Earn-outs are commonly used in private equity transactions, to retain and incentivise the management shareholder, and after the closing of a transaction, to ensure that the target continues to be profitable and meets the agreed performance thresholds. In return for meeting the thresholds, the management shareholders are incentivised and “earn” the payment of the deferred consideration. Normally, the parties agree that the better the financial performance or the target, the larger the deferred consideration the seller will receive.

Duration of an earn-out mechanism

Earn-outs are mostly dependent on the future performance of the target and the duration varies from transaction to transaction. There are many variables that are considered, such as the complexity of the transaction, the nature of the target’s business, or the regulatory environment in which it operates, but ultimately the duration of an earn-out mechanism is dependent on the outcome of the purchaser’s risk assessment of the target’s financial performance. Generally, the duration of earn-outs range between one and three years. From a purchaser’s perspective, if there is uncertainty regarding factors that may negatively impact the future financial performance of the target, the purchaser would try and negotiate a longer earn-out period and vice versa.

Calculation of the earn-out

The calculation of the purchase consideration by way of an earn-out mechanism benefits the purchaser, and in most cases, also the seller, as it allows the parties to purchase and sell the target for its true worth. This prevents parties from being overcharged or undercut by one another.

The earn-out will usually be calculated with reference to financial metrics such as the profits, sales, or net asset value of the target. It is critical that these provisions be set out in the sale agreement in sufficient detail, to avoid disputes regarding the calculation of the earn-out. The parties will typically agree to appoint an auditor or accountant to calculate the earn-out. If, for example, the buyer’s auditor calculates and certifies the earn-out, then the seller should be given the opportunity to review the calculation. Where parties fail to agree on the calculation of the deferred consideration, the sale agreement should make provision for such disputes to be referred to an independent expert who will make a fair determination.