Earnout: price adjustment method in share purchase agreements

The purchase price is invariably one of the most contentious points during the negotiation phase of an M&A transaction. Particularly in cross-border transactions, the buyer may wish to minimize risk by opting for alternative payment methods. One of these methods is the “earn-out”, where part of the purchase price will be calculated according to the future financial performance of the target company. Statistics for the year 2020 indicate that earn-out clauses were used in approximately 27% of acquisitions concluded in the United States. In addition, earn-out clauses are frequently used in share purchase contracts concluded in Europe. This is particularly the case in transactions involving start-up companies, where uncertainty increases about the future performance factors of the target company and where the buyer does not have in-depth market experience.

What is the “Earn-Out” payment?

Earnout is a purchase price adjustment mechanism in the share purchase agreement whereby a portion of the purchase price will be paid in the future subject to the fulfillment of certain stated conditions in the agreement. Accordingly, the purchase price is divided into two parts: (i) a fixed amount to be paid at the time of the transfer of the shares, (i.e. at closing), and (ii) a variable amount to be paid pay after closing based on the target company’s future earnings expectations. Therefore, the remaining portion of the purchase price is paid to the seller only if the parameters set out in the share purchase agreement are met. Failing this, the buyer is not required to pay an additional price in addition to the lump sum. The amount of the price supplement to be paid in the future would often be between 20% and 30% of the total purchase price. In addition, higher or lower percentages can be agreed on a case-by-case basis.

Earnings Parameters

Complementary price clauses should be designed in such a way as to avoid a conflict of interest and to achieve a balance between the parties. Thus, the starting point for triggering a fair price supplement request is the calculation of the objective financial data of the target company. Objective financial data related to the financial situation of the target company may include budgetary objectives, such as cash flow, balance sheet result, gross or distributable profit, annual turnover, EBIT (profit before interest and taxes) and EBITDA (earnings before interest, taxes, depreciation and amortization). However, these calculation formulas may not reflect the actual financial situation of the target company, so buyers prefer to agree on achieving certain revenue targets instead of using previous target values. EBITDA is one of the most preferred metrics because the buyer has less opportunity to manipulate costs.

Non-financial parameters may also be decided to determine the future payment of the purchase price. In general, non-financial events are used as a basis when acquiring start-ups and companies operating in regulated sectors, such as the condition that the seller retains its role in the management of the company after closing or obtaining the necessary official authorizations. For example, in the acquisition of a start-up where the future performance of the target company is linked to the management of the seller, the parties can negotiate on the executive role of the seller in the management of the target for a period of earnout time. From now on, the seller is only entitled to receive the balance of the purchase price at the end of this period. Similarly, for a target company operating in the pharmaceutical industry, the acquisition of official authorizations or a patent may be considered within the framework of the share purchase agreement as a condition for the payment of an additional price. . In this regard, the seller may only receive the balance of the purchase price after obtaining the official authorization or the patent.

On the other hand, the parties can also agree simultaneously on financial and non-financial parameters as part of the share purchase agreement.

Why make money?

The earn-out provides fair value to both buyer and seller. Generally, the seller will be paid with the fixed price at closing, and the rest of the purchase price depends on the occurrence of certain parameters agreed between the parties. That being said, for the parties, it has the advantage that the buyer pays only part of the purchase price upfront and eliminates uncertainty about the future performance of the lens, and the seller must receive additional compensation in the future if the company achieves financial results. or non-financial they envision.

Complement agreements are effective ways to hold the seller accountable for the information they provide about the expectation of the future state of the target business. In addition, an earn-out clause can also be attractive for the seller, as it gives him the possibility of benefiting from a successful transaction in the longer term beyond the purchase price.

Accordingly, the buyer’s interests which may suffer from uncertainties and risks regarding the future financial performance of the target company can be secured by providing earn-out protection. For this reason, the use of earn-out clauses increases dramatically in due course, especially in start-up acquisitions, and such arrangements become more attractive to both buyer and seller if the parameters are properly formulated. .

Earnings mechanism under Turkish law

Price supplements are not specifically regulated by Turkish law. However, Turkish law allows the parties to agree on a purchase price payable subject to the fulfillment of certain conditions, and therefore does not prevent the implementation of an earn-out mechanism. In addition, price determination based on the fulfillment of certain conditions in the future refers to the existence of a lagging condition [geciktirici koşul]. To be specific, the terms and conditions of the share purchase agreement subject to the payment of the price supplement can be qualified as a delaying condition under Article 170 of Law No. 6098 of the Turkish Code of Obligations . [“TCO”].

As mentioned above, such a delaying condition may be determined based on future financial expectations or the occurrence of non-financial events. In this respect, the seller will not be entitled to receive the corresponding part of the purchase price until the condition is fulfilled. This part of the purchase price will only be due and payable to the seller after the deferral condition has been satisfied.

Article 175 of the TCO is worth mentioning here. In accordance with this provision, if the acquirer taking control following the transfer of shares prevents the fulfillment of the conditions set out in the share purchase agreement in order to avoid the obligation to pay the additional price, the relevant condition could undoubtedly be interpreted as being fulfilled, and the seller becomes entitled to collect the additional price due to the bad faith of the buyer. Here again, depending on the characteristics of the earn-out contract, the provisions of the TCO relating to sales and mandate contracts can be applied by analogy.1

Disputes related to price supplements

An earn-out agreement is attractive to both the seller and the buyer: while the seller is entitled to a higher purchase price if the business succeeds, the buyer will only pay a part of the purchase price instead of the total purchase price only if the conditions are met. However, price supplements constitute one of the main grounds for disputes between the parties. For example, the buyer’s strategy in long-term investment plans, or the transfer of a large percentage of the company’s assets, or the investment in other companies would most likely affect the future add-on receivable. seller’s price, thus causing a dispute between the parties.

Therefore, not only the value and the calculation of the purchase price to be paid in the future, but also the factors that would affect the amount of the earn-out must be taken into account during negotiations. As a first step, covenants may be considered in the agreement so that the seller retains a level of control over the target’s operations or to prevent the buyer from making significant changes that may result in a decrease in the add-on amount. of price. In addition, in cases where the buyer’s decisions affect the economic activity of the target, and therefore result in a loss in the company, the payment of the price supplement can be calculated as if no loss had occurred. .

Eleanor C. William