The Earn-Out Clause (Complément de Prix) in the Sale of a Business

The sale of an SME or of a stake by a private equity fund often runs into a disagreement on valuation: the seller values the company on a growth potential that the buyer refuses to pay for until it has been realised. The earn-out clause resolves this deadlock by splitting the price into a fixed part paid at closing and a deferred supplement, indexed to future performance. This attractive mechanism nonetheless contains a time bomb: badly drafted, the earn-out is one of the first sources of post-acquisition disputes, around the manipulation of the accounts and the loss of a chance of receiving the supplement. This guide sets out how to secure the drafting of the indicators, organise the governance of the post-closing period and anticipate disputes, for sellers, buyers and financial investors.

Earn-out: definition and economic function

The earn-out, or price supplement (complément de prix), is a clause in a share sale agreement (or, more rarely, a sale of a business (fonds de commerce)) under which part of the price remains conditional on the target company meeting performance objectives over a reference period following the sale. The price is then made up of two blocks: a fixed price, or upfront, paid on the completion date, and a variable supplement whose amount and payability depend on future results.

Economically, the earn-out is an instrument for sharing risk and bridging the valuation gap. The seller remains exposed to the performance of the business it is leaving, which encourages it to hand over a healthy asset and to support the transition. The buyer defers payment of part of the price and protects itself against overpaying: it pays for the potential only if it materialises. In transactions run by investment funds, the earn-out is frequently used to align the interests of the selling management who remain in charge, by retaining them and rewarding them for the value they continue to create. How these transactions work and how they are structured legally is set out in our article on private equity transactions.

This logic of risk sharing has a major legal consequence. The price supplement by nature involves uncertainty: on the day of signature, no one knows whether the objectives will be met. This uncertainty underpins the validity of the mechanism but also feeds its disputes, since each party has a direct financial interest in influencing the measurement of performance.

The legal architecture of the price supplement

Determination of the price and the requirement that it be determinable

In the law of sale, the price must be determined or determinable. Article 1591 of the French Civil Code provides that the price of the sale must be determined and designated by the parties, and Article 1163 requires the performance to be determined or determinable, the price clause not being allowed to depend on the sole will of one of the parties. For the earn-out, this means that the formula for calculating the supplement must rest on objective elements, outside the debtor's discretionary will, failing which the clause is liable to be void for indeterminacy of the price.

Determinability is therefore the clause's first line of defence. The contract must specify the calculation base (which accounting or operating aggregate), the reference period, the mathematical formula linking the aggregate to the supplement, and any ceiling (cap) and trigger threshold (floor or hurdle). A clause that merely indexed the supplement to results without specifying the method of calculation would be exposed to annulment.

Performance indicators and the earn-out structure

The structure of an earn-out rests on the choice of indicators. The most common are financial: turnover, gross margin, gross operating surplus (EBE or EBITDA), net profit. Each has a distinct risk profile. Turnover is simple to measure but can be manipulated by an aggressive commercial policy at the expense of profitability. EBITDA better reflects operating performance but depends on numerous accounting adjustments, each a potential point of friction. Net profit, finally, is the most sensitive to the decisions of the buyer, who has become master of the management: depreciation policy, intra-group recharges, management fees.

Alongside financial indicators, non-financial or operational indicators may be used: obtaining a regulatory approval, signing a framework contract, passing a threshold of active customers, completion of a research project. They are useful where the value rests on a precise milestone, but their binary measurement concentrates the dispute risk on the question of whether the milestone has been reached or not.

The earn-out structure generally combines several parameters: the length of the observation period (often one to three financial years), whether the measurement is annual or cumulative, whether the scale is linear or progressive, and the existence of limits. The more complex the structure, the more grey areas multiply. Securing the clause therefore means seeking simplicity in the indicator, even if its definition has to be locked down with extreme precision.

Drafting the indicators: the core of securing the clause

The quality of an earn-out is decided in the contractual definition of the reference aggregate. The same accounting term may cover different realities depending on the adjustments allowed. The clause must therefore fix a standalone definition, independent of the buyer's future management choices.

Several drafting precautions are needed:

• define the reference aggregate in a standardised way, referring to a precise accounting framework and listing exhaustively the adjustments allowed and excluded
• neutralise scope effects, by excluding from the calculation acquisitions, disposals or restructurings decided by the buyer during the period, or by providing for a like-for-like adjustment mechanism
• limit the charges recharged by the acquirer (management fees, head office costs, pooling costs) so that they do not artificially compress the margin used as the base
• provide for the treatment of exceptional items and changes of accounting method, adjusting them to preserve comparability
• fix the date and procedure for drawing up the reference accounts, as well as the format of the financial statements used for the calculation

An annotated earn-out clause example

By way of illustration, an example earn-out clause may provide that the price supplement is equal to a multiple of the normalised EBITDA of the first financial year closed after the sale, provided that EBITDA exceeds a trigger threshold, up to a ceiling expressed as a percentage of the fixed price. The clause will then specify that normalised EBITDA means operating profit adjusted for depreciation, amortisation and provisions, excluding any management fee charged by the acquirer, any restructuring cost decided after the sale, and on a constant scope of activity as compared with the completion date.

The example shows the spirit of the approach: every adjective counts. Writing simply "the company's EBITDA" opens a wide road to disputes, since the acquirer may argue that a given charge is properly an operating one, while the seller will see in it a manoeuvre intended to reduce the aggregate. Securing the clause means leaving no term open to interpretation.

Governance of the post-closing period

The earn-out creates an atypical situation: the seller has a direct financial interest in a business it no longer controls, while the buyer runs a company whose management determines a debt it will have to pay. This structural divergence of interests must be framed by governance provisions, failing which every management decision becomes a source of dispute.

The first lever is to define undertakings on the running of the business (conduct of business) for the observation period. The buyer undertakes to manage the company in accordance with prior practice and in its corporate interest, to maintain commercial and human resources, not to transfer activity or customers to other group entities, and not to take any decision whose purpose or effect is to reduce the reference aggregate artificially. These undertakings translate, in operational terms, the requirement of performance in good faith laid down by Article 1104 of the French Civil Code, under which contracts must be negotiated, formed and performed in good faith.

The second lever is information and control. The seller must have a right of regular access to the relevant financial data, a right to receive periodic reporting and a right to audit the accounts used for the calculation. Where the seller remains a manager or employee during the period, a careful link between its operational status and its status as creditor of the supplement must be provided for, in particular to prevent early departure from depriving it of the supplement (good leaver and bad leaver clauses).

The third lever concerns structuring decisions. The clause may make certain decisions subject to the seller's prior consent or, failing that, provide for their neutralisation in the calculation: disposal of significant assets, change of accounting method, reorganisation, discontinuation of a product line. The aim is not to paralyse the buyer's freedom of management, but to ensure that the measurement of performance is not distorted by decisions unrelated to the intrinsic performance of the business sold.

Earn-out disputes

Manipulation of the accounts

The most frequent disputes concern the preparation of the accounts used for the calculation. The seller accuses the buyer of having steered the management or the accounting entries so as to reduce the reference aggregate and to lower, or even eliminate, the supplement due. Typical complaints concern the booking of excessive provisions, the transfer of customers to another group entity, the recharging of disproportionate head office costs, the bringing forward of charges or the artificial deferral of income.

The litigation response rests first on performance in good faith. An acquirer who took decisions whose purpose was to defeat payment of the supplement would breach the obligation in Article 1104. Depending on the circumstances, such conduct may also engage its liability for fraudulent manoeuvres within the meaning of Article 1137 of the French Civil Code, where the manipulations reveal an intention to deceive the counterparty. On the evidential front, however, the seller will have to show that the entries complained of depart from the contractual definitions and from the accounting principles normally applicable, which requires effective access to the accounts and, often, expert evidence. On the procedural means of gathering this material before bringing the action, see our analysis of the ex parte application to secure evidence.

This is where precision in drafting the indicators produces its protective effects. The more the aggregate is defined with exhaustively listed adjustments, the harder it becomes for the acquirer to justify an entry reducing the base, and the better armed the seller is to challenge it. Conversely, a vague definition moves the debate onto questions of accounting judgment where the outcome is uncertain.

Loss of a chance

Where the supplement is not reached because of the buyer's conduct, the seller cannot always show with certainty that it would have received the whole of the supplement without the decisions complained of. French law responds to this difficulty with the theory of loss of a chance (perte de chance). The compensable loss is not the supplement itself, but the disappearance of the probability of obtaining it, assessed according to the degree of that probability.

This characterisation has concrete consequences for compensation. If the seller shows that, but for the buyer's breach, it had a serious chance of meeting the objectives, the compensation will correspond to a fraction of the hoped-for supplement, weighted by the probability of its being achieved, and not to the whole of it. Loss of a chance is compensable as damages for breach of contract, Article 1231-1 of the French Civil Code providing that the debtor is ordered to pay damages in the event of non-performance or delay, unless there is force majeure.

For the seller, the litigation strategy therefore consists in documenting, from the observation period onwards, the buyer's decisions that may have affected performance, in order to establish the link between the breach and the chance lost. For the buyer, the challenge is the reverse: to show that the failure to meet the objectives results from market factors or from the intrinsic performance of the business, and not from its own decisions.

Good faith as the common thread

Beyond clear-cut manipulation, earn-out disputes frequently crystallise around the duty of cooperation inherent in good faith. It is accepted in French law that the debtor of an obligation must not, by its own act, prevent the fulfilment of the condition on which its performance depends. Applied to the earn-out, this principle prevents the buyer from adopting a management approach that would deprive the seller of even the possibility of meeting the objectives. Symmetrically, where the seller remains operational, good faith prevents it from steering the management solely to inflate the indicator to the detriment of the company's long-term interest.

Securing dispute resolution

The method of resolving disputes is an integral part of securing the clause. The accounting technicality of earn-out disputes often justifies providing for a two-stage settlement mechanism. A first stage entrusts an independent expert with deciding purely accounting disagreements on the preparation of the reference aggregate. The appointment of a third-party valuer is linked to Article 1592 of the French Civil Code, which allows the price to be left to the arbitration of a third party; its decision, if properly framed, then binds the parties on the technical questions submitted to it.

The clause must specify the exact scope of the expert's mission (resolving accounting disagreements only, excluding questions of liability), the terms of appointment in the event of disagreement, the time limits, the allocation of fees and the effect of the decision. Disputes concerning the buyer's liability, in particular manoeuvres and loss of a chance, remain for the judge or the arbitrator, depending on the arbitration clause or jurisdiction clause chosen. The drafting and effect of the arbitration clause are dealt with separately in our article on the arbitration clause in B2B contracts.

A well-designed resolution clause prevents a technical disagreement from degenerating into long and costly proceedings, while preserving access to the court for serious breaches. It thus contributes to the predictability of the transaction, a particularly strong requirement for financial investors whose funds have a limited life and cope poorly with protracted disputes.

Conclusion

The earn-out is not a comfort clause to be drafted at the end of negotiations: it is a high-dispute-risk mechanism whose strength depends entirely on the precision of its drafting. Three convictions emerge from the analysis. First, legal certainty is won at the stage of definitions: a standardised reference aggregate, with exhaustively listed adjustments and neutralisation of scope effects, defuses most of the disputes over manipulation of the accounts. Second, post-closing governance is not incidental: without undertakings on the running of the business, an information right and a framework for structuring decisions, the seller finds itself the creditor of a debt whose base its debtor alone controls. Finally, anticipating disputes, through a prior accounting expert mechanism and a clear link with the court, turns a legal uncertainty into a managed risk.

For the seller, the watchword is control: negotiate effective access to the accounts and management safeguards. For the buyer and the investor, it is preserved freedom of management, provided that any decision whose purpose would be to defeat the supplement is ruled out. Before any signature, have your draft earn-out clause audited by an adviser who will simulate the calculation across several management scenarios: it is by testing the formula against the opportunistic behaviour of each party that its robustness is measured.

Frequently asked questions

What is an earn-out in the sale of a business?

The earn-out, or price supplement, is a clause under which part of the price for the sale of the shares remains conditional on performance objectives being met over a period following the sale. The price is made up of a fixed part paid at closing and a variable supplement indexed to financial or operational indicators. The mechanism makes it possible to bridge the valuation gap between an optimistic seller and a cautious buyer, while sharing the risk of future performance.

Can an earn-out clause be annulled for indeterminacy of the price?

Yes, if the calculation formula depends on the sole will of the debtor or if the base is not defined with sufficient precision. Article 1591 of the French Civil Code requires the price to be determined and designated, and Article 1163 requires a performance that is determined or determinable by reference to objective elements. A clause that indexed the supplement to results without specifying the aggregate, the period and the formula would be void. Security comes from a standalone, standardised definition of the indicator.

How can the seller protect itself against manipulation of the accounts?

Protection rests first on drafting: define the reference aggregate with exhaustively listed adjustments, neutralise scope effects and limit the charges recharged by the acquirer. It rests next on governance: information right, periodic reporting, audit right and undertakings on the running of the business for the observation period. Finally, in the event of manoeuvres, the seller may rely on performance in good faith under Article 1104 of the French Civil Code, or even on fraud (dol) under Article 1137.

What is loss of a chance in an earn-out dispute?

Where the seller cannot prove with certainty that it would have received the supplement without the buyer's decisions, French law compensates not the supplement itself, but the disappearance of the probability of obtaining it. The compensation corresponds to a fraction of the hoped-for supplement, weighted by the degree of that chance. It is based on damages for breach of contract provided for in Article 1231-1 of the French Civil Code. The seller must show a link between the buyer's breach and the chance lost.

What length of earn-out period should be provided for?

The observation period generally runs over one to three financial years, depending on the nature of the business and the time needed for the potential to materialise. A short period reduces the seller's exposure to the buyer's management risk but captures growth poorly; a long period better reflects the potential but multiplies the decisions that may affect the indicator. The choice must be weighed against the business cycle of the company and the parties' ability to frame governance over the chosen period.

Is an independent expert useful in the event of disagreement?

Yes, it is strongly recommended to provide for a clause entrusting an independent expert with resolving purely accounting disagreements on the preparation of the reference aggregate. This mechanism is linked to Article 1592 of the French Civil Code, which allows the price to be fixed by a third party. The clause must delimit precisely the expert's mission, time limits and the effect of the decision, reserving to the judge or the arbitrator disputes of liability such as manipulation or loss of a chance.

Is the earn-out suitable for private equity transactions?

The earn-out is frequent in transactions run by funds, in particular to retain and reward selling management who remain in charge after the sale. It aligns interests by making part of the price conditional on future value creation. Its main limit lies in the funds' limited investment horizon, which copes poorly with long disputes: hence the importance of an effective dispute resolution clause and of simple, locked-down indicators, in order to preserve the predictability of the transaction.