The earn-out clause is often used in mergers and acquisition transactions to defer part of the purchase price by conditioning it to certain future events or the achievement of performance or growth milestones after the closing of the transaction. Once these milestones are met, the seller will be entitled to an additional price.
The earn-out clause has several functions. Essentially, is is used to align the interests of the parties and their different views on the assessment of the business, allowing them to reach an agreement on a fundamental element of the transaction – price.
Developing countries, such as Brazil, have risks that contribute to investor mistrust, especially international investors, such as economic distress, political uncertainties, problems with infrastructure and corruption. Such risks may cause the asset to become less attractive to investors, who may try to reduce the price, making it unattractive to the seller. Given the asymmetry of information between investor/buyer and seller about the asset being acquired, the earn-out can be used as a form of risk allocation among the parties as well as bringing an economic rationale of incentive to maximize results, that would probably not be possible to achieve if not by means of the agreement of an earn-out clause.
Another favorable scenario for negotiating an earn-out provision is when the buyer wants to keep the current shareholders in the management of the company to secure growth on the business in the short- and medium-term, especially when the business is highly dependent of the expertise of the current shareholders and their relationship with customers, suppliers, and employees.
However, there are many potential conflicts that may arise when negotiating an earn-out clause, as they depend on several variables, some of which are beyond the control of the parties. There are fundamental elements of the earn-out that must be agreed upon by the parties and must be expressly included in the clause to avoid disputes at the time the amount of the earn-out is to be determined.
It is advisable for the parties to seek expert legal advice when negotiating the earn-out provision so that it meets its purpose and serves its economic rationale, securing greater upsides for the parties, and avoiding future disputes.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.