Basic Information

A central issue in M&A contract negotiations is the determination of the purchase price for the target company. The parties must agree on the valuation and profitability of the target-company, despite uncertainties about its future economic development. To account for this uncertainty, earnout clauses state the obligation of the buyer to pay, under certain conditions, an additional amount to the agreed purchase price (i.e. a variable “earnout payment”) after the closing of the SPA.

Determination of the Earnout Payment

For the determination of the additional earnout payment, both financial and non-financial indicators can be used.

The turnover is the easiest value to determine among the financial ratios. By its very nature, the turnover reflects only the earnings. Costs, on the other hand, are not included. Additional financial indicators can be derived from the income statement (e.g. EBITDA, EBIT, profit before tax) or cash flow figures. EBITDA or EBIT are often used in conventional transactions because of their high significance. Both financial indicators have in common that they indicate economic earning power at the operating level, however in contrast to sales, they take into account the evolution of costs.

Non-financial indicators, such as the maintenance of customer relationships, can be used to determine the variable elements of the purchase price (e.g. if the determination of the purchase price is in any way based on these customer relationships).

Clear Contractual Provisions

In particular, Financial indicators used in the calculation of the earnout payment must be clearly defined in the SPA.

In general, in addition to the period for determining whether the agreed key figure has been reached (triggers the earnout payment), it is recommended to explicitly define any duties, control rights, disclosure obligations (e.g. in what period of time which person has to prepare an initial balance sheet), as well as any objection periods. Regarding the agreed key figure, the parties must also agree on the accounting principles and clear rules on how to determine the agreed financial ratio, e.g. whether gross sales or net sales are to be taken into account, or whether rebates, expenses, cash discounts and other reductions in sales are to be considered.

Furthermore, it is advisable from the point of view of the seller, who loses control over the purchased object, to prohibit restructurings (e.g. a merger of the purchase object with another company of the buyer) for a certain period of time, or to permit restructurings only if a prior agreement has been reached on the adjustment of the earnout clause.

It is also recommended to define in the SPA the decisions the buyer may or may not make and implement regarding the management of the sold company, as well as the decisions that may be made only with the approval/consultation of the seller.

What To Do

In particular, Financial indicators used in the calculation of the earnout payment must be clearly defined in the SPA.

There are a few pitfalls to consider when agreeing or designing earnout clauses. It is recommended not only to include exact calculation formula to determine the purchase price, but also to specify in detail how the earnout payment is calculated in order to prevent manipulations of the calculation bases. Failure to do so will most likely lead to disputes between the parties.