Earn-Out and Reverse Earn-Out: Contractual Strategies for Managing M&A/Private Equity Transactions

Translated article written for Altalex - Il Quotidiano Giuridico

The earn-out and reverse earn-out clauses are instruments used in M&A and Private Equity transactions to address differences in company valuation and distribute risks between the buyer and the seller. The earn-out ties part of the price to future objectives, while the reverse earn-out provides for an initial payment with potential refunds. Both require a precise structuring of parameters and governance to avoid disputes. Their relevance has grown in a volatile economic environment, making them essential for balancing protection and expectations.

Earn-Out and Reverse Earn-Out Clauses: Negotiation Balance, Risks, and Prospects in M&A and Private Equity Transactions

Instruments for Addressing Valuation Gaps: An Introduction to the Context

In the world of mergers and acquisitions (M&A) and private equity, one of the most delicate and debated elements is certainly the definition of the price to be established between the buyer and the seller. This aspect is central to the process, often becoming the crucial point around which negotiations and discussions develop.

The challenge is heightened in a global economic context characterized by volatility, where traditional valuation methods face the uncertainty of future company performance. This is particularly evident in sectors such as technology, pharmaceuticals, or innovative startups, where value is often linked to intangible elements, such as human capital, innovation, or market relationships.

In such scenarios, simply applying market multiples or discounted cash flow analysis may not be enough to reach a satisfactory agreement for both parties. This is where contractual instruments like earn-out and reverse earn-out clauses come into play, designed to bridge the valuation gap and equitably distribute risks between the seller and the buyer. These mechanisms are not entirely new in the M&A landscape, but their relevance has increased in recent decades alongside the complexity of transactions and the need for flexible solutions that cater to the specifics of each deal.

Earn-Out Clauses: Structure and Purpose

Earn-out clauses are one of the most common solutions to address valuation differences in a target company. In essence, these provisions tie a portion of the purchase price to the achievement of future objectives, measured through specific indicators such as revenue, EBITDA, or sector-specific operational parameters. For example, in a technology acquisition, the payment might be linked to the number of active users on a digital platform in the three years following the transaction, while in manufacturing, it could be based on gross production levels.

The rationale behind this mechanism is both simple and effective: the earn-out helps bridge the gap between the seller’s valuation, often based on optimistic projections, and the buyer’s caution, which aims to minimize risksstemming from potential overestimation or unforeseen variables after the deal closes. In this sense, the earn-out acts as a “deferred payment”, where the final price is determined over time based on tangible and verifiable results.

An additional advantage of these clauses is their ability to align the economic interests of both parties. The seller has an incentive to support an orderly transition and maintain business performance post-sale, especially when they retain a managerial role. This aspect is particularly relevant in transactions involving entrepreneurs, whose know-how and network are essential components of the company’s goodwill.

Reverse Earn-Out: A Variant with Different Effects

Alongside the classic earn-out structure, negotiation practices have developed a less common but equally interesting variant: the reverse earn-out. In this configuration, the mechanism is reversed: the buyer pays the full agreed price at the time of closing, but the seller commits to refunding part of the price if the company fails to meet specific performance objectives. This structure provides the seller with immediate access to funds—an important factor for those looking to reinvest the proceeds in other ventures without delays—but shifts the financial risk to the buyer, who commits significant resources without guaranteed future returns.

The reverse earn-out proves useful when the buyer trusts the seller’s projections but seeks protection against unfavorable outcomes. However, this mechanism requires careful definition of terms to ensure clarity and sustainability, increasing the buyer’s exposure to post-deal uncertainties. For instance, in a manufacturing acquisition, a partial refund of the price might be required if production levels fall below a minimum threshold within two years, providing a safeguard against unexpected demand drops.

Evolutions and Variants for Greater Adaptability

In recent years, additional variations of these instruments have emerged. One possibility is to split the payment into tranches, each linked to achieving specific milestones, such as obtaining a patent or entering a new market. This structure allows for risk distribution over time and correlates the price with the actual milestones achieved, such as launching a new product or expanding into a geographical market.

A more advanced option involves the use of participatory financial instruments, whose value is tied to the company’s performance over a defined period. In this case, the seller does not receive a direct additional payment but instead participates in the future financial outcomes through equity rights.

Structuring: Parameters, Timing, and Governance

Drafting an earn-out or reverse earn-out clause requires attention to detail, as every aspect can influence the transaction outcome. Choosing performance parameters must be objective and relevant: revenue alone, for example, may not adequately reflect a company’s investment phase value, making a combination of indicators—such as operating margins and customer growth—preferable.

Equally crucial is the accounting framework used: GAAP or IFRS standards can produce different results, and failure to specify the applicable system may lead to ambiguities. Additionally, it is necessary to clarify how to treat extraordinary items—such as gains from asset sales or exceptional legal costs—to prevent distorted results.

The time horizon should also be balanced: a too short period (e.g., six months) may not allow the company’s full potential to unfold, while a too long period (over five years) introduces uncontrollable external variables. A timeframe between one and three years is often considered appropriate, subject to specific evaluation.

A particularly sensitive issue is the target company’s governance during the earn-out period. Once acquired, the company falls under the buyer’s control, who might adopt management decisions—such as cost-cutting or strategic shifts—that artificially reduce performance outcomes, thereby limiting additional payouts to the seller. To prevent opportunistic behavior, contracts may include specific constraints, such as maintaining certain investment policies, or introduce control mechanisms through independent experts or supervisory committees.

Risks and Disputes: Limits and Solutions

Despite their clear utility, earn-out and reverse earn-out clauses are not without challenges. One major risk is the potential for disputes between parties, which can concern both the interpretation of performance indicators and post-closing management conduct.

These disputes, if not managed properly, can escalate into long legal battles, with significant costs in terms of time and resources. Therefore, alternative dispute resolution mechanisms, such as arbitration or third-party expert involvement, are often used to provide quick and balanced resolutions.

Conclusion: A Key Element of Modern Deals

Earn-out and reverse earn-out clauses have become essential tools for addressing negotiation complexities in M&Aand Private Equity transactions. By allowing for the alignment of diverging valuations and structured risk management, they meet the needs of a volatile and dynamic economic environment. Their effectiveness, however, depends on careful structuring, tailored to each transaction’s specifics, ensuring a precise balance between risks and incentives. In a constantly evolving global market, these mechanisms are a crucial component of contractual structures, fostering a balance between buyer protection and seller interests.