Earn-Outs in M&A: Getting them right from the start (how not to stuff them up)

Where Things Go Wrong

In theory, the mechanics seem straightforward: agree on a financial target, measure performance after completion, and pay the earn-out if the hurdle is met. In practice, it is rarely that simple.

For sellers, the obvious risk is loss of control. Once the buyer is running the business, decisions about staffing, accounting policies, strategy or capital expenditure can all affect whether the target is achieved. Market downturns or regulatory changes may derail outcomes, and cash flow issues or insolvency can put the earn-out itself at risk.

For buyers, earn-outs can encourage short-term behaviour, with management chasing hurdles at the expense of long-term value. If targets are set too low, the buyer may overpay for the business. Monitoring compliance and resolving disputes can drain management resources, while large earn-out payments falling due in one hit may also create financial pressure.

Avoiding the Pitfalls: 9 Top Tips

The best protection for both buyers and sellers lies in careful drafting. Some recurring pressure points include:

1. Clarity on the metric: Be explicit about whether the hurdle is revenue, EBITDA or something else, and how it will be calculated. Targets should be capable of objective evaluation, not open to interpretation.
2. Accounting principles: When the earn-out is based on financial results, the accounting treatment matters as much as the target itself. Agreements should specify the principles or policies to be applied, and how items such as revenue recognition or expense allocation will be treated. Without this, disputes often focus on the numbers rather than performance.
3. Timeframes: Earn-outs usually run for one to three years post-completion. The agreement should define this window clearly, along with when and how performance will be measured.
4. Payment terms: Spell out when payments will be made (lump sum or instalments) and in what form (cash, shares or a mix).
5. Control and protections: Sellers often want assurances about how the business will be run during the earn-out. This may include covenants to operate in line with past practice or an agreed business plan, and sometimes restrictions on changes that could materially affect performance. Buyers, however, have paid for the business and will expect flexibility to run it their way. Striking the right balance is critical.
6. Information rights: Sellers should seek regular reporting and audit rights to track performance against the target and verify how results are being calculated.
7. External events: COVID-19 showed how quickly external shocks can derail assumptions. Agreements should anticipate unforeseen circumstances and set out how they will be treated.
8. Litigation risk: Courts may adjust outcomes to what they see as fair, not necessarily what was intended. Where appropriate, use clear definitions and illustrative examples to avoid leaving gaps that a court might fill unpredictably.
9. Dispute resolution: Quick, binding expert determination is usually preferable to litigation, provided the target can be assessed objectively.

Keeping Perspective

Earn-outs are not inherently bad. In the right circumstances they can align interests and make deals possible that might not otherwise proceed. But they do require careful handling.

A recent example is the dispute between Pact Group and the sellers of TIC Retail Accessories. Years of litigation in the Supreme Court of Victoria over earn-out targets not only delayed resolution but also spilled over into broader corporate disputes. Minority shareholders challenged the planned takeover and delisting of Pact, leading to intervention from the Takeovers Panel.

In another recent case, Wilson v QBT Pty Ltd, a contingent earn-out was linked to the target retaining its joint venture interest after the sale. The change of control triggered by the sale gave the other JV party the right to buy out that interest, and the earn-out provisions left gaps that, on a literal reading, produced an absurd outcome. The Court rectified the agreement to reflect the broader bargain, a decision upheld on appeal. While not binding in Queensland, the case is persuasive authority that courts may correct unclear drafting where the intended commercial outcome is evident.

Final Thought

An earn-out should be a bridge, not a battleground. The key is to stress-test the mechanics before signing, anticipate where things could go wrong, and document the solutions. It is far cheaper (and less painful) to do that at the front end than to litigate about it for years afterwards.

Article written by Andrew Williams (Special Counsel – Corporate and Commercial Law)