What is an earn-out and when is it worth considering?
An earn-out is a pricing mechanism in M&A transactions whereby part of the seller’s consideration is contingent, for example, on the future financial or operational performance of the company being acquired. The buyer pays a specified base amount at the closing of the transaction, and the remainder of the price is paid at a later date – provided the company meets pre-agreed targets.
In practice, earn-outs are most commonly used in three situations. The first – and most typical – is a valuation gap between the parties. The seller believes in the company’s growth potential and expects a higher price, whilst the buyer perceives the same projection as risky. An earn-out allows part of the valuation risk to be deferred to the post-transaction period: if the company actually achieves the targeted results, the seller receives additional remuneration.
The second situation concerns transactions where the seller remains with the company after closing – most often as a board member or key manager. In such cases, the earn-out serves as an incentive, linking part of the price to the effectiveness of future management. The third category covers transactions in regulated sectors – including energy and renewable energy – where the company’s future performance depends on external factors, such as obtaining licences, environmental decisions or tariffs. In such cases, the earn-out allows the regulatory risk to be shared between the parties.
In the Polish M&A market, earn-out clauses are appearing with increasing frequency, particularly in transactions involving technology companies and renewable energy projects, where a valuation based solely on historical data rarely reflects the business’s actual potential.
Key elements of an earn-out clause
The effectiveness of the earn-out mechanism depends first and foremost on the precise definition of its structural elements in the SPA. Each of these requires separate analysis and negotiation.
The financial metric forms the foundation of the entire clause. The most commonly used metrics are EBITDA (earnings before interest, taxes, depreciation and amortisation) and net revenue. The choice of indicator is not neutral – EBITDA gives the buyer greater scope to influence the result (through cost policy), whilst revenue is harder to manipulate but does not reflect the profitability of the business. In transactions involving renewable energy projects or technology companies, non-financial KPIs are also increasingly being used – for example, the volume of energy produced, the number of customers acquired or the obtaining of specific permits.
It is crucial for the entrepreneur that the definition of the indicator is autonomous – that is, included in the SPA itself, rather than based solely on a reference to accounting standards.
The earn-out period is the timeframe during which the company’s performance is measured. It typically ranges from 12 to 36 months from closing, though in the case of infrastructure projects – including wind farms or solar power plants – it may be longer. A period that is too short carries the risk that results will be distorted by seasonality or one-off events. A period that is too long increases uncertainty and the potential for conflict between the parties.
Another key element is the payment thresholds and limits – the so-called cap (maximum earn-out amount) and floor (minimum guaranteed amount or threshold below which the earn-out is not paid at all). Setting these correctly protects both parties: the buyer from excessive liability, and the seller from a situation where a slight deviation from the target deprives them of the entire deferred price.
Risks and pitfalls – the perspective of both parties
Although an earn-out is intended to reconcile interests, in reality it creates a structural conflict of interest between the buyer and the seller in the post-transaction period. The buyer – as the new owner of the company – has full control over its operations, whilst at the same time having a financial interest in the earn-out targets not being met (as this means a lower price). The seller, in turn, loses operational control whilst retaining financial exposure to results over which they no longer have any influence.
A common mistake is failing to adequately regulate how the company is run during the earn-out period. The buyer may take decisions that are objectively rational from the perspective of the group – for example, transferring customers to another company, charging the target company with group management costs, changing pricing policy or delaying the execution of contracts – which simultaneously reduce the metrics forming the basis of the earn-out. Such actions need not be the result of bad faith – they may stem from post-transaction integration – but their effect on the seller is the same.
From the buyer’s perspective, the reverse situation poses a significant risk: the seller, who continues to manage the company, may seek to artificially inflate results in the short term – by accelerating revenue recognition, postponing necessary investments, or accepting higher-risk contracts. As a result, the buyer pays a higher earn-out for results that are not sustainable.
How to safeguard the earn-out clause in the SPA
Properly safeguarding the earn-out clause requires provisions at several levels.
Anti-manipulation clauses – the agreement should oblige the buyer to conduct the company’s business during the earn-out period in a manner consistent with previous practice. It is worth specifying precisely which actions the buyer may not undertake without the seller’s consent – typically, this includes significant changes to the structure of revenue and costs, the transfer of assets or customers, changes to accounting policies, and extraordinary transactions with related parties.
Calculation and verification mechanism – the agreement should specify who prepares the earn-out calculation (usually the buyer), by when the seller receives the calculation along with the supporting documentation, the procedure for raising objections and – most importantly – how discrepancies are resolved. The market standard is to entrust the resolution to an independent auditor (so-called ‘expert determination’), whose findings are binding on the parties. An alternative is arbitration, although this is slower and more costly.
Securing payment – the obligation to pay the earn-out alone is of limited value if the buyer does not have the funds available at the time of payment or disputes the calculation. It is crucial for the entrepreneur to negotiate a security mechanism – most commonly in the form of an escrow account (funds deposited with an agent), a bank guarantee or a surety from the buyer’s parent company.
Under Polish law, the earn-out is not an institution explicitly regulated by statute. Its legal classification is a matter of debate in legal doctrine – depending on the structure of the specific clause, the earn-out may be treated as a performance subject to a condition precedent.
Summary
The earn-out mechanism remains one of the most useful tools for structuring the price in M&A transactions – it allows a deal to be closed where a traditional valuation does not provide the parties with a basis for agreement. Its value, however, depends not on its mere application, but on the legal quality of the clause in the SPA. A management board considering the sale of a company with an earn-out component should treat negotiations on this clause with the same care as negotiations on the base price – because in practice, the earn-out is a price, albeit a deferred and conditional one.
She specializes in commercial and civil law. She has gained experience in Warsaw law firms providing comprehensive services to companies and a law firm specializing in labor law. She has extensive experience in corporate consulting. She has participated in mergers and acquisitions at every stage of the process, from pre-transaction legal examination to fulfillment of regulatory requirements related to the transformation process. She prepares and reviews contracts entered into by clients and advises in cases of…
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