Earn-out as a transaction closing tool

In a company purchase agreement, the primary point of contention usually arises when both parties attempt to convert business value into a closing price.

The seller tends to believe the price should reflect not only the current reality of the business but also the growth already underway, a commercial pipeline pending maturity, untapped operational potential, or synergies that a third party could capture with relative ease. The buyer, conversely, usually adopts a more cautious stance: they are willing to pay for what the company has already proven, but not always for what it has yet to execute.

This disagreement does not mean the deal is doomed to fail. In fact, in today’s M&A market—where transactions are increasingly selective and sophistication in price structuring carries more weight—the earn-out has established itself as one of the most effective tools to bridge this valuation gap without blocking the closing, especially when discrepancies exist regarding the company’s valuation between buyer and seller. This technique allows a portion of the price to depend on the company's future performance, providing an effective solution to overcome differences in criteria regarding current value and business projections.

What is an Earn-out?

An earn-out is a contingent pricing mechanism whereby a portion of the consideration is not paid in full at closing but is instead conditioned upon the acquired company meeting certain future objectives.

From a practical standpoint, it allows the price to be split into two tranches:

  • A first component: fixed and payable at closing.
  • A second component: variable, the accrual of which depends on the business reaching certain metrics or milestones within a subsequent period.

However, reducing the earn-out to the idea of a "variable price" falls short. Its true utility lies not just in deferring part of the payment, but in redistributing risk between buyer and seller. In other words, it allows an abstract discussion about future expectations to be transformed into a verifiable agreement based on effectively obtained results.

Therefore, an earn-out should not be understood as a simple concession by the buyer nor as an optimistic expectation of the seller. Properly structured, it is a tool for risk allocation and the alignment of interests.

Why it is used in an M&A transaction

The economic logic of an earn-out is clear. The seller believes the business value will be higher in the short or medium term and wants the price to reflect that. The buyer, for their part, does not want to assume the cost of a projection today that has not yet been consolidated.

The earn-out allows both positions to coexist within the same contractual structure. The buyer protects against overpayment risk. The seller retains the possibility of capturing part of the value they defend, provided that value actually materializes.

This is particularly useful when the company is in a growth phase, when there is a relevant component of future execution, when the business relies heavily on contracts in the process of consolidation, or when the retention of the founder or management is a key piece of the investment thesis.

It can also be a particularly effective solution in sectors where value creation is not yet perfectly reflected in operating profit, as is the case in certain technology businesses, SaaS, healthcare, biotechnology, or models intensive in commercial expansion.

The Earn-out does not just solve a pricing problem

One of the most common mistakes when negotiating these types of clauses is thinking that an earn-out only serves to "bring numbers closer." In reality, it fulfills a much more sophisticated function:

  • On one hand, it allows the valuation gap between the parties to be closed.
  • On the other, it acts as a deal governance tool, because it forces the parties to anticipate how future performance will be measured, who will have control over the variables affecting that performance, and what will happen if the parties disagree on the final calculation.

In this sense, an earn-out is not just a financial solution. It is also a contractual technique that requires ordering the post-closing relationship.

When it makes sense to propose one

Not all transactions require an earn-out. In many deals, a combination of a fixed price, adjustments for net debt and working capital, and a reasonable regime of representations and warranties (R&Ms) is sufficient to close the deal efficiently.

However, an earn-out typically makes special sense when there is a material difference between the valuation defended by the buyer and the seller; when part of the value depends on identifiable future milestones; when the seller remains tied to the business after the sale; or when the buyer needs to moderate the initial outlay without giving up on recognizing a higher price if performance follows.

In other words, it works best when the discrepancy is not about the past, but about the future.

The decisive issue: How it is structured

The utility of an earn-out depends not on its existence, but on its design. Most post-closing conflicts do not arise because the business performed worse than expected, but because the clause was poorly conceived, ambiguous, or left too many issues open.

The Metric: What is measured and what risk each party assumes

Choosing the metric is probably the most sensitive aspect of the entire negotiation. It is not just about choosing a known financial figure, but about deciding what risk each party assumes and what degree of exposure the seller will have to the buyer’s subsequent decisions.

An earn-out based on Revenue usually protects the seller better against accounting manipulation or cost reallocations, because sales figures are, in principle, harder to artificially alter. However, it can also create perverse incentives if whoever continues to manage the business prioritizes commercial growth at the expense of profitability.

An earn-out based on EBITDA fits better with classical valuation logic and the standard way of modeling a transaction. But precisely for that reason, it requires much more detail: what adjustments are permitted, what extraordinary items are excluded, how the buyer’s corporate overhead will be treated, what accounting criteria will be applied, and what happens if, after closing, investment or expense allocation policies are modified.

In businesses where value is better explained by growth than immediate profit, it may even be preferable to use specific operational metrics, such as ARR, churn, new customers, renewals, gross margin, or the achievement of regulatory or technological milestones. Here, the key is not to choose the "most well-known" metric, but the one that best reflects actual value creation in that specific business.

The measurement period

The duration of the earn-out is also decisive. A period that is too short may prevent the growth thesis from being reflected in the numbers. One that is too long prolongs uncertainty, complicates integration, and can deteriorate the relationship between the parties.

In practice, the design must respond to the actual business cycle. If value depends on recurring sales, commercial integration, or customer acquisition, the horizon will be one length. If it depends on regulatory, technological, or industrial consolidation milestones, it will be another. What matters is that the timeframe has economic logic and is not simply the result of an improvised concession.

Post-Closing governance

This is where a well-drafted earn-out distinguishes itself from a problematic one.

Once the deal is closed, the buyer controls the company. But if the seller has a relevant part of the price pending, they cannot be left completely exposed to unilateral decisions that artificially alter the agreed-upon metric. Therefore, it makes increasing sense to expressly regulate certain operating covenants during the earn-out period.

This may include commitments regarding the maintenance of the business unit with a reasonable degree of autonomy, restrictions on the reallocation of income or costs within the group, limits on accounting changes that affect the calculation, obligations not to divert business opportunities to other subsidiaries, maintenance of certain investment levels, and periodic access for the seller to relevant financial information.

The goal is not to freeze the buyer or prevent integration. It is to prevent the earn-out from being drained of content by management that the seller no longer controls.

The calculation formula

The formula must be clear, verifiable, and as simple as possible. It is advisable to precisely set the minimum threshold that triggers payment, the accrual scale, the maximum cumulative amount, the review schedule, and the exact date on which payment becomes due. A good earn-out is not the one that looks most sophisticated on paper, but the one that can be executed without opening an interpretative discussion every time the calculation is due.

Information, review, and dispute resolution

If the seller does not have sufficient access to relevant financial information, conflict is practically guaranteed from day one. Therefore, it is advisable to regulate the delivery of reporting, review periods, supporting documentation, and the procedure for challenging the calculation.

It is also recommended to provide from the outset a resolution mechanism for purely accounting discrepancies through an independent expert. Experience shows that many earn-out controversies are not legally complex; they are, above all, disputes over figures, adjustment criteria, and calculation perimeters.

The Earn-out pursues several objectives:

  • Align Interests: By linking part of the purchase price to the future performance of the company, the seller has an incentive to continue contributing to the business's success after the sale, which also benefits the buyer.
  • Mitigate Risks: The buyer will only pay additional amounts if the company meets certain pre-established objectives, reducing the risk of paying for expectations that do not materialize.
  • Manage Expectations: This mechanism allows the seller to visualize a clear path to receiving additional payments based on future performance, which can facilitate negotiations.
  • Close Valuation Gaps: For example, if the seller values the company at €150 million and the buyer is only willing to pay €120 million, an earn-out can serve as a bridge to cover the €30 million difference, depending on the fulfillment of future goals.

Its operation is based on predefined performance indicators, such as revenue or, typically, EBITDA or Free Cash Flow.

An operational example:

Imagine a company where the seller aspires to a valuation of €150 million, while the buyer is only willing to recognize €120 million at closing because they believe part of the expected growth has yet to be proven.

A reasonable solution could consist of agreeing on a €120 million fixed price and an additional earn-out of up to €30 million, conditioned upon meeting specific EBITDA, gross margin, or commercial growth targets over the following two fiscal years.

If the results are fully achieved, the seller will receive the full variable tranche. If they are only partially achieved, they will collect the proportional part provided for in the formula. If they are not met, the buyer will have avoided paying from day one for a value that ultimately did not consolidate.

That is, in essence, the function of the earn-out: not to eliminate uncertainty, but to distribute it in a negotiated manner.

Advantages and disadvantages of the Earn-out:

For the Buyer

Advantages:

  • Allows for a reduction in the initial cash outlay.
  • Minimizes risks by linking payments to future performance.
  • Ties the seller to a smooth ownership transition and ensures the seller collaborates with the buyer post-transaction.

Disadvantages:

  • Can complicate accounting.
  • Hinders business integration if independent metrics are required.

For the Seller

Advantages:

  • Makes it possible to achieve a higher price if the business plan on which the earn-out was based is met.

Disadvantages:

  • Risk of not receiving additional payments if the buyer controls the calculations or does not invest adequately in the business.

Conclusion

The earn-out remains one of the most useful tools for closing M&A deals when the buyer and seller do not fully agree on the price. It allows risk to be shared, valuations to be reconciled, incentives to be aligned, and transactions to be unlocked that, with a purely fixed structure, would likely never be signed.

But precisely for that reason, it demands rigor. It is not enough to agree that a portion of the price will depend on the future performance of the business. One must precisely define what is measured, how it is measured, for how long, who controls the variables affecting the result, and what will happen if a discrepancy arises.

Ultimately, the quality of an earn-out is not measured by its ability to close the deal, but by its ability to keep working once the deal has closed.

An earn-out should not be seen as a standard solution, but as a strategic piece within the global architecture of the transaction. Because in M&A, value is often lost not in the initial valuation, but in a poor structuring of price and risk.

At Maraz Corporate Finance, we are experts in transactions and can advise you on a successful sale of your company.

Javier de Rojas Roca de Togores

Partner - Maraz Corporate Finance