Introduction to Earn-out Clauses
Earn-out clauses are a central instrument within the framework of Mergers & Acquisitions (M&A) and play a significant role, especially in company sales. The term “earn-out” refers to a variable portion of the purchase price that is not paid immediately but depends on the future success of the company. An earn-out clause in the purchase agreement thus regulates that part of the purchase price only becomes due when certain goals or key figures defined in the purchase agreement are achieved.
Typically, earn-out clauses are used when uncertainties exist regarding the future development of the company – for example, with innovative technologies, start-ups, or in turnaround situations. They enable a fair risk distribution between buyer and seller: while the buyer minimizes the risk of overpaying if the company does not succeed, the seller gets the opportunity to achieve a higher total purchase price in case of positive development. Furthermore, earn-out clauses can help keep the seller tied to the company following the transfer of shares, e.g., when the seller remains active as managing director.
The basis for earn-outs is usually a business-related financial metric such as revenue, EBIT, or EBITDA, which is derived from the company’s profit and loss statement. Alternatively, real figures such as sales volume or other measurable performance indicators may be agreed upon. When applying an earn-out clause, the purchase price divides into a fixed base purchase price and a variable additional purchase price, whose amount and due date depend on the achievement of the agreed objectives.
For the successful application of earn-out clauses, a precise and balanced design in the purchase agreement is indispensable. Both economic and legal framework conditions should be considered to avoid later disputes. In Germany, the Higher Regional Courts (OLG) and Regional Courts are responsible for deciding disputes related to earn-out clauses. The correct application and structuring of these clauses can significantly contribute to achieving the goals of both parties and securing the success of the company acquisition.
Given the complexity and the possible risks, it is advisable to consult an experienced lawyer or corporate advisor before concluding a purchase agreement with earn-out clauses. This allows potential pitfalls to be identified early and the interests of buyer and seller to be optimally protected. In practice, earn-out clauses have proven to be an effective tool for risk distribution and to promote successful integration of the target company into the M&A process.
Contractual Provisions in the Purchase Agreement Take Precedence – OLG Naumburg Ruling, Case No. 12 U 23/23
Earn-out clauses are frequently included in purchase agreements. After the conclusion of the purchase agreement, the contract signing process is a crucial step in which compliance with all legal provisions and adherence to common rules in the M&A process are of special importance. If a contractually agreed profit participation for the current fiscal year is not distributed, this can become a contentious issue between the parties. The Higher Regional Court of Naumburg clarified in its ruling from June 26, 2023, that a contractually agreed earn-out clause shall take precedence over statutory regulations (Case No. 12 U 23/23), whereby the signing of the purchase agreement marks the completion of the procedure.
Shareholders have broad discretionary power regarding the appropriation of profits pursuant to Section 29 (2) GmbHG. In certain cases, the legal evaluation of the contractual arrangement is particularly relevant, with the topic of earn-out clauses in focus. It may also be decided not to distribute the profit. However, if this discretionary power conflicts with an earn-out clause in the purchase agreement, the contractual provision shall take precedence according to the OLG Naumburg ruling, as explained by the law firm MTR Legal Rechtsanwälte, which advises, among others, on corporate law and M&A transactions.
OLG Naumburg: Contractual Earn-out Agreement Is Binding
In the underlying case, a shareholder sold his shares in a GmbH to another shareholder, who became the sole shareholder through the purchase. Part of the purchase agreement was an earn-out arrangement. This provided that the seller should participate in the profit achieved after the current fiscal year. Specific targets for the target company were established under the earn-out clause, with the result, such as the profit achieved or other performance indicators, being decisive for the payout of the variable purchase price portion. However, in his new position as sole shareholder, the buyer decided not to distribute the profit for the respective fiscal year, justifying this with an allegedly uncertain economic outlook of the company. Consequently, the seller did not receive any variable purchase price portion. In connection with the share acquisition, the buyer bears special responsibility, as he must ensure the integration of the target company and the implementation of the contractual agreements after the acquisition.
The case ultimately landed before the Higher Regional Court of Naumburg. At the heart of the legal dispute was the question of whether the buyer, as the sole shareholder, may undermine the contractual earn-out agreement through his resolution on profit distribution. The Higher Regional Court explicitly denied this. Although shareholders are fundamentally permitted under Section 29 (2) GmbHG to decide on the use of the net profit at their discretion, this legally granted discretion can be restricted by contractual provisions. This was precisely the case here, as the share purchase agreement provided for an explicit participation of the seller in the company’s profits. This agreement is binding. During the proceedings, it became clear that negotiations on the earn-out clause and the integration of the target company’s business units after the purchase played a central role in enforcing the contractual claims.
Corporate Structuring Has Limits
In its reasoning, the court clarified that contractual obligations arising from a share purchase agreement may not be circumvented by corporate structuring powers. By refusing the profit distribution, the buyer not only violated the principle of good faith but also breached his obligations under the purchase agreement. As a result, in addition to a previously granted right to information for the seller, there may also be a claim for damages. The seller should be economically positioned as if he were still involved in the company through the contractually agreed earn-out arrangement. The buyer must not abuse his new position of power to render the contractual agreement ineffective.
The judgment is significant for M&A transactions. Earn-out clauses are a common tool to structure purchase prices flexibly in company sales. They serve to fairly share uncertainties regarding the company’s future economic development between buyer and seller. Initially, the seller receives only a fixed base amount, while the variable part – the so-called earn-out – depends on subsequent performance metrics. Such agreements primarily aim to reduce the risk that the buyer pays too high a price if the company develops worse than expected after the transfer.
Conflict Potential with Earn-out Clauses
However, this mechanism bears considerable conflict potential. The buyer, who usually gains sole control of the company after the deal, can directly influence the achievement of earn-out criteria through operational decisions, for example by increasing costs, shifting revenues, or, as in the present case, simply withholding distributions. There is a fundamental dependency of the earn-out purchase price on the achievement of predefined targets and results, such as revenue or EBITDA goals, which are set out in the share purchase agreement. The Higher Regional Court of Naumburg’s ruling made it clear that the provisions in the purchase agreement take precedence.
To avoid legal disputes, earn-out clauses should be formulated with legal precision. It should be explicitly regulated in the contract how relevant key figures are determined, what information obligations exist, and whether there is, for example, an obligation to make distributions or to use results in a particular manner. Furthermore, it is advisable to agree on transparency obligations as well as the seller’s rights of inspection or co-determination regarding relevant decisions. The setting of targets and expected results is typically the subject of intensive negotiations between the parties in order to establish fair and realistic conditions and to prevent later disputes. This can prevent a buyer from manipulating or deliberately avoiding earn-out conditions.
After the acquisition, integrating the target company is a decisive step in which the previously agreed targets and the measurement of results play a central role in order to realize synergy effects and safeguard the interests of both parties.
MTR Legal Rechtsanwälte provides advice on corporate law and in M&A transactions.
Feel free to contact us!
