The Application of Earn-Out Clauses in M&A Transactions: Advantages, Challenges, and Contractual Design

Introduction and Functionality
In M&A transactions, Earn-Out provisions represent a flexible instrument to bridge discrepancies in valuation expectations. By linking a portion of the purchase price to the future performance of the company, a mechanism is created that preserves the seller's interests while keeping risks manageable for the buyer. An Earn-Out constitutes a variable component of the purchase price, paid to the seller in addition to a fixed amount. This payment depends on achieving pre-defined goals; in practice, the buyer initially pays a fixed base price at closing, which is often set lower. This base price can subsequently increase if the acquired company realizes the agreed-upon economic performance targets. This structure serves to bridge differing valuation expectations: sellers can receive additional payments if the company develops positively, while buyers only have to make higher payments if the forecasted results actually materialize. The variable component usually becomes due after an observation period of one to five years post-closing and depends on the fulfilment of the agreed performance indicators.

Market Context
The increasing use of Earn-Outs also reflects current conditions in the Dutch transaction market. In an environment characterized by economic volatility, rising financing costs, and geopolitical uncertainty, Earn-Outs are experiencing a significant upswing. Buyers use this instrument to limit valuation uncertainties, while sellers wish to secure their price expectations. Thus, Earn-Outs act as a bridge between current uncertainty and future success potential, representing an important instrument for risk management.

Forms of Earn-Out Models
Earn-Out structures vary greatly but are mostly linked to revenue, EBITDA, or the achievement of specific milestones.

• EBITDA-based models: Here, the variable payment is bound to reaching a pre-defined EBITDA value, which reflects operational earning power. This form is popular because it reduces the risk of accounting manipulations. However, this carries a risk for sellers: buyers can influence EBITDA through investments, cost allocations, or internal cross-charging. For this reason, sellers are well-advised to include precise provisions (Earn-Out Covenants) regarding management during the Earn-Out period in the Sales and Purchase Agreement (SPA).
• Revenue-based models: These link the Earn-Out to realized revenue. Such figures are easier to determine than EBITDA numbers but provide less insight into profitability. These models are often advantageous for sellers, as revenue growth usually represents a shared goal and manipulations are more difficult. Buyers, however, must prevent revenue from being artificially inflated, for example, through granting excessive discounts. This can be counteracted by corporate governance provisions or the obligation to conduct the company in the ordinary course of business.
• Milestone-based models: In this case, payment is linked to achieving specific, non-financial goals, such as concluding a strategic contract, obtaining market approval for a product, or reaching a certain user count. This type of Earn-Out is primarily used with start-ups and digital business models.

Contractual Protection of Earn-Out Claims
For sellers, effective contractual protection of Earn-Out claims is essential. Therefore, Earn-Out Covenants are often included in the SPA to regulate management during the Earn-Out period and establish sanctions for violations. Here, it is crucial to find a balance between the seller's protective interests (e.g., continuing existing business practices) and the buyer's entrepreneurial freedom.

If the seller retains an operational role post-transaction, they can contribute to achieving the goals themselves, making less detailed covenants necessary. In more complex structures, such as EBITDA-based Earn-Outs, or if the seller exits the company, detailed guarantees are indispensable. These include, among other things, clear accounting standards, reporting obligations, and inspection rights by independent third parties.

Conflict Risks in Earn-Out Agreements
Earn-Outs carry significant potential for conflict; claims depend on future results that can be influenced by both internal management decisions and external market factors. Common points of dispute concern the accrual of the claim, the amount of the variable payment, or alleged violations of Earn-Out Covenants. Conflicts regularly arise from unclear contractual wording, accounting interventions by the buyer, or payment delays. Two recent judgments illustrate how differently courts view buyers' obligations and which aspects are important in contract design.

Case Law

• Court of Amsterdam, February 28, 2024: A seller demanded the maximum Earn-Out, believing the buyer had invested insufficiently in the development of products that could have generated revenue. The court ruled that the buyer was not obliged to continue all activities or invest additionally, as long as they made efforts within the agreed scope of entrepreneurial freedom. This judgment underscores that the buyer may pursue their own strategy within contractually defined limits and that the entrepreneurial risk lies partially with the seller.
• District Court of Overijssel, February 21, 2024: In this case, the software company KLS was acquired by TKH. The seller (plaintiff) demanded the maximum Earn-Out of EUR 3.5 million, claiming TKH had deprived them of the chance to achieve it by discontinuing the development of crucial products like IDQare and Medicomaat. However, the Earn-Out provision granted TKH full entrepreneurial freedom regarding the execution of KLS's activities. Consequently, TKH was allowed to determine which activities were continued and which were not, provided this did not serve exclusively to disadvantage the seller. At the same time, there was a "best efforts" obligation (Inspanningsverplichting): TKH had to endeavor to generate the highest possible revenue appropriate to the circumstances and corporate strategy; however, this did not mean that all activities had to be continued. TKH decided to focus on the Product-Market Combination (PMC) with the highest return potential, Indivion, and to end loss-making or less strategic activities. The court ruled that this action was not in contradiction to the Earn-Out provision. The court pointed out that Earn-Outs are linked to uncertain future circumstances, placing part of the risk on the seller.

Both judgments underscore the importance of clear contractual agreements regarding the scope of the buyer's entrepreneurial freedom during the Earn-Out period, the buyer's obligation to endeavor to generate revenue, and the entrepreneurial risk inherent in Earn-Outs. Future results can ultimately be disappointing without this automatically constituting a breach of the agreement.

Recommendations and Conclusion
To minimize disputes over the Earn-Out as much as possible, the following points deserve special attention when drafting the agreement: 

a) Clear definitions and calculation mechanisms, especially for EBITDA models. 

b) Sample calculations as an annex.

c) Transparent obligations to provide financial information.

d) Restrictions on actions that could adversely affect the Earn-Out.

e) An escalation process accompanied by independent experts.

f) A mediation clause for amicable dispute resolution.

In summary, Earn-Out clauses constitute a flexible but legally complex instrument for price determination in M&A transactions. They can bridge valuation differences, but the associated potential for conflict must not be underestimated. Sound legal and tax guidance is therefore essential, ideally starting from the initial phase, such as in the Letter of Intent, to establish the right structures and expectations from the very beginning.