Earn-Out

What is an earn-out?

Earn-Out (German: erfolgsabhängiger Kaufpreisbestandteil) is a part of the purchase price in a company sale that is paid only after closing and depends on whether the company sold achieves agreed targets. Closing means the transfer of the shares; the remaining purchase price is paid at that point as usual. The contractual provision (earn-out clause, also earn-out arrangement or agreement) is set out in the company purchase agreement, usually in a separate annex.

Literally, earn-out means that the seller still has to earn this part of the price. An orchard whose price is paid in part only after the next harvest, and only if it turns out well, follows the same idea. Earn-outs occur mainly in the sale of growth companies whose value depends heavily on future development. The parties involved are the selling shareholders, often founders who remain in the management after the sale, and a strategic buyer or financial investor.

Function of the earn-out: valuation gap, risk sharing and retention

Seller and buyer often assess a company's future differently. The seller knows the product, customers and sales pipeline and expects further growth; the buyer values the development more cautiously. The earn-out bridges this valuation range: the part of the price that the buyer regards as secure is paid immediately, the rest only if the seller's expectations are met.

This shifts risk to the seller: the seller bears the uncertainty of reaching the targets, waits for part of the proceeds and depends on the buyer's decisions after closing. If founders stay in the company, the earn-out also ties them to its further development. Buyers use it for this purpose in particular where the founders' participation is already fully earned on a sale through an acceleration rule (Accelerated Vesting).

Structuring an earn-out model

Measurement basis

Revenue, gross profit, adjusted EBITDA (earnings before interest, taxes, depreciation and amortisation, adjusted for one-off effects), annual recurring revenue (ARR) or non-financial milestones such as a product release come into consideration. Revenue measures can hardly be influenced by the buyer's cost decisions but do not reflect profitability and can be bought through price discounts. Earnings measures capture profitability but depend on which costs are allocated to the unit. Gross profit lies in between.

Which measure fits depends on who controls costs after closing. If the buyer determines budget, staff and group allocations, there is much to be said for a revenue-based measure; if the sellers retain operational responsibility, an earnings measure with narrowly drawn accounting rules is defensible.

Period and calculation

Terms of one to three financial years are widespread, measured annually or cumulatively. In a stepped model, a fixed amount falls due as soon as a threshold is reached; narrowly missed thresholds lead to large shortfalls and invite dispute over every booking. Linear models pay pro rata between a lower limit and a target value. Most models have a cap, and multi-year ones partly have a catch-up rule under which a shortfall can be made up by over-performance in the following year.

Protective mechanisms for the seller

After closing, the buyer decides about the company whose result determines the earn-out. Without contractual rules, the buyer can cut budgets, divert customers to other group companies or allocate costs. Contracts therefore provide for several layers of protection:

• Management and budget commitments: The buyer undertakes to continue the company during the term as a stand-alone unit with its existing business model. The buyer provides a minimum budget for sales and development and does not shift revenue to other companies.
• Accounting rules: The measurement basis is determined under the previous principles. Group allocations are excluded or capped, integration and transaction costs are disregarded, and intra-group services are charged at arm's length prices.
• Information rights: The seller receives regular reports and may have the statement reviewed by the seller's own auditor.
• Procedure and expert determination: The statement follows a fixed process with an objection period, and disputed points are decided by an expert (Schiedsgutachter), similar to the purchase price adjustment after closing.
• Acceleration: On onward sale, merger, discontinuation of the business or a breach of the commitments, the earn-out falls due immediately, in full or in an agreed amount (Change of Control).
• Security: A guarantee from the parent company or a bank guarantee secures the seller's payment claim.

A commitment to continued employment protects founders in the management only to a limited extent, because as shareholder the buyer can in principle remove a managing director of a GmbH (German limited liability company) at any time under Section 38(1) of the German Limited Liability Companies Act (GmbHG). Contracts therefore attach legal consequences to a removal without good cause, for example early maturity of the earn-out, rather than a prohibition. If express rules are lacking, the seller is left only with the legal principle of Section 162 of the German Civil Code (BGB), under which a condition prevented in breach of good faith is deemed to have occurred; the requirements are hard to prove.

Potential for dispute and the buyer's view

Earn-out arrangements are regarded in practice as prone to dispute because the interests diverge after closing. The seller needs a measurable, stand-alone unit; the buyer wants to integrate and realise synergies. Every decision on prices, sales channels, product bundles or staff changes the measurement basis, and the narrower the commitments, the later synergies arise. Both sides are served by a measurement basis that is little affected by integration decisions and by a contract annex that shows the calculation with a numerical example.

Tax treatment of the earn-out

For the seller, the earn-out is in principle part of the sale price. If the seller holds a stake of at least 1% as private assets, the gain is taxable at 60% under Section 17 of the German Income Tax Act (EStG) under the partial income method. If a holding GmbH holds the shares, 95% is tax-exempt under Section 8b of the German Corporation Tax Act (KStG). In which year a performance-dependent part of the purchase price is to be taxed depends on the structure. According to the case law of the Federal Fiscal Court (Bundesfinanzhof), such parts are in certain constellations recognised only at the time of their realisation, so not necessarily in the year of the sale.

The link with the seller's activity is delicate. If the earn-out lapses or falls when the seller leaves the company (leaver rules), the payment may be treated wholly or partly as remuneration for the activity rather than as purchase price. For the seller, the full income tax rate then applies instead of the partial income method or the tax exemption, and an obligation to deduct wage tax may arise. The treatment also changes for the buyer: instead of acquisition costs of the shareholding, there may be personnel expense. The separation of purchase price and remuneration, for example through an earn-out without an activity condition and a separate retention package, therefore belongs in the tax review before signing.

Worked example: earn-out in the sale of a software company

A software company with ARR of EUR 8 million is sold. The fixed purchase price for the shares is EUR 24 million, the earn-out at most EUR 6 million. It is measured by ARR at the end of the second financial year after closing: nothing below EUR 10 million, the full amount from EUR 14 million, linear in between.

• Payment per EUR 1 million of ARR above the lower limit: EUR 6 million divided by a range of EUR 4 million = EUR 1.5 million
• Scenario A, ARR of EUR 12.4 million: (12.4 minus 10.0) × 1.5 = EUR 3.6 million; total purchase price 24 plus 3.6 = EUR 27.6 million
• Scenario B, ARR of EUR 9.8 million: lower limit missed, no earn-out; total purchase price EUR 24 million
• Scenario C, ARR of EUR 15.0 million: the cap applies, EUR 6 million; total purchase price EUR 30 million
• Stepped model for comparison (EUR 3 million from EUR 12 million ARR, EUR 6 million from EUR 14 million ARR): at EUR 11.9 million ARR nothing, at EUR 12.0 million EUR 3 million; the linear model pays 1.9 × 1.5 = EUR 2.85 million at EUR 11.9 million
• Expected value at assumed probabilities of 50% for scenario A, 30% for B and 20% for C: 0.5 × 3.6 plus 0.3 × 0 plus 0.2 × 6.0 = EUR 3.0 million; discounted at 10% per year over two years: 3.0 divided by 1.21 = about EUR 2.48 million

A deviation of EUR 100,000 in ARR changes the payment by EUR 3 million in the stepped model, by EUR 150,000 in the linear model. For the valuation of an offer, what counts is not the maximum amount of the earn-out but its expected, discounted value. From the seller's point of view, the offer here is worth about EUR 26.5 million, EUR 24 million fixed plus EUR 2.48 million, before a discount for the buyer's payment risk. A competing offer with a fixed price of that amount would be equivalent, even though the maximum amount of EUR 30 million promises considerably more.

Distinctions: earn-out, vendor loan and purchase price retention

• Vendor Loan: The seller defers a fixed part of the purchase price against interest. The amount does not depend on the company's development.
• Purchase price retention: A part of the purchase price already owed is held back to secure the buyer's claims, often in an escrow account. It is not an additional, performance-dependent price.
• Retention Bonuses: Retention bonuses reward key persons for staying and are personnel expense, not purchase price.

Common mistakes

• Loosely defined measurement basis. Terms such as “result” or “revenue” without reference to accounting rules, scope of consolidation and special effects lead almost inevitably to dispute.
• Hard thresholds. Stepped models without linear transitions let a large part of the price hang on small deviations.
• Missing management and budget commitments. Without them, the buyer can change the measurement basis through ordinary business decisions without breaching the contract.
• No rule for onward sale and restructuring. If the buyer merges or sells the company, the measurement basis can no longer be meaningfully determined without an acceleration clause.
• Maximum amount planned as certain. Sellers who include the full earn-out in their financial planning underestimate missed targets and the time value of money.
• Purchase price and remuneration mixed. If the earn-out depends on the seller remaining in the company, there is a risk of classification as employment income with a higher tax burden.

Frequently asked questions

What belongs in an earn-out clause?

The clause regulates the measurement basis and accounting rules, the period, the calculation formula with lower and upper limits, the statement procedure, maturity and security. For the seller, management and budget commitments from the buyer and acceleration cases such as an onward sale are added. A template is useful as an outline; definitions and figures must fit the business model.

How long does an earn-out usually run?

Often one to three financial years after closing. Longer terms are possible but make measurement harder, because integration and restructuring change the company over time.

May the buyer set off warranty claims against the earn-out?

In principle yes, if the contract does not exclude set-off and the counterclaim is due. Sellers therefore often negotiate that only acknowledged or finally determined claims may be set off.

Is an earn-out taxed like the rest of the purchase price?

As a rule yes, as long as it is consideration for the shares. If it depends on the seller's continued activity, it may be treated wholly or partly as employment income. The time of taxation also depends on the structure.

What happens to the earn-out if the buyer sells the company on?

The contract determines this. Acceleration clauses are usual under which the earn-out falls due in full or in an agreed amount on an onward sale, or an obligation to transfer the payment obligation to the new acquirer.

The Roemer Capital view

In sell-side mandates, Roemer Capital treats an earn-out as an instrument for a specific valuation gap, not as a substitute for a reliable fixed price. Roemer Capital runs every proposed structure through the financial model in the base, cautious and optimistic cases, discounts the expected payments and compares the result with offers that have a higher fixed-price share.

In the negotiation, Roemer Capital ensures that the measurement basis fits the founders' future role and that budget commitments and acceleration cases are quantified. The contractual wording lies with the law firm, the tax classification with the client's tax adviser; Roemer Capital supplies the scenario calculation on which both build.