How does an earn-out work in a French share deal?

A badly drafted earn-out is scheduled litigation: the party that controls the company during the calculation period also controls, in fact, the figures on which the additional price depends. The whole contractual exercise consists of neutralising that conflict of interest.

1. When an earn-out makes sense, and when to avoid it

An earn-out is useful where value depends on near and measurable events: renewal of a major contract, reaching a revenue threshold, success of a launch. It is risky where the seller leaves the company and loses any hold on performance, where the business sold is integrated into the buyer’s group to the point of becoming incomparable, or where the calculation period is long. In those cases a firm price, even a lower one, beats an uncontrollable deferred component.

Before accepting an earn-out, the seller should check that it keeps, throughout the period, either operational control or management undertakings enforceable against the buyer.

2. Choosing the metric: revenue, EBITDA, another aggregate

Revenue is simple to measure and hard to manipulate through costs, but it ignores profitability. EBITDA reflects economic performance, but depends on management and cost-allocation choices the buyer controls. Metrics lower in the income statement multiply the points of friction. The contract must define the metric line by line, by reference to a constant accounting framework, that of the reference accounts, and expressly neutralise exceptional items, intra-group recharges and changes of method.

The golden rule: a third party must be able to recompute the metric from the contract and the accounts alone, with no discretionary judgment by either party.

3. Duration and calculation timetable

The earn-out period usually runs over one to three financial years. The longer it is, the further the business drifts from the one that was sold and the more fragile the calculation becomes. The contract sets the full timetable: preparation of the accounts used for the calculation, delivery to the seller with supporting detail, a contestation period, payment. A stepped earn-out, with amounts due per threshold reached, limits the cliff effects of a single all-or-nothing target.

Every date in the timetable should carry a consequence in case of silence, payment deemed due or figures deemed accepted, so that no party gains by letting things drag.

4. Protecting the seller: conduct of the business during the period

The additional price depends on a business the seller no longer controls. The contract therefore sets management undertakings for the buyer during the period: operation consistent with past practice, maintenance of resources and scope, prohibition on transferring the business or its contracts to another group entity, framing of intra-group recharges and of decisions that would artificially depress the metric. Some drafting provides that in case of breach, the earn-out becomes payable at its maximum.

Beyond the undertakings, the seller should obtain periodic information rights during the period: without access to the running figures, it discovers the dispute when it is too late to correct it.

5. Protecting the buyer: cap and payment terms

On the buyer’s side, the earn-out is capped at a maximum amount, a condition of its financial sustainability and of the determinability of the price. The contract sets the payment terms, instalments, possible set-off against sums due under the warranty and indemnity provisions, and the fate of the earn-out if the company is resold during the period. The interplay with the warranty must be written out: a warranty claim must not be capable of being neutralised through the earn-out, nor the reverse.

The buyer should check that the cap, added to the price paid at completion, stays within its financing envelope, because the earn-out reaches its maximum precisely when the business performs.

6. Disagreement on the calculation: expert determination

The contract organises the dispute: a reasoned notice of disagreement, a discussion phase, then, failing agreement, the appointment of an independent expert, most often on the basis of article 1592 of the French Civil Code, which allows the price to be left to the estimation of a third party. The contract defines the expert’s mission, limited to the points in dispute, the binding character of the determination, the allocation of fees and the timetable. A well-drafted clause turns years of litigation into a few months of expert determination.

The parties should designate in the contract the institution or mechanism for choosing the expert, because the choice of the expert is itself the first sticking point once the disagreement arises.

7. Earn-out and price adjustment: do not confuse them

A price adjustment corrects the price at completion in view of the company’s actual position at that date, cash, debt, working capital, by comparison with reference accounts. The earn-out indexes a fraction of the price to future performance. The first looks backwards, the second forwards; they often coexist in the same agreement, with distinct metrics, timetables and expert procedures that must not contaminate each other.

Where the two mechanisms coexist, the contract must deal with their overlaps: the same euro of performance must never be counted twice, in the adjustment and then in the earn-out.

Frequently asked questions

This information is general and does not constitute legal advice. Every transaction calls for its own analysis.