Introduction
In mergers and acquisitions (M&A), agreeing on a fair valuation can be challenging—especially when buyers and sellers have differing views on future performance. Earn-out agreement offers a solution by tying part of the purchase price to the target company’s post-acquisition success.
This brief guide, based on ICAEW’s Best-Practice Guideline 70, explores how earn-out agreement work, their benefits, common pitfalls, and best practices for structuring them effectively.
What Is an Earn-Out Agreement?
An earnout is a deferred payment mechanism in M&A where part of the purchase price is contingent on the business achieving predefined financial or operational milestones after the deal closes.
Key Features of Earnout Agreement:
- Performance-Based: Payments depend on metrics like EBITDA, revenue, or customer retention.
- Time-Bound: Typically spans 1–3 years post-acquisition.
- Alignment of Interests: Ensures sellers remain motivated while buyers mitigate overpayment risk.
When Should You Use an Earn-Out Agreement?
Earnouts are particularly useful in:
✅ High-growth industries (e.g., tech, healthcare) where future performance is uncertain.
✅ Bridging valuation gaps between buyers and sellers.
✅ Retaining key management to ensure business continuity.
Earn-Out vs. Deferred Consideration
- Earn-outs are contingent on performance.
- Deferred payments are fixed but delayed (e.g., installments).
Structuring an Effective Earnout Agreement
1. Choosing the Right Metrics
Common financial metrics include:
- EBITDA (most popular)
- Revenue
- Gross profit
- Non-financial KPIs (e.g., customer retention, product launches).
Pro Tip: Avoid “cliff-edge” thresholds (all-or-nothing payouts). Instead, use sliding scales to reduce disputes.
2. Drafting the SPA (Sale & Purchase Agreement)
- Clearly define accounting policies (e.g., GAAP vs. IFRS).
- Include conduct clauses to prevent buyer manipulation.
- Attach pro forma earn-out accounts to minimize ambiguity.
3. Avoiding Common Pitfalls
❌ Poorly defined metrics → Disputes over calculations.
❌ Overly long earn-out periods → Business changes too much.
❌ Lack of seller protections → Risk of buyer interference.
Tax & Accounting Implications
For Sellers:
- Employment income vs. capital gains:
- If linked to continued employment, taxed as income (higher rate).
- If treated as sale consideration, taxed as capital gains (lower rate).
- Stamp duty: May apply to earn-out payments.
For Buyers:
- IFRS vs. FRS 102:
- Under IFRS, earn-out revaluations hit P&L.
- Under FRS 102, adjustments may go to goodwill.
Resolving Earn-Out Disputes
Disputes often arise from:
🔹 Ambiguous SPA wording
🔹 Changes in business operations
🔹 Accounting disagreements
Dispute Resolution Process:
- Negotiation between parties.
- Expert determination (independent accountant).
- Legal action (last resort).
Best Practice: Define dispute mechanisms in the SPA to avoid delays.
Key Takeaways
✔ Start early: Agree on earnout terms during heads of terms.
✔ Be specific: Define metrics, accounting policies, and dispute processes.
✔ Consider tax impact: Structure payments to optimize tax treatment.
✔ Monitor performance: Maintain transparent communication post-deal.
Final Thoughts
Earn-out agreement is a powerful tool to bridge valuation gaps and align buyer-seller interests—but only if structured carefully. By following best practices, you can maximize deal success while minimizing disputes.
🔗 Links for More:
Download and read the guide on ICAEW website or NeoForm LinkedIn page.
📌 About NeoForm:
NeoForm Business Partners is a PE and M&A advisory firm providing strategic transactions, due diligence, and deal structuring services. Our experts help businesses navigate complex deals with confidence. Check NeoForm blog for more insights.
Need expert advice on structuring your earn-out? Contact NeoForm’s M&A specialists today.