The Precarious Nature of Earn-out Clauses in Share Purchase Agreements

The Precarious Nature of Earn-out Clauses in Share Purchase Agreements.

[Prajoy Dutta]

The author is a fourth-year student at Institute of Law, Nirma University.

The merger and acquisitions market in India has seen some exceptional activity in the recent years,[1] especially in cases of start-ups. Concerns usually revolve around the valuation of the company, the purchase price that both parties can agree on, and the issue of control over the newly acquired company post the completion of the acquisition. A pertinent legal point that covers both the issue of purchase price and control is the earn-out clause in the share purchase agreement.

Structure of Earn-out Clauses

An earn-out clause allows the deal to move forward when the buyer and seller cannot mutually agree on the valuation of the target company. The clause stipulates that a portion of the mutually agreeable purchase price shall only be payable contingent on the achievement of certain milestones or the satisfaction of certain conditions[2] by the company, post the transfer of shares. These milestones or conditions may include provisions such as revenue from certain products, cash flow over a defined period of time, EBITDA, market share captured by the company over a defined period of time etc. Thus, in the case of an earn-out, a basic purchase price is paid upfront and a variable purchase price component(s) is paid at a later date, contingent on the fulfillment of certain predetermined performance indicators set out in the earn-out clause. The significance of this is that the seller continues to participate in the economic success of the target company, even after all the risks and rewards have been transferred.[3]

The Role of Earn-out Clauses in M&A Deals

Earn-out clauses are almost always insisted upon by the buyer. The most pertinent reason for this could be the inaccessibility to private information about the target company at the time of the acquisition[4] which may, as a consequence, result in an incorrect valuation of the target company. Other reasons that could result in incorrect valuations could be uncertainty in the market itself, or that the company’s product or service is too futuristic for the present market. All of these are factors that the buyer must reduce his risk in. An incorrect valuation or measurement of the target’s performance benchmark pre-acquisition could very well be the basis of undesired future litigation, post-acquisition. An earn-outs clause thus provides the best possible solution.

Types of Earn-out Clauses

The practice of mergers and acquisitions has led to the development of two principal types of earn-out clauses:

Economic Earn-outs: Parameters set out in these types of earn-out clauses set down financial thresholds. These might include conditions such as the targets net revenue, net income, cash flow, EBIT, EBITDA, and net equity thresholds.[5]

Performance Earn-outs: Parameters set out in these types of earn-out clauses set down non-financial thresholds. Apart from the reason that they may give operational focus to the target, performance earn-outs are usually used in cases of companies that may be difficult to value, mainly due to their high growth rates.[6] Performance earn-outs can include conditions such as the launch of a new product in the market by the target, the existing products capturing a significant portion of the existing market share or even in some cases, the target company receiving a coveted industry award.[7]

Important Considerations while Structuring an Earn-out Clause

Though an earn-out clause seems like the perfect solution to keep the deal moving forward despite a disagreement over price, it has some inherent disadvantages for the seller. If these disadvantages are not identified and remedied contractually, the seller could stand a chance of being paid a much lower amount than what was mutually agreed upon. This is principally because the variable component of the purchase price stands to be paid post the transfer of shares of the target company and its associated risks and rewards. Further, since the disadvantages and their remedies were not identified in the earn-outs clause itself, the share purchase agreement can very well be interpreted to mean that the seller understood the associated risks of an earn-out but chose to not protect himself against such risk. Therefore, there may be very limited legal remedies for the seller to recover the variable component of the price. Hence, the following major issues are considerations that the seller must keep in mind while structuring an earn-outs clause in the share purchase agreement.

Following a Consistent Accounting Methodology – Pre Sale and Post Sale[8]

A major concern that arises in most M&A deals is the accounting practice to be followed by the newly created merged entity or the acquired company. Common accounting standards become all the more important in the case of an earn-out due to financial conditions required to be fulfilled in order to receive the variable purchase price component. If the acquired company is required to follow the accounting standards of the buyer, there may arise a situation where the buyer may manipulate the results of the earn-out. Manipulations could potentially include inventory valuation methods, depreciation schedules and reserves for bad debts. Sometimes, the manipulations may occur simply because the target company’s industry is very different from that of the buyer. Should the seller set out a clear methodology of the accounting practices to be followed, the risk of above mentioned manipulations is significantly reduced.

Tax Sharing Agreements With The New Parent Company[9]

In a case where the earn-out is based upon a before tax indicator, such as EBIT or EBITDA, care should be taken to ensure that tax payable includes payments made under tax sharing agreements with the new parent company. In the event that the earn-out is based upon an after tax indicator, special attention must be paid to how the taxes of the parent holding company are allocated to all the member companies of the group. Special focus must also be given towards certain tax sharing agreements which mandate that the newly acquired company may have to make payments to the new parent company as a consideration of the overall reduction in taxes achieved due to the tax sharing agreement.

Consistency of Operations Post-Closing of Acquisitions

The seller must ensure that the buyer is prepared to let the target company operate in a manner free of mismanagement of the target company’s operations. The surviving management team of the target company, who are the recipients of the earn-out, must be allowed to function in a manner which furthers the interests of the target company. This consistency of operations should also include the latitude to allow the target company to undertake certain decisions which may appear to be risky at the present time but are calculated to help in achieving the earn-out targets. If the buyer does not agree with this, it allows him the ability to reduce the value of the variable purchase price component by mismanaging the target’s operations, either intentionally or unintentionally. Hence, such situations must be foreseen by the buyer pre-acquisition and remedies must be drawn up in the earn-outs clause itself.

Provision of Adequate Capital[10]

This is a factor ancillary to the consistency of operations. The seller must extend special concern towards the buyer agreeing to provide adequate capital to sustain the operations of the target company as well fund any projected expansions.

Anticipating an Overlap of Products or Services Offered by the Target and the Purchaser

A situation might arise where the products or services offered by the target company and the purchaser are similar. Hence, post-acquisition, the purchaser might want to consolidate sales teams, manufacturing units and distribution systems. This consolidation may play a role in bringing about operational efficiency for the purchaser, but the same can complicate calculations to determine the achievement of targets for the earn-out.


Though effective risk hedging tools, earn-outs occupy a precarious position in the share purchase agreement, if not structured in the correct manner. It is necessary that the considerations mentioned above are taken into account while structuring the earn-out clause to allow both parties to focus on the larger goal of scaling the business post the completion of the deal despite their being differences on the point of valuation.

[1]Indian Tech Startup Funding Report H1 2017: $5.56Bn Invested Across 452 Deals, Inc 42, available at, last seen on 26 January 2018 at 10.49am.

[2]G. Quatrini & M. Cavallo, “Earn-Out Clauses: Advantages and Pitfalls”, Portolano Cavallo, available at, last seen on 25.04.17 at 6.37pm.

[3] “Share purchase agreements – Purchase price mechanisms and current trends in practice”, 2 ed., Ernst and Young, available at Share_Purchase_Agreements_spring_2012/$FILE/EY-

[4] Supra 1.

[5] Leigh Walton, Bryan W. Metcalf, Angela Humphreys Hamilton, “Earnouts and Other Purchase Price Provisions”, American Bar Association Annual Meeting 2004, Earnouts in Business Acquisitions: A Practical Solution Or A Trap For The Unwary?, available at, last seen on 25.04.17 at 7.37pm. SPA%20brochure-spring-2012_eng.pdf, last seen on 25.04.17 at 7.06pm.

[6] Ibid.

[7] Ibid. See also, Spencer G. Feldman, “The Use of Performance (Non-Economic) Earn-outs in Computer Company Acquisitions”, Insights (August 1996).

[8] Ibid.

[9] Supra 6.

[10] Ibid.

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