Earn-out and non-compete: key clauses in M&A
In company purchase and sale transactions, earn-out and non-compete are among the clauses that generate the most discussion. Understanding them helps balance risks between seller and buyer.
What an earn-out is
An earn-out is the clause that ties part of the transaction price to the company's future performance after the sale. Instead of paying the full amount at closing, the buyer pays an initial portion and conditions the remainder on the achievement of targets, such as revenue, EBITDA or other indicators defined in the contract. It is a way of bringing the parties' value expectations closer together.
How to structure the earn-out
- Clearly define the targets, the indicators and the measurement period
- Establish accounting criteria and calculation rules to avoid divergent interpretations
- Set out who manages the company during the period and which decisions require agreement
- Regulate auditing, access to information and the way any disputes will be resolved
Common risks in an earn-out
The main risk of an earn-out is conflict over the measurement of the targets, especially when the seller no longer controls management. The buyer's decisions may affect the results that serve as the basis for payment. For this reason, in general, the more objective and verifiable the criteria are, the lower the chance of a dispute.
The non-compete clause
The non-compete clause seeks to prevent the seller from competing again with the sold company for a certain period and in a certain region, preserving the value the buyer acquired, especially the customer base and know-how. To be valid, it usually requires reasonable limits on term, territory and activity, so as not to constitute an excessive restriction on free enterprise.
How the two clauses relate
Earn-out and non-compete frequently appear together. If the seller remains involved in the transition during the earn-out, the non-compete tends to protect the business during that period and afterward. The joint design of these clauses usually reflects the level of trust between the parties and the agreed payment terms.
Frequently asked questions
Can a non-compete clause last forever?
As a rule, no. To be considered valid, a non-compete usually needs reasonable limits on time, geographic area and type of activity. Excessively broad restrictions or those of indefinite duration may be challenged for disproportionately limiting the freedom to work and free competition.
What happens if the earn-out targets are not met?
In general, if the targets set out in the contract are not achieved, the portion of the price tied to the earn-out is not paid, in whole or in part, according to what was agreed. This is why it is important for the contract to clearly define the method of measurement and the effects of each scenario.
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