What Is an Earn-Out Clause? A Mechanism for Bridging Valuation Gaps in M&A and Its Dispute Risks

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

In negotiations to acquire a startup that is growing rapidly even though it has not yet turned a profit, the parties sometimes cannot agree on the purchase price. The seller asks for a high enterprise value that factors in future growth, while the buyer wants to calculate the consideration based on results that can be objectively confirmed at present. An earn-out clause is a practical option considered to bridge this kind of valuation gap.

An earn-out clause is a mechanism under which, in addition to the consideration paid at closing, the buyer pays the seller additional consideration if the target company's results or metrics achieve pre-agreed targets during a certain period after closing. In M&A deals where valuations tend to vary widely, such as for companies with little operating track record yet or companies holding new products or technologies expected to generate future profits, it serves to bridge the gap in perceptions between the seller and the buyer and makes it easier to close the transaction. The Small and Medium Enterprise Agency's SME M&A Guidelines (3rd Edition) (Japanese) also explains that earn-outs are often used in M&A of venture companies for which future profit prospects are hard to forecast but significant growth is expected (p. 54, as of August 2024).

That said, an earn-out is not a cure-all for resolving price differences. If ambiguities remain regarding the choice of metrics, the calculation formula, management authority after the acquisition, the determination procedure, and the like, they become the seeds of new disputes over the payment of additional consideration after closing.

The Price Gap an Earn-Out Resolves, and Where It Differs from Installment Payments

Besides an earn-out, another method of paying the purchase price is to fix the total amount of consideration in advance and pay it on separate due dates. The SME M&A Guidelines describe this as "post-closing installment payment of the purchase price," noting that it is sometimes used when the buyer lacks funds, while cautioning that payments may stall depending on the post-closing business environment and the buyer's circumstances, and that this risk increases the longer the period lasts (p. 53).

The decisive difference between an earn-out and fixed installment payments is whether the total amount of consideration itself varies with the degree to which future metrics are achieved. Installment payments merely defer the due dates while the total consideration is fixed, whereas in an earn-out the total consideration itself is not fixed. To determine which method to adopt in a negotiation, the parties should identify whether the disagreement stems from the buyer's lack of funds or from the valuation of the target company's future prospects itself.

As discussed in The Basics of Reviewing an M&A Letter of Intent (LOI), how definitively the price should be stated becomes an issue from the LOI stage. If there is a possibility of using an earn-out, indicating that direction at the LOI stage, before entering into negotiations on the definitive agreement, helps keep later negotiations from wavering. When an earn-out is provided in a company split or similar transaction, the parties confirm consistency with the matters required by law to be stated in the split agreement and with the method of delivering the consideration. Whether deferred payment is possible is examined in light of the combination of transactions and how it is provided for in separate agreements. This is as confirmed in How to Choose an M&A Structure.

Sources of Dispute in Choosing Metrics

The metrics set for an earn-out include financial and non-financial metrics. Financial metrics used in practice include net income, net sales, and EBITDA (earnings before interest, taxes, depreciation and amortization). The parties need to agree on a calculation formula specifying which expenses are deducted or added back. Non-financial metrics include achieving stages of progress (milestones) in product development, the number of new contracts obtained, and the number of users of a service. The SME M&A Guidelines also introduce examples in which non-financial targets such as product sales volume and facility occupancy rates are used (p. 54).

When considering metrics, the parties assess both how easily a party can manipulate them and how much they are affected by the external environment. Metrics that deduct expenses, such as net income and EBITDA, are easier for the buyer, who manages the target company after the acquisition, to adjust at its discretion, for example in terms of the timing of booking expenses. For this reason, sellers tend to prefer net sales, which offer greater clarity, as the metric. On the other hand, from the buyer's standpoint, a profit metric that also reflects expenses is more in line with the reality of the business, and the buyer may prefer profit-based figures on the ground that appropriate cost control can be expected if the seller remains in management. No uniform assessment holds, such as net sales being safe and profit being inappropriate.

Even when net sales are used as the metric, the risk of manipulation remains. For example, changes in the timing of revenue recognition, heavily discounted sales, and the reallocation of customer contracts within the buyer's group can all move the net sales figure. Meanwhile, capital expenditure affects cash outflows and subsequent depreciation expenses, and changes in payment terms mainly affect cash flow. Because these do not immediately change net sales or profit in the same way, the parties examine the effects on each metric separately. Conversely, in a structure where the seller remains in management after closing, there is also a concern that the seller will have an incentive to steer results during the target period in its own favor. Furthermore, if the buyer or the target company acquires or merges with another company engaged in a similar business during the target period, the figures can change significantly due to organizational integration, so whether to include covenants restricting such actions or provisions adjusting target values is another issue to consider. It is important to choose metrics after assessing, case by case, who controls management and which party has a motive to move the figures.

Drafting the Calculation Formula, Accounting Policies, and Determination Procedure

Regarding the evaluation period for an earn-out, the SME M&A Guidelines (3rd Edition) state "a certain period after closing (often within three years)" (p. 54, as of August 2024). This statement introduces the tendency in practice at that time and does not mean a legal upper limit. The period is agreed and set for each deal, taking into account the characteristics of the target business and the time needed for results to show up in the figures.

When financial metrics are adopted, the accounting standards and treatment methods for calculating the metrics, and the procedure for finalizing them, need to be agreed in advance in the contract. Unless it is made clear whether the target company's existing accounting policies will be followed, whether generally accepted corporate accounting standards will apply, or whether specific treatment standards will be set for particular items, the calculation results themselves will be disputed. If, despite an agreed standard, the buyer switches to its own group's internal standards for the calculation, not only the calculated amount but also whether there has been a breach of contract may become an issue. As with net asset price adjustments in share transfers, the fact that deviation from the agreed accounting treatment leads directly to disputes over consideration is a common point of caution for earn-outs as well.

For the determination procedure, the contract should also specify who prepares the calculation statements and by when, by when the other party may raise objections, and to which expert the final decision is entrusted if the matter is not resolved through consultation. As a drafting example, one could design a provision under which the buyer presents a draft calculation statement of the metrics within 60 days after the end of the evaluation period, the seller gives notice of consent or objection within 30 days after receipt, and if no agreement is reached, an accounting firm designated in advance makes the final decision. However, periods such as 60 days and 30 days are merely examples set by contractual agreement. Also, unlike price adjustments made immediately after closing, an earn-out sets the procedural deadlines to match the end of each target period over multiple years. As for the final decision by an expert, the contract should specify the scope of the accounting calculation entrusted to the expert and the procedure for handling disputes over legal interpretation. Merely stating that the final decision is entrusted to an expert does not give it the same effect as an arbitral award under the Arbitration Act. In addition, securing reasonable access to the target company's officers, employees, and related documents so that the seller can verify the validity of the calculation is another point to consider in keeping the procedure effective.

Balancing the Parties' Interests over Post-Acquisition Management Authority

In a transaction in which the buyer acquires a majority of the shares and gains management control, the post-closing management policy affects the degree to which the metrics are achieved and, in turn, the amount of the earn-out payment. In a transaction acquiring a minority stake, the location of control is different, and the duties under the Companies Act that officers owe to the company, such as the duty of care of a prudent manager, need to be distinguished from the buyer's obligations under the purchase agreement. For example, one could design the contract so that the buyer must not, without the seller's prior consent, take actions that could allow it to avoid or reduce payment of the consideration, while providing that, unless otherwise stipulated, the buyer does not bear an obligation to make special efforts to achieve the targets or an obligation to maximize the consideration. However, even if a maximization obligation is expressly disclaimed, intentional payment avoidance or misconduct contrary to the principle of good faith is not necessarily exempt from liability. For the seller, a realistic defensive measure is to negotiate provisions that individually restrict actions that would hinder achievement of the targets, such as selling the core business, making large capital investments, or discontinuing sales of the flagship product.

In the U.S. Sonoran Scanners decision (U.S. Court of Appeals for the First Circuit, October 29, 2009), the court recognized, under Massachusetts law and in the context of the contract, an implied obligation of the buyer under a business asset purchase agreement to use reasonable efforts in technology development and sales promotion. However, whether that obligation had been breached was left to the court on remand. This decision does not apply directly to share transfers under Japanese law, but the possibility cannot be ruled out that, in contract interpretation under Japanese law as well, certain obligations of the buyer may be derived from the principle of good faith and the like even without express provisions. If the buyer wishes to make clear that it does not bear excessive management obligations, it should state clearly in the contract that it does not bear any efforts obligation or maximization obligation.

Contractual measures available to both parties include acceleration clauses and buyout clauses. As a defensive measure for the seller, the contract may provide a right to terminate the earn-out midway and claim payment of an amount based on a pre-agreed formula (acceleration rights), for example if the buyer commits a material breach of its obligations. Some contracts use the commencement of legal insolvency proceedings against the buyer as a triggering event, but it should be noted that this does not overcome constraints under insolvency law or give priority over other creditors. On the buyer's side, there is a right to terminate the earn-out early by paying the full amount based on a predetermined sum or calculation formula (buyout rights). When the buyer tries to sell the target company on to a third party after the acquisition, the existence of an earn-out clause can hinder negotiations, so this right serves as preparation for such situations. Both rights are optional measures agreed between the parties in advance, and they presuppose that the amount or calculation formula is clearly agreed.

Treatment in the Event of Departure, Resale, or Business Suspension

If the seller remains in management of the target company after closing, the contract should provide for the treatment if the seller leaves partway through the evaluation period. Depending on whether it is a voluntary resignation or a dismissal by the company, and whether there is just cause for the dismissal, the contract distinguishes whether the earn-out continues, lapses at that point, or is finalized early. Whether the consideration paid to the manager is, for tax purposes, consideration for the transfer of shares or consideration for services (salary, bonuses, and the like) is examined according to the individual circumstances, such as the payment terms and the person's role. As explained in Risks Founders Tend to Overlook in SPA Representations and Warranties, the scope of liability for representations and warranties and indemnification when a founder is the seller is examined in conjunction with the treatment upon departure.

Provisions for cases where the buyer resells the target company or its business to a third party during the earn-out period, or suspends or discontinues part of the business, are also important. Even if the buyer resells, the buyer's earn-out payment obligation does not necessarily transfer automatically to the new buyer, and absent an agreement between the parties or an assumption of the obligation by the new buyer, the original buyer's payment obligation does not automatically cease. Unless the contract specifies whether resale or business suspension is restricted as an act of payment avoidance, or whether the earn-out is terminated early and settled in cash, it becomes unclear which party bears the disadvantage, and a dispute is more likely to arise.

There is also a design in which the parties agree that the earn-out payment obligation may be set off against claims arising from price adjustments or indemnification claims under the share purchase agreement. However, set-off requires that the parties be the same and that the legal requirements be met, and in insolvency proceedings it is also subject to constraints such as prohibitions on set-off. This set-off provision is designed to be consistent with the overall indemnification framework and price adjustment structure explained in SPA (Share Purchase Agreement) Indemnification, Price Adjustment, and Closing.

Numerical Simulation Before Drafting the Clause

Preparing a simple simulation using projected values for the metrics before starting to draft the contract provisions makes it easier to find gaps in the provisions. The main situations to verify in advance are the following five.

• When the target is exceeded slightly and when it is exceeded significantly (if a cap is set, how results exceeding it are treated)
• When the target is not met (whether additional consideration is zero, or whether a fixed amount or staged payments according to the degree of shortfall are provided)
• When, after closing, the target company switches to the buyer group's accounting treatment (how this affects the calculation of the metrics and whether the agreed definitions can address it)
• When system migration costs and personnel integration costs arise from PMI (post-merger integration) (whether to treat these as exceptional costs excluded from the metric calculation)
• In a structure where the seller remains in management, when the seller leaves during the target period for personal reasons (whether the earn-out continues, is cut off, or is paid early)

The purpose of the simulation is to identify gaps in the contract provisions. To prepare for negotiations, the parties need trial calculations for each metric prepared together with financial advisors and accountants, draft definitions of the accounting policies for the evaluation period and the exceptional costs to be excluded, a list of early termination events including departure, resale, and business suspension, and a list showing to what extent the underlying financial and business data have been confirmed in due diligence. With these in hand, the parties can negotiate the wording of the earn-out clause while checking the calculation results.

At LegalAgent, when designing earn-out clauses, we examine the choice of metrics and calculation formulas, post-acquisition management authority, the determination procedure, and the treatment of unforeseen events, aligning them with the results of due diligence and the negotiation strategy. We can be consulted from the stage where the valuation gap cannot be bridged and negotiations are stalling. The contractual placement of purchase price provisions, including earn-outs, can be found in Key Provisions of an SPA (Share Purchase Agreement).

• M&A Support
• SPA (Share Purchase Agreement) Indemnification, Price Adjustment, and Closing
• Risks Founders Tend to Overlook in SPA Representations and Warranties

Frequently asked questions

What is an earn-out clause?

It is a mechanism under which, in addition to the consideration paid at closing, the buyer pays additional consideration to the seller if indicators such as the target company's sales or profits over a certain period after closing achieve targets. It serves to bridge the price gap in transactions where the seller's and buyer's valuations of the company differ and agreement is difficult to reach, such as when the target company lacks a sufficient track record of business operations.

Is it safe to use sales as the earn-out indicator?

Not necessarily. While EBITDA and net income are easy for the buyer to manipulate through how expenses are recorded, manipulation risks have been pointed out even for sales, such as the buyer controlling the target company changing the timing of capital expenditures or trade payables, or, where the seller remains in management, the seller having an incentive to move the indicator itself. For each indicator, it is necessary to check who has a motive to move it in which direction.

Which parts of an earn-out clause are especially prone to disputes?

The accounting policies for calculating the indicators, the mechanism for objections and expert determination in the assessment procedure, restrictions on management authority after the acquisition, and the treatment when the seller resigns or the buyer resells or discontinues the business. If these remain ambiguous in the contract, the parties' interpretations of whether additional consideration is payable, and how much, are likely to diverge.