of, for example, a separate escrow account, other collateral or a guarantee provided by the parent company.
An earn-out clause should be carefully planned
A well-drafted earn-out clause can make a deal happen that would otherwise not have materialised. On the other hand, if drafted carelessly, it is one of the most common causes of post-acquisition disputes. It is therefore advisable to apply the same level of care to the drafting of the clause as to the negotiation of the purchase price itself.
We regularly assist both buyers and sellers in drafting and negotiating earn-out clauses, and we have also witnessed disputes arising from them. We are therefore happy to assist should this matter become relevant.
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