Earn-Out Clauses: Protecting the Seller
In mergers and acquisitions (M&A) transactions involving the sale and purchase of shares or equity interests, one of the most complex points of negotiation is the valuation of the target company. Buyers are typically concerned about overpaying based on uncertain future projections, while sellers believe in the superior growth potential of their businesses.
To bridge this valuation gap, the parties often resort to **earn-out clauses**. Under this mechanism, part of the purchase price is paid at closing, while the remainder constitutes variable, contingent consideration that depends on the company's future financial performance—for example, EBITDA, net profit or revenue—over a defined period, typically one to three years.
Although an earn-out may appear to be an ideal compromise on paper, in practice it carries significant risks of financial manipulation. Once the buyer assumes full operational control of the company, it gains the ability to influence expenses, revenues and accounting policies, potentially reducing reported profits and thereby substantially reducing or entirely eliminating its obligation to make additional payments to the seller.
Legal Classification of Earn-Out Clauses Under Contract Law
Under North Macedonian contract law, an earn-out clause may be structured as an obligation subject to a condition precedent, meaning that the obligation to make the relevant payment depends on an uncertain future event or in this case, the achievement of a specified financial performance threshold. If the condition is satisfied, the payment obligation becomes due.
A key principle under North Macedonian law in this context is the principle of good faith and fair dealing. The buyer must not act fraudulently or induce the seller into error in relation to the fulfilment of the agreed condition.
Prevention: How Can the Seller Protect Themselves During Negotiations?
To prevent the seller's contractual rights from becoming the subject of lengthy and costly litigation, it is essential to structure the Share Purchase Agreement (SPA) precisely.
Ordinary Course of Business Covenant
The buyer should be contractually required to operate the target company throughout the earn-out period in the ordinary course of business, consistently with past practice and in accordance with the standard of a prudent businessperson. The buyer should also be prohibited from taking actions intended to reduce, or having the direct effect of reducing, the earn-out consideration.
Regulation of Permitted and Prohibited Expenses (P&L Normalization)
The definition of the relevant financial metric, such as EBITDA, must clearly specify which items are to be excluded from the calculation, including:
Intercompany allocations: An express prohibition on charging the target company for general overheads, software or management services provided by the parent company for the purpose of calculating the earn-out.
Exceptional transaction costs: Legal fees, consultancy fees and banking charges relating to the acquisition itself must not be charged to the target company's profit and loss account.
Changes in accounting policies: Financial statements prepared for earn-out purposes must strictly follow the accounting policies and principles of consistency applied before closing the transaction.
Information, Audit and Inspection Rights (Audit Rights)
If the seller fully exits the ownership structure, they lose their shareholder inspection rights. The agreement should therefore expressly guarantee the seller:
Periodic written financial reports on the company's performance, on a quarterly or semi-annual basis.
The right to inspect accounting records through an independent authorised auditor.
The right to have the audit costs borne by the buyer if the auditor identifies a discrepancy in reported profits exceeding an agreed percentage, for example, 5%.
Accounting Dispute Resolution Mechanism (Independent Expert Determination)
Rather than allowing a dispute over accounting calculations to proceed immediately to court, the agreement should provide for the appointment of a reputable independent accounting or audit firm. Its determination should be final and legally binding on both parties, subject to the terms and limitations specified in the agreement.
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CONCLUSION
An earn-out clause can be an excellent tool for bridging valuation gaps in M&A transactions, but only if it is supported by robust legal and financial safeguards. A seller who agrees to an earn-out without strict protective mechanisms, restrictions on intercompany allocations and an express guarantee that the business will be operated in the ordinary course effectively hands the buyer a blank cheque.
North Macedonian contract law provides an important corrective mechanism through the legal principle under which a condition may be deemed fulfilled if a party has prevented its fulfilment in bad faith. Nevertheless, the best protection remains a precisely drafted contractual clause that prevents opportunities for accounting and operational manipulation from arising in the first place.
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Disclaimer: This article has been prepared for informational purposes only and does not constitute legal advice or instructions for taking action in a specific case. Legal matters are complex, and each situation has its own particular circumstances that must be assessed individually. We therefore recommend consulting a qualified lawyer who can assess your specific circumstances and identify an appropriate solution.
