By Tom Evans and Linzi Mutter

Earn-outs article - pharma deals

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Earn-outs, where additional consideration is paid post-completion based on the performance of a target business, are becoming increasingly common in private M&A transactions. Our recent survey of European deals between July 2013 and June 2015 shows earn-outs were used twice as often as during previous periods surveyed, although overall, this still represents a small minority of transactions.

So why the increase in earn-outs? According to conventional wisdom, earnouts bridge the valuation gap between buyers and sellers, so they share the risk of the future target business’ performance. Earn-outs have been used for this purpose on a number of recent transactions.

As further explanation, earn-outs are more common for businesses where revenue post-completion will be derived from significant investment pre-completion in research and development. While risk is associated with that future revenue stream, such risk may only be that the underlying products are subject to regulatory approval, but are otherwise ready to come to market. The pharmaceutical sector is an example of where this type of investment is required, and a sector where earn-outs are very common.

Earn-outs article - European transactions with earn-out

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But there are risks associated with earn-outs. For a seller, the possibility of the buyer manipulating performance metrics — particularly Earnings Before Interest Tax Depreciation and Amortisation (EBITDA) — to reduce or eliminate any earn-out payment is particularly relevant. For a buyer, if the target business is to be integrated into the buyer’s existing business or future acquisitions, sharing with the seller the benefits of any synergies realised is a key consideration, as are restrictions on the operation of the target business post-completion. Further, if key managers are to receive earn-out payments, their commitment to the business following payment of any earn-out is a consideration.

From a legal perspective, parties should exercise a great deal of care to strike the right balance between rewarding the seller for post-completion performance and allowing the buyer the freedom to carry on the business post-completion. With complexity comes an increased risk of dispute, but with seller-friendly terms for attractive assets continuing to prevail in Europe, the use of earn-outs is something that we expect to see continue in PE M&A.


  • Synergistic benefits Typically the buyer will seek to exclude synergistic benefits from the earn-out calculation. However, in practice such benefits may be difficult to quantify. As a result, a buyer may agree to operate the target business on a standalone basis.
  • Acquisitions and disposals If an earn-out is determined by reference to group performance, parties may agree that acquisitions be ignored for the purpose of determining the earn-out. However, in practice quantifying the necessary adjustments may be challenging.
  • Ongoing restrictions on conduct of business Protections that restrict the buyer from taking actions that would artificially reduce the earn-out can significantly impede a buyer’s freedom to operate the target.
  • Tax treatment Stamp duty in the UK is payable on any ascertainable maximum earn-out consideration, with no ability to reclaim overpaid stamp duty if less is ultimately paid. In addition, a poorly structured earn-out can result in an earn-out payment to management being treated as an employment related payment with negative tax consequences.
  • Security A seller will be concerned that the buyer may not pay the earn-out when due – it may seek security in the form of a parent guarantee, charge over assets, bank guarantee or cash escrow
  • Credit agreements The ability of the buyer to make any additional payment of consideration under the terms of any borrowings should be considered.


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