An earn out does not resolve a purchase price dispute. It postpones it.

Earn outs can be an effective way to bridge different views on valuation in an M&A transaction. Buyer and seller do not have to agree entirely on a fixed purchase price at signing. Part of the consideration can instead depend on how the business performs after closing.

For Searcher deals, this can be particularly attractive. Part of the purchase price becomes payable only after closing, the immediate cash requirement for the acquisition is reduced, and different expectations about the future performance of the business can be reflected in the purchase price structure.

The valuation discussion does not disappear. It moves into the post closing period.

An earn out therefore involves more than agreeing on the amount of potential additional consideration. The parties also need to determine which metric applies, how that metric is calculated, which decisions may affect it and how the seller can verify the final result.

An earn out is more than a purchase price formula

Consider a simple example. The seller values the business at EUR 5 million. The Searcher values it at EUR 4 million. The parties agree on EUR 4 million payable at closing and up to EUR 1 million of additional consideration if the business reaches certain targets over the following two years.

The valuation gap has been structured economically. At the same time, a new layer of purchase price mechanics has been created.

During the earn out period, the parties need to address the relevant performance metric, changes to the business, management decisions and the process for determining the final amount.

An earn out moves part of the purchase price mechanics into the post closing phase. Performance, control and verification therefore need to be considered together.

The first decision is the metric

The chosen metric determines much of the potential for later disputes.

Possible reference points include revenue, gross profit, EBIT, EBITDA, cash flow, recurring revenue, customer metrics or specific operational milestones. A combination of several metrics is also possible.

In many traditional SME transactions, the discussion tends to focus on revenue or EBITDA. Both can work. Both create different issues.

A revenue based earn out reduces the direct impact of many cost decisions on the payout. The definition of relevant revenue still requires precision. Discounts, credit notes, intragroup revenue, transfers of customer contracts within the buyer group and revenue generated by newly acquired businesses may all affect the calculation.

Even a metric that appears straightforward needs a robust definition.

EBITDA is where the real negotiation starts

EBITDA captures more of the operating profitability of the business. It also introduces more variables.

New hires, changes to the management team, additional marketing spend, advisers and investments in the organisation can all affect the result. Following an integration, central services, management fees or intragroup charges may also become relevant. Accounting decisions and the treatment of individual expenses can have a direct impact on the earn out.

A clause stating that “the seller receives 20 percent of EBITDA above EUR 1 million” therefore only describes the surface of the arrangement.

The real issue is which EBITDA applies and how it is calculated.

The SPA should define the relevant accounting principles, permitted adjustments and the treatment of exceptional items. Without that framework, a seemingly mathematical earn out can quickly become an accounting dispute.

Control changes after closing

In a traditional Searcher acquisition, the buyer will normally control the shareholder level after closing and set the strategic direction of the business.

The seller may remain involved as managing director or continue to play an operational role. The economic position has still changed. Part of the seller's purchase price remains linked to the performance of the business, while key corporate and strategic decisions are now made on the buyer side.

Governance during the earn out period therefore becomes part of the purchase price discussion.

Growth can reduce the earn out

A simple example illustrates the issue.

Assume the business generates EUR 1 million of EBITDA at closing. The seller receives additional consideration if EBITDA reaches at least EUR 1.2 million after two years.

Following closing, the buyer invests in growth. A new Head of Sales joins the business, additional sales staff are hired and the marketing budget is increased. The additional annual cost amounts to EUR 400,000.

Revenue grows significantly. EBITDA still reaches only EUR 1.1 million because of the additional investment.

From the buyer's perspective, those decisions may be entirely rational and value creating. For the seller, the same decisions may reduce or eliminate the earn out.

The potential conflict therefore lies less in the formula itself and more in the decisions that shape the numbers behind it.

The earn out must leave room to run the business

Searchers acquire businesses in order to develop them. New employees, new products, new systems, changes in pricing and further investment may all form part of the post closing plan.

The earn out needs to leave sufficient room for those decisions.

The seller also needs protection against actions that could materially undermine the earn out position.

The SPA should therefore establish an appropriate framework for the earn out period. Depending on the business and the contemplated post closing strategy, relevant topics may include changes to the business strategy, discontinuation or transfer of business lines, intragroup charges, management fees, management remuneration, significant hiring decisions, restructuring costs, acquisition costs or changes to accounting methods.

The right level of protection depends on the specific business.

A well structured earn out therefore starts during due diligence. If the buyer already knows which changes are likely to be implemented after closing, the purchase price mechanics can be designed around that plan.

Integration needs to be addressed

Integration can become particularly relevant in Searcher transactions.

Some businesses remain largely standalone after closing. Others are partially integrated into an existing group.

Finance, HR, IT or Legal may be centralised. A holding company may begin providing certain services. Sales or procurement may be managed across several portfolio companies. Each of these changes can affect the earn out metric.

Take a management fee as an example. Before closing, the target bears certain functions directly. After closing, the buyer group provides Finance, Legal, HR and IT services and charges the target EUR 200,000 per year.

For an EBITDA based earn out, those EUR 200,000 may directly affect the payout.

The parties should therefore agree before signing how such charges are treated. They may be fully included, recognised only up to a certain amount or neutralised for purposes of the earn out calculation.

These points may look technical. Economically, they are part of the purchase price.

Accounting principles belong in the formula

An earn out based on EBIT or EBITDA requires a clear accounting framework.

The SPA should define the applicable accounting principles, whether the target's historical methods continue to apply, how provisions are treated and which adjustments are permitted. Changes to historic accounting practices may also need to be addressed.

The more precisely these points are defined, the more robust the subsequent calculation becomes.

A term such as “Adjusted EBITDA” only creates clarity if the adjustments are clearly defined as well.

Information rights are purchase price rights

After closing, the seller may no longer hold any shares in the company. The right to part of the purchase price may still depend on the financial performance of the business.

The seller therefore needs sufficient information to verify the calculation.

The SPA may provide access to management accounts, annual financial statements, relevant accounting records, the earn out calculation itself, explanations of adjustments and information on intragroup charges.

The scope should match the transaction. The seller does not need unrestricted access to the business. The seller does need a reliable route to the information on which the purchase price claim depends.

The calculation needs its own process

Even a detailed definition will not eliminate every disagreement.

The SPA should therefore establish a clear process for determining the final earn out.

The buyer may prepare the calculation after the end of the relevant period and provide it to the seller together with the agreed supporting documents. The seller then receives a defined period to raise specific objections. Undisputed items become final. Remaining calculation disputes can be referred to an independent expert under a defined procedure.

Clear deadlines, responsibilities and limits on the scope of review matter.

For an earn out worth several hundred thousand euros, the process for determining the amount can be just as important as the percentage itself.

The term changes the risk profile

The length of the earn out period is part of the economic allocation of risk.

A shorter period keeps the calculation more closely linked to the business at closing. Short term fluctuations carry more weight.

Over a longer period, investment decisions, market developments, management changes and integration can have a greater impact on the relevant metric.

The right period therefore depends on the business model. A SaaS business with monthly recurring revenue may call for a different structure from a project based business with long sales cycles.

The duration, calculation periods and payment dates should be designed as one coherent mechanism.

The cap defines the exposure

A cap limits the maximum amount of additional consideration.

It provides clarity on the buyer's maximum exposure and the seller's maximum upside.

The mechanics should still be precise. The parties need to determine whether the earn out is calculated annually or cumulatively, whether stronger and weaker years can offset each other and whether minimum thresholds apply.

Those points belong in the purchase price formula rather than in later interpretation disputes.

Why earn outs can be attractive for Searchers

Searcher deals are heavily shaped by capital structure.

Equity, acquisition financing, seller loans, rollover equity and variable purchase price components can all be combined.

An earn out can reduce the amount of cash consideration payable at closing.

For example, a purchase price of up to EUR 5 million could be structured as EUR 3.5 million payable at closing, EUR 750,000 through a seller loan and up to EUR 750,000 as an earn out.

Compared with a fully fixed purchase price of EUR 5 million, the buyer would need EUR 750,000 less cash for the purchase price at closing.

That can be attractive from a financing perspective.

The future payment still needs to be planned for. If the agreed performance targets are met, the earn out becomes payable.

Liquidity planning and the financing structure should therefore take that potential obligation into account from the outset.

An earn out is purchase price structuring. It is not free capital.

Earn outs can bridge valuation gaps

Valuation discussions in SME transactions are often based on different views of the future.

The seller knows the business intimately and may see significant growth potential. The Searcher needs to price the acquisition based on due diligence, available capital and the proposed financing structure.

An earn out can convert those different expectations into a measurable economic arrangement.

If the business performs as expected, additional consideration becomes payable. If performance remains below the agreed thresholds, the variable portion of the purchase price is reduced accordingly.

This can help bridge a valuation gap.

It also creates an ongoing economic relationship between buyer and seller for the duration of the earn out.

The seller remains economically exposed

This point is easy to underestimate during the purchase price negotiation.

After closing, the seller may have fully exited the cap table. Through the earn out, part of the seller's economic position still depends on the performance of the business.

Revenue, costs, hiring, investment, accounting, integration and strategy therefore remain relevant even though the buyer now controls the company.

A piece of the purchase price negotiation remains inside the business after closing.

The larger the earn out, the longer its duration and the more sensitive the metric is to buyer decisions, the more important the governance framework becomes.

Tax treatment requires separate analysis

The tax treatment of an earn out depends heavily on its specific structure.

Relevant factors may include the selected performance metric, the conditions for entitlement and the seller's personal position.

Particular care is required where the seller remains involved in the business after closing and variable payments are linked to continued employment, management activity or continued service.

The tax treatment may then depend significantly on how the contractual arrangements are structured.

The tax analysis should therefore be developed alongside the purchase price mechanics.

Three elements determine the quality of an earn out

A robust earn out can ultimately be reduced to three elements.

Performance: The agreement needs to define which metric triggers which amount of additional consideration.

Control: The SPA needs to address which decisions may affect that metric after closing and how those decisions are treated.

Verification: There needs to be a reliable process for determining the metric, sufficient information rights and a clear mechanism for resolving calculation disputes.

These three elements belong together.

EBITDA, a percentage and a time period do not yet make a robust earn out mechanism. A well drafted structure also defines the economic and accounting environment in which that EBITDA is expected to arise.

Conclusion

Earn outs can be highly effective in Searcher deals. They can reduce the amount of cash consideration payable at closing and reflect different expectations about the future development of the business within the purchase price structure.

They also extend part of the economic relationship between buyer and seller beyond closing.

The key negotiation therefore goes beyond the percentage, the term and the cap. It is about performance, control and verification.

What matters is not only the number written into the SPA. What matters just as much is who can influence how that number is created after closing.