Earn-outs: the devil’s in the detail

In our article last October, Corporate trends: deferred consideration & earn-outs return, we provided insight on the use of deferred consideration when selling a business and briefly explained the purpose of ‘earn-outs’ as part of this wider topic.

Earn-outs have featured heavily in many of our recent transactions and, this month, we take a deeper dive into what they are, when and why they are used and how to get them right (and wrong).

What is an earn-out?

An earn-out is a contractual mechanism, usually included in the main sale agreement. It allows part of the purchase price payable for the business to be deferred (paid later) based on the future financial performance of the business.

Broadly speaking the gross value of the business (including both the payment on the date of the sale and the earn-out) represents today’s price but builds in the ‘opportunity value’ that the business presents. This arrangement is commonly used when there is a gap between the buyer’s and seller’s expectations regarding the company’s real value.

When are earn-outs used?

Earn-out provisions are typically used in transactions where:

• Having completed an element of financial due diligence (or considering the current market or the flight-risk of the management team), a buyer is uncertain about the company’s future earnings or growth potential.
• The seller believes the business has higher ‘potential’ value than the buyer is willing to pay upfront.
• A true measure of business’s success depends on factors that will materialise after the sale (e.g. such as contract renewals, products currently being trialled, or market expansions that are yet to fully bear fruit).

Why are earn-outs used?

It’s important to remember that earn-outs can be beneficial for both parties. For the buyer, it mitigates risk by linking part of the payment to the business’s ongoing performance rather than paying a lump sum now in the hopes that the trajectory of the business continues.

For the seller, it provides an opportunity to realise the full value of the business (albeit over time) if expected performance targets are met.

For both parties, it can bridge valuation gaps and facilitate deal completion.

How can earn-outs go wrong?

While earn-outs can be very useful, they can be source of dispute if not considered and drafted properly. Common issues include:

• Unrealistic or poorly defined performance targets – the earn-out criteria are unclear or difficult to measure and carry too much discretion or subjectivity.
• Buyer’s control over operations – after the sale, the buyer will (ultimately) be in control of the business. If the Buyer operates the business in a different manner to the seller (for example, by charging management fees for centralised services from another group company or loading costs in the acquired business) it may unfairly affect the business’ ability to meet earn-out targets.
• Accounting and financial disputes – differences in how financial performance should be calculated (such as variations to the pre-sale accounting policies used by the business, bad debt provisions or how revenue is recognised).
• Conflicts of interest – if the seller stays on to manage the business, the dynamic between them and the new management team may come under pressure if the seller is unduly restricted in operational decisions, leading to a breakdown in the relationship.

How to get earn-outs right

To reduce the risk of disputes, an earn-out provision should be carefully drafted such that it provides clear performance metrics that are sufficiently precise and measurable (such as revenue or gross profit). Vague targets should be avoided and the manner in which financial performance is calculated (including the accounting policies to be deployed) should be set out in the agreement.

Parties should also ensure that the agreement provides for any necessary control needed by the seller during the earn-out period to ensure the earn-out can be delivered. Buyers will, of course, be careful about relinquishing too much control, but many seller protections should be fairly uncontroversial, to the extent that they prevent the earn-out rights of the seller from being artificially supressed or circumvented (for example, by restructuring the group, diverting profits or reducing profits by paying large bonuses or making significant salary increases to new management).

A clear and effective dispute resolution mechanism is critical, including independent third-party determination of the metrics if required. Buyers may also want to ensure that caps are included to avoid indefinite obligations.

Strict adherence to the terms

Ensuring that the terms are accurately translated into binding obligations that are clearly articulated is crucial. However, it’s also important to ensure that the parties comply with those terms strictly.

The time, energy and professional costs incurred in agreeing the metrics and process for determining earn-out payments can be greatly undermined if the terms are not adhered to.

For example, earlier this month, in the case of Hughes v CSC Computer Sciences Ltd (2025) the High Court looked at an agreement under which the buyer (CSC) had acquired shares in a company. The sellers were individuals and part of the purchase price was payable under an earn-out, contingent on the target company’s financial performance over two years.

The agreement provided for CSC to generate a determination of the earn-out payable for the first year following completion and submit it to the sellers so it could be agreed or challenged (such agreement being deemed if not challenged).

Unfortunately for CSC, they sent the determination by email to the sellers which was not expressly permitted under the notice provisions in the SPA. On the basis that the earn-out determinations were integral to calculating the purchase price, the judge took the view that the buyer must strictly adhere to the terms of the agreement (including notices) and their determinations were therefore deemed invalid, resulting in significant legal and financial consequences for the buyer.

We recently advised on a matter at Morr & Co in which the buyer had the opportunity to challenge a not dissimilar financial metric affecting the purchase price payable to our clients (the sellers).

On this occasion our clients had agreed to accept notice by email in the share purchase agreement and the buyer had sent an email on the final day of the period during which a challenge could be made (a Friday) just before 5pm local time (they were based in the States).

Due to the time difference, this was after 9pm London time. Unfortunately for the US buyer, email was only deemed to be served on the same day if received before 5pm London time, otherwise it was deemed to be received on the next business day. As such, our clients’ calculations on the price adjustment had to be accepted, which was a costly oversight for the Buyer.

Conclusion

Earn-out provisions can be a valuable tool in share purchases, but they must be properly structured, carefully drafted and strictly adhered to. Sellers should ensure the terms protect their interests, and buyers must ensure that the conditions are achievable and align with their post-acquisition plans.

With clear drafting, careful negotiation and post-completion advice to ensure compliance with the agreement, an earn-out can provide a fair and effective way to complete a business sale, while ensuring all parties benefit from the company’s future success.

How can Morr & Co help?

If you have any questions or would like any further information on the content of this article, please do not hesitate to contact our Corporate and Commercial team on 01737 854500 or email info@morrlaw.com and a member of our expert team will get back to you.

Disclaimer
Although correct at the time of publication, the contents of this newsletter/blog are intended for general information purposes only and shall not be deemed to be, or constitute, legal advice. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of this article. Please contact us for the latest legal position.