In M&A deals, buyers and sellers often have conflicting views on value, especially during market highs or lows. The board of a target company aims to maximise shareholder value and is hesitant to sell during downturns when valuations are depressed, even if offers seem reasonable. Buyers, meanwhile, may see strategic or counter-cyclical opportunities but are cautious about overpaying, particularly if their valuation is also affected by the cycle. This creates a valuation gap, with sellers rejecting offers they view as opportunistic, and buyers unwilling to increase bids. A key issue is uncertainty, in terms of which neither side can be sure where they are in the market cycle or how it will shift. Added to this is a psychological bias, particularly on the seller side, towards maintaining the status quo when faced with risk or uncertainty, often leading to a decision not to proceed with the deal.
To address this valuation gap and general market uncertainty, earn-outs are frequently used in private equity deals. Earn-outs are a form of deferred consideration where payment is contingent on the target company achieving specific performance milestones, typically financial metrics such as EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) and net profit.
Earn-outs are also used to keep management shareholders engaged and motivated after the transaction closes. They help ensure that the target business remains profitable and achieves specific performance goals. If these goals are achieved, the management shareholders receive additional payments, known as deferred consideration. Typically, the agreement provides that the stronger the target company performs financially, the higher the deferred payment that the seller will be entitled to.
When utilising earn-outs in practice, careful consideration should be given to the drafting of the applicable provisions, to include the following:
- Clear performance targets: Vague terms lead to disputes. Metrics must be specific, measurable, and based on verifiable data.
- Measurement periods and timing: The earn-out period (usually 1–3 years) and payment triggers must be well defined.
- Access to information: Sellers often negotiate rights to monitor performance, especially if they are not involved post-transaction.
- Dispute resolution: Pre-agreed mechanisms (such as, e.g. independent accountant determination) can help avoid litigation.
In conclusion, earn-outs are a powerful tool, but they must be drafted with precision under South African law to reduce post-deal disputes. Tailoring the approach to each transaction and involving experienced legal counsel is crucial for both buyers and sellers.
Disclaimer: This article is the personal opinion/view of the author(s) and is not necessarily that of the firm. The content is provided for information only and should not be seen as an exact or complete exposition of the law. Accordingly, no reliance should be placed on the content for any reason whatsoever and no action should be taken on the basis thereof unless its application and accuracy have been confirmed by a legal advisor. The firm and author(s) cannot be held liable for any prejudice or damage resulting from action taken on the basis of this content without further written confirmation by the author(s).
