Earn-Out

Earn-out structures vary considerably, but are most commonly linked to revenue, EBITDA or the achievement of specific milestones.

EBITDA-Based Models

Here, the variable payment is tied to the achievement of a pre-defined EBITDA figure, which reflects the operational earning power of the company. This form is popular as it mirrors the company’s commercial performance. However, this carries a risk for sellers: buyers can influence EBITDA through investments, cost allocations or internal transfer pricing.

For this reason, sellers are well advised to include precise provisions (earn-out covenants) in the purchase agreement (SPA) governing the management of the business during the earn-out period. Crucial is the reference to concrete accounting standards and the avoidance of vague catch-all clauses such as “all extraordinary expenses shall remain disregarded”.

Revenue-Based Models

These link the earn-out to the revenue achieved. Such figures are easier to determine than EBITDA numbers, but provide less insight into profitability. For sellers, these models are often advantageous, as revenue growth is generally a shared objective and manipulation is more difficult.

However, buyers must prevent revenue from being artificially inflated, for example through the granting of excessive discounts or the “buying” of unprofitable revenues. This can be countered through minimum margin agreements or an obligation to run the business in the ordinary course of business.

Milestone-Based Models

In this case, the payment is linked to the achievement of specific, non-financial targets, such as the conclusion of a strategic contract, the obtainment of market authorisation for a product or the reaching of a certain number of users. This type of earn-out is used primarily in the context of start-ups, digital business models and innovative technology companies.

The legal treatment of earn-out arrangements has undergone considerable development in recent years. Three recent judgments illustrate how courts assess the obligations of buyers and sellers and which aspects are of particular importance in contract drafting.

BFH Judgment of 9 November 2023 (IV R 9/21): Tax Treatment of Earn-Out Payments

With its judgment of 9 November 2023, the Federal Fiscal Court (BFH) provided fundamental clarification on the tax treatment of variable purchase price components. The decision confirms and extends the existing case law on profit- or revenue-dependent purchase price claims.

Key principles of the judgment:

• Profit- or revenue-dependent purchase price components payable in addition to the fixed purchase price are only to be taxed at the time of receipt as subsequent business income (§ 24 No. 2 in conjunction with § 2 para. 1 sentence 1 No. 2 EStG).
• They do not retrospectively increase the disposal gain arising in the year of the sale pursuant to § 16 para. 1 sentence 1 No. 2 EStG.
• This also applies to so-called earn-out clauses where the arising of the variable purchase price components is uncertain both as to whether they will arise and as to their amount.

BFH reasoning:

The BFH classifies earn-out payments as purchase price claims subject to a condition precedent (§ 158 para. 1 BGB). At the time of disposal, it is neither certain whether a purchase price claim will arise legally in one of the subsequent years, nor how high it will be. This uncertainty justifies excluding earn-out payments from the key-date-based calculation of the disposal gain, having regard to the principle of taxation according to economic capacity and by analogy with the realisation principle.

Practical consequences:

• Earn-out payments are not subject to the preferential tax rate under § 34 para. 3 EStG (half tax rate).
• Sellers must tax the variable purchase price components in the year of receipt at the full income tax rate.
• This can result in significant additional tax burdens that should be taken into account in purchase price negotiations.

FG Cologne, Judgment of 4 December 2024 (12 K 1271/23): Earn-Out as Employment Income

A particularly practice-relevant and not yet definitively resolved question concerns the distinction between earn-out as a purchase price component and employment income. The Cologne Fiscal Court drew clear guidelines on this with its judgment of 4 December 2024.

Facts:

A shareholder-managing director had sold his GmbH shares and undertaken to remain active as managing director for a further five years. Part of the agreed purchase price was structured as an earn-out and was expressly linked to the continued exercise of the managing director role. Provision was also made for proportional repayment upon premature departure.

Decision of the Cologne Fiscal Court:

The court classified the earn-out as employment income, not as a tax-privileged disposal gain. The decisive factor was that the earn-out was closely connected with future work performance. The agreement of a repayment clause in the event of premature termination confirmed that it constituted consideration for future work performance.

Consequences:

• Full income tax and social security liability instead of the partial income method (60% taxable)
• Significant additional financial burden for the seller
• The appeal is pending before the Federal Fiscal Court (ref. IX R 1/25), so the matter has not yet been definitively resolved.

Structuring guidance:

• Is the payment linked to a continuing corporate office or an employment or service relationship?
• Are there repayment provisions in the event of the seller’s premature departure?
• Precise separation of purchase price and remuneration for services in the contractual clauses

The more closely the earn-out is linked to the seller’s active involvement after closing, the greater the risk of classification as employment income. To be distinguished from this are earn-out payments that depend solely on the future development of the company, independent of any activity on the part of the seller.

OLG Naumburg, Judgment of 26 June 2023 (Ref. 12 U 23/23): Frustration of the Earn-Out by the Buyer

The Higher Regional Court of Naumburg had to decide on a case in which a buyer prevented the distribution of profits by way of resolutions at the shareholders’ meeting, despite the seller having a contractual entitlement to profit participation.

Facts:

Following the sale of shares in a GmbH, the buyer, as the now sole shareholder, passed a resolution providing that no profit distribution was to take place for the year in question. This was justified on the basis of a negative economic forecast.

Decision of the OLG Naumburg:

The court made clear that, notwithstanding the discretion under § 29 para. 2 GmbHG, the contractual provisions in the share purchase agreement take precedence. The earn-out clause indirectly establishes an obligation to distribute profits. Since the buyer had not complied with this obligation, a liability to pay damages (§ 280 BGB) could arise.

Comprehensive rights to information: The court granted the seller far-reaching information rights, which include in particular the following points:

• The composition of all assessment bases from the balance sheet, profit and loss account and notes to the approved annual financial statements
• Composition of individual (cumulated) balance sheet items relating to expenditure and operating expenses of the company
• The formation of provisions and their necessity and amount
• Effects of the items recorded on the company’s profit, to be evidenced by appropriate documentation

Practical note: The judgment shows that the rights and obligations of the buyer in connection with earn-out clauses should be regulated in detail and comprehensively in order to avoid potential post-M&A disputes.

For sellers, effective contractual protection of earn-out claims is essential. For this reason, earn-out covenants are often included in the SPA to regulate the management of the business during the earn-out period and to set out sanctions for breaches.

Core Elements of Effective Earn-Out Covenants

1. Precise KPI Definitions

The key figures relevant to the calculation of the earn-out must be defined with reference to concrete accounting standards. Vague formulations such as “all extraordinary expenses shall remain disregarded” should be avoided.

Recommendation: Include sample calculations as a contract exhibit to document the mutual understanding.

2. Consistent Accounting Principles

The purchase agreement should stipulate that during the earn-out period the same accounting and valuation methods must be applied as in the past. Changes should only be possible with the consent of the seller.

3. Comprehensive Information Rights

Sellers should secure far-reaching rights of access to information:

• Access to balance sheets, profit and loss accounts, notes and other relevant documents
• Monthly or quarterly reporting obligations of the buyer
• Audit rights through the seller’s own tax advisors or auditors
• Right to participate in supervisory board or advisory board meetings

4. Rules of Conduct for the Buyer (Covenants)

The purchase agreement should contain specific obligations of the buyer:

• Continuation in the ordinary course of business
• Prohibition or limitation of cost allocations, management fees or internal transfer prices
• Obligation to maintain certain investment levels
• Prohibition of merger with other business divisions
• For EBITDA-based earn-outs: provisions on depreciation, write-downs and provisions

5. Sanction Mechanisms

In the event of breaches of earn-out covenants, the agreement should provide for clear sanctions:

• Automatic acceleration of the earn-out, even if the targets were not achieved
• Claims for damages
• Contractual penalties

Differentiation According to Seller’s Role

Seller remains operationally involved: If the seller retains an operational role after the transaction (e.g. as managing director), they can themselves contribute to achieving the targets, meaning fewer detailed covenants are required. However, the risk of tax classification as employment income arises here (see FG Cologne judgment).

Seller leaves the company: In more complex structures or where the seller departs from the company, more detailed warranties are indispensable, including:

• Clear accounting standards
• Reporting obligations and control rights through independent third parties
• Far-reaching information and consent rights
• Membership of the advisory board or supervisory board

Earn-outs carry considerable potential for conflict. The claims depend on future results, which can be influenced by both internal management decisions and external market factors.

Common Points of Dispute

• Whether the claim has arisen at all: Were the targets actually achieved?
• Amount of the variable payment: How are the KPIs correctly to be calculated?
• Breaches of earn-out covenants: Has the buyer violated rules of conduct?
• Accounting interventions: Have accounting or valuation methods been changed?
• Payment delays: Is the buyer refusing to make timely payment?

Typical Conflict Triggers

• Last-minute earn-outs: When an earn-out is agreed as a “quick fix” at the last minute, thorough consideration is often lacking. The contractual wording remains too vague.
• High binary thresholds: With “all-or-nothing” clauses, a comparatively minor matter can determine whether a multi-million euro earn-out is paid.
• Seller still in management: Disagreements about the running of the business can arise if the seller continues to act as managing director after closing.
• Vague exclusion clauses: Formulations such as “all extraordinary expenses shall remain disregarded” regularly give rise to disputes.

Best Practice Checklist for Dispute Prevention

a) Clear Definitions and Calculation Mechanisms

• Precise definition of KPIs with reference to concrete accounting standards
• For EBITDA models: exact definition of which items are included/excluded
• For revenue models: establishment of a minimum margin to avoid unprofitable revenues
• For milestone models: objectively verifiable criteria

b) Sample Calculations as an Exhibit

Inclusion of model calculations for various scenarios in the purchase agreement, in order to document the mutual understanding and minimise subsequent scope for interpretation.

c) Transparent Obligations to Provide Financial Information

• Monthly or quarterly reporting obligations
• Access to all relevant documents (balance sheets, profit and loss accounts, subsidiary ledgers)
• Right to appoint own auditors

d) Restrictions on Actions that May Adversely Affect the Earn-Out

• Catalogue of earn-out covenants with concrete rules of conduct
• Prohibition of earn-out-detrimental measures or seller’s consent requirement
• Sanctions for covenant breaches

e) Escalation Process with Independent Expert Involvement

A multi-tier dispute resolution mechanism is recommended:

• Level 1: Negotiations at management level (good-faith discussions)
• Level 2: Mediation for out-of-court dispute resolution
• Level 3: Expert determination / independent expert for accounting and technical matters
• Level 4: Arbitration proceedings for legal matters

Advantages of arbitration proceedings: Confidentiality (no public judgments), greater speed than ordinary courts and the selection of industry-knowledgeable arbitrators.

f) Mediation Clause for Amicable Dispute Resolution

A mediation clause obliges the parties to attempt mediation before initiating court or arbitration proceedings. This can save considerable costs and time and preserve the business relationship.

For Buyers

Realistic target agreement:

• Appropriate observation period (recommended: maximum 2–3 years)
• Graduated earn-outs instead of binary thresholds
• Lower multiples reduce dispute potential

Flexibility in business management:

• Find a balance between earn-out covenants and entrepreneurial freedom
• Provisions on strategic measures (integration, restructuring)
• Clarification of which decisions require the seller’s consent

Careful structuring:

• Transparent calculation of various scenarios before contract conclusion
• Close coordination between lawyers and financial experts
• Allow sufficient time for contract drafting, even when under time pressure

Earn-out clauses represent a flexible yet legally and tax-technically complex instrument for determining the purchase price in M&A transactions. They can bridge valuation differences and offer economic advantages to both parties, but the associated potential for conflict must not be underestimated.

Current case law highlights three central challenges:

• Tax treatment: Earn-out payments lose the preferential tax rate and are fully taxable in the year of receipt (BFH 2023).
• Demarcation from employment income: A close link with continuing activity can lead to classification as employment income (FG Cologne 2024, appeal pending).
• Frustration by the buyer: Contractual earn-out obligations take precedence over corporate law discretion; breaches may give rise to liability in damages (OLG Naumburg 2023).

Sound legal and tax guidance is therefore essential, ideally from the outset in the Letter of Intent. The structuring should take account of the following principles:

• Simplicity over complexity: The simpler the provision, the lower the potential for manipulation and dispute.
• Precision: Clear KPI definitions with reference to accounting standards.
• Balance: Protection of the seller while preserving the buyer’s entrepreneurial freedom.
• Conflict prevention: Multi-tier dispute resolution mechanisms with mediation and expert determination clauses.