Among the various mechanisms imported from American practice into the Brazilian M&A market, few have become as widespread as the earn-out clause. Its use has become particularly common in transactions involving technology companies, rapidly expanding businesses, and sectors where the economic value of the asset depends largely on future expectations.
The popularity of the mechanism is understandable. When the seller maintains steep growth projections, the earn-out resolves the valuation gap between the parties by tying part of the price to the future performance of the business. Instead engaging in the preparation of exhausting financial projections and assumptions at the negotiating table, the parties defer the determination of a portion of the price, which, in economic terms, appears to be the most reasonable and efficient solution.
However, the success of the earn-out as a financial mechanism often masks the main issue: the party bearing the economic risk rarely controlsthe variables capable of influencing whether that risk materializes. Therein lies the principal weakness of the mechanism. The earn-out does not resolve the misalignment over the purchase price at the time of negotiation; it merely defers that discussion to the future.
Unsurprisingly, earn-out clauses are among the leading sources of post-closing disputes in M&A transactions. Although the debate is generally framed as a discussion about contractual good faith or opportunistic conduct on the part of the buyer, the real issue appears to be a different one: the separation between economic exposure and decision-making power.
During the negotiation, the seller agrees that the purchase price will be conditioned on achieving additional targets. In theory, this amounts to a shared bet on the company’s performance. In practice, however, once the acquisition is completed, management control shifts, with the buyer assuming control of the company and thus deciding all key matters that may directly affect the achievement of the metrics underlying the earn-out payments. As a result, the seller is exposed to the financial effect of those decisions without being able to effectively influence them, even if the seller remains an executive of the company.
In the United States, where the mechanism has developed with greater sophistication, courts have dealt for decades with disputes over the limits of the buyer’s discretion following the closing of the acquisition. Decided cases address duties of good faith, implied obligations to cooperate, and allegations that certain business decisions undermined the ability to reach the agreed-upon targets. Nevertheless, even with an extensive body of case law and reasonable predictability, litigation remains intense, given how thorny the subject is.
In Brazil, the challenge is even greater. The difficulty lies not only in the quality of the contract or the parties’ conduct, but in the evidentiary obstacle that arises when the targets are not met. A seller seeking to challenge the non-payment of the earn-out must not only demonstrate that a particular management decision was improper but must also prove something far more complex: that such decision caused the contractual metrics to fail. This means reconstructing a scenario that never existed.
It is necessary to convince arbitrators or judges that, had certain measures been taken, the company’s economic performance would have been sufficient to trigger the additional payment. Few evidentiary exercises are more difficult in today’s business environment.
Corporate results stem from countless variables, including, without limitation, macroeconomic conditions, consumer behavior, competition, credit availability, exchange rate fluctuations, regulation, and internal management factors. It is difficult to isolate the effect of a single decision on a specific financial indicator, a task that eludes even the most sophisticated economic models.
The growing sophistication of contractual clauses is a legitimate response to this issue. Specific business conduct covenants, minimum investment commitments, restrictions on material strategic changes, enhanced reporting mechanisms, and even limited seller involvement during the earn-out measurement period have become more common. Such solutions mitigate important risks, but do not eliminate the structural tension that characterizes the mechanism.
The debate over earn-outs has frequently been framed from the standpoint of contract drafting, precision of the metrics, or duties of good faith. All of these issues are relevant, but none of them addresses the central weakness of the earn-out, which consists in exposing the seller to the company’s economic outcome without giving the seller any control over the conditions that will produce that outcome. This is a risk that sellers must learn to live with, difficult as it is for many.
Authors:
João Carlos Anderson Corrêa de Mendonça – Partner (joaomendonca@felsberg.com.br)
Pedro Henrique de Oliveira Fontes – Attorney (pedrofontes@felsberg.com.br)
Cindy Massesine Pimentel Canova – Attorney (cindypimentel@felsberg.com.br)