India: Earn-Outs In M&A – Part I: Pitfalls To Avoid – The Seller's Perspective

Last Updated: 21 September 2016
Article by Pritha Jha


Very simply put, earn-out transactions are those transactions where the acquirer acquires a business but holds back a part of the purchase consideration, the payment of which is dependent on the performance of the business acquired. The seller continues to manage the operations of the business and the amount of consideration payable is contingent on the future performance of the acquired business. From the acquirer's perspective, this ensures that the seller has some "skin in the game". From the seller's perspective, this acts as an incentive to ensure that the business continues to grow and the seller gets the opportunity to maximize the upside on the growth.

Earn-out transactions in the M&A space have been gaining momentum over the last few years in the Indian market. Historically, deferring payment of consideration to an Indian seller required prior approval of the Reserve Bank of India. This forced the acquirer to complete earn out transactions in tranches, with the acquirer leaving behind in most cases between 10% to 25% of the share capital with the Indian seller against which such deferred consideration would be paid.

Earn-out transactions are now likely to see further activity given the recent liberalization made by the Reserve Bank of India permitting a deferral of not more than 25% of the purchase consideration for a period not longer than 18 months. While the liberalization may not be sufficient to encourage acquirers to take this route, it is a step in the right direction.

Earn-out transactions are almost always more complex than they sound on paper. A deal can be a success or a failure depending on the depth of discussions and negotiations that took place between the acquirer and the seller at the time the deal was struck. For this reason, it is recommended that both parties have a battery of advisors', experienced specifically in earn-out transactions.

This article seeks to cover those issues which may not get discussed, or are discussed too late i.e. once the deal is already done.


The move for a seller from being an "owner" to an "employee"

This is perhaps the most difficult step to take for an entrepreneur, especially one who has been an entrepreneur all his/ her life. When a seller sells his/ her business to another company, the seller is likely to become a part of something larger, a larger group of entities, a larger group of people, which entails a difficult task, i.e. "fitting in".

While the seller may retain his/ her position as head of operations or chief executive officer, every decision will most likely be subject to confirmation by the board of directors, which will probably be controlled by the acquiring entity. Being under the constant supervision of any individual/ group of people is something most entrepreneurs are not used to.

All of a sudden, a seller may not be entitled to incur expenses he/she once did. The seller may not be permitted to sign contracts at will, and may not even have the right to hire or fire significant employees. The seller has to be prepared for a shift in momentum. The seller is now a part of a "long marriage" where all decisions may not go the seller's way.

The role the seller will continue to play in the business post acquisition should be discussed upfront at length, not just with the acquirer's team that the seller is negotiating with but more importantly, with the team that the seller will eventually need to work with. There should be no mismatch in expectations. Seller's lawyers must carefully draft into the management rights and the employment agreement of the seller, the extent of control which the seller will continue to exercise in the day to day operations of the business. This is especially important since the people the seller negotiated the deal with may not be a part of the acquirer organization in the future.

The hidden costs

All earn-out transactions are based on performance of the business post acquisition. This seems normal, ordinary even. However, has the seller protected itself from increase in costs, costs resulting from following new policies the acquirer may have, charges the acquiring entity may levy for performing back office functions? What happens if the acquirer requires the seller to terminate an agreement with an existing client? Will the seller be compensated for the increase in cost if the acquirer hires an expensive chief financial officer? Can the acquirer hire a chief financial officer without the seller's consent? Can the acquirer expand the business of the company without the seller's consent?

Carefully read through the policies the acquirer will need the seller to adopt. Only the seller knows the changes that will impact his/ her growth. Point these out. Ask for specific protections where adoption of new policies affects the seller's business negatively.

Seek out a list of clients of the acquirer. Are there any client agreements the seller may need to terminate due to client conflict? Where the acquirer requires the seller to terminate a client agreement, revenue that such client contributed to the company's top line should be added back for the purposes of calculating a seller's earn-out.

Will the seller be required to pay a fee for being a part of a larger global group? Will the acquirer compute the income of the seller's business differently than how the seller's auditors computed it for all these years? What happens if the acquirer needs the seller to move to a more lavish office with heavier lease rentals?

It is quite impossible to think of every scenario, and it is unlikely that the acquirer will change its stance, however, it may agree to protect the seller in terms of the earn-out for all these eventualities. The seller's lawyers should insist on it.

Claw-back provisions

Everyone executing an earn-out transaction assumes that the business will continue to grow. Rarely ever does an acquisition document deal with what happens if the business continues to drop progressively. In the Indian context, this could mean that there are shares still remaining to be bought and money which has to be paid since the shares cannot be transferred for no consideration. The acquirer may no longer be willing to buy the remainder of the business given its downward trend. Is it possible for the acquirer to back away? Is it possible for the acquirer to claim that it paid too much money for the shares it bought upfront? Will it be permitted to "claw back" on the amount it has already paid?

More often than not, transaction documents do not cover this occurrence thereby resulting in prolonged litigation. It is preferable to agree to the consequence upfront and document it in the agreement. From the seller's perspective, it should be agreed upfront that money that has already been paid to the seller cannot be refunded under any circumstances.

Hidden rights to terminate employment

The seller's right to continuing to remain in control of the day to day management of the acquired business is key to the earn out and it must be protected. The board of directors should not have the right to terminate the employment agreement at will. Termination should only result from an "established" cause. The seller's employment period must cover the entire period of the earn-out. Rights to terminate the agreement for not following any policy should be avoided since this can become a tool in the hands of the acquirer. Agree only to specific objective circumstances under which the acquirer should have the ability to terminate the seller's employment.

Payment Protection

More often than not, acquirers do not use entities of substance to acquire new companies. If the acquiring entity is one which does not have a healthy balance sheet, the payment of future earn outs should be guaranteed by its parent company. This may be in the form of a separate guarantee or a contractual right in favour of the seller within the acquisition agreement from the parent of the acquiring entity.


In conclusion, an earn-out may not be for everyone, but it can certainly be an excellent tool to extract the best deal value. Even if the entire negotiation may not go the seller's way, make an informed decision, know the risks being taken and know them well. The sale of the business in an earn-out transaction is only the beginning for a long road ahead.

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.

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