An earn-out is a contractual clause in company sales or mergers that links part of the purchase price to the future performance of the company being sold. This structure makes it possible to defer part of the purchase price payment to a later date and make it dependent on the achievement of certain performance targets. Earn-outs are often used to bridge valuation differences between buyer and seller and to share risks.

Main features of an earn-out:

1. performance targets: Defined key figures that the company must achieve within a specified period.
2. time frame: Typically 1-5 years after completion of the transaction.
3. additional payments: If the targets are achieved, the seller receives further payments.
4. staggered payments: often staggered payments depending on the degree of target achievement.

Common performance indicators for earn-outs:

– Turnover
– EBITDA (earnings before interest, taxes, depreciation and amortization)
– Net profit
– Market share
– Customer numbers or loyalty
– Product development milestones
– Regulatory approvals

Advantages for buyers:

1. risk mitigation: shares the risk of future company performance with the seller.
2. bridging valuation gaps: enables agreement to be reached in the event of differing values.
3. performance incentive: motivates salespeople/management to achieve business goals.
4. cash flow management: postpones part of the purchase price payment into the future.

Advantages for sellers:

1. higher total purchase price: potential for additional payments over and above the base purchase price.
2. value realization: the possibility of realizing the full value of the company.
3. flexibility: allows sales in a potentially unfavorable market environment.
4. participation in the upside: benefits from positive developments after the sale.

Challenges and risks:

1. complexity: Earn-out structures can be complex and difficult to manage.
2. conflicts of interest: possible divergence between short-term earn-out targets and long-term corporate strategy.
3. loss of control: the seller may have limited influence on the achievement of objectives.
4. calculation disputes: Disagreements about the calculation or interpretation of key performance indicators.
5. manipulation risk: Risk of manipulation of key figures to influence the earn-out.

Legal and contractual aspects:

1. clear definitions: Precise definition of key performance indicators and calculation methods.
2. reporting obligations: Regular and transparent reporting on relevant key figures.
3. inspection rights: possibility for the seller to check the calculation.
4. dispute resolution mechanisms: definition of procedures for resolving differences of opinion.
5. adjustment clauses: provisions for unforeseen events or changes in the business environment.

Tax considerations:

– Time of taxation: question of whether earn-out payments are treated as a deferred purchase price or as income.
– Valuation: Challenges in the valuation of future, uncertain payments.
– International aspects: Complexity in cross-border transactions.

Best practices for the design of earn-outs:

1. realistic goals: Set achievable but challenging performance targets.
2. balance: balance between short-term goals and long-term corporate development.
3. flexibility: incorporation of mechanisms to adapt to changing market conditions.
4. transparency: clear communication and regular updates on progress.
5. incentive structure: design that motivates both buyers and sellers.
6. safeguard clauses: agreements to protect against manipulation or unintended consequences.

Alternatives and additions to earn-outs:

– Escrow agreements: Deposit of part of the purchase price as security.
– Seller’s loan: Part of the purchase price as a loan from the seller to the buyer.
– Option structures: right of the buyer to acquire additional shares.
– Milestone payments: Payments upon achievement of specific, non-financial targets.

Industry-specific applications:

– Technology: Often based on product development or user numbers.
– Pharma/biotech: Often linked to regulatory approvals or clinical trial results.
– E-commerce: Focus on customer numbers, conversion rates or sales per customer.
– Services: Often linked to customer loyalty or turnover per employee.

In summary, earn-outs offer a flexible way to structure transactions and spread risk between buyer and seller. However, they require careful planning and execution to be effective and minimize potential conflicts. The successful implementation of an earn-out depends heavily on the clarity of the agreement, the appropriateness of the performance targets and the ongoing cooperation between the parties.