What is an Earn Out Clause? A Comprehensive Legal Overview
Definition & meaning
An earn out clause is a provision in a business purchase agreement that ties a portion of the sale price to the future performance of the business. This clause is typically included when the buyer and seller have differing views on the business's current value, especially if the seller believes that the business will perform better financially in the future. If the business meets certain financial targets after the sale, the seller may receive additional compensation based on those results.
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Earn out clauses are commonly used in business transactions, particularly in mergers and acquisitions. They are relevant in various legal areas, including contract law and corporate law. These clauses can help bridge valuation gaps between buyers and sellers, making them a useful tool in negotiations. Users can find templates for earn out clauses through legal form services like US Legal Forms, which can assist in drafting agreements that comply with applicable laws.
Key Legal Elements
Real-World Examples
Here are a couple of examples of abatement:
Example 1: A company is sold for $1 million, but the seller believes it can achieve $1.5 million in revenue within two years. The purchase agreement includes an earn out clause that stipulates the seller will receive an additional $500,000 if the revenue target is met.
Example 2: A startup is acquired for $500,000, with an earn out clause based on achieving specific growth metrics over the next 18 months. If the startup meets these metrics, the seller will receive an additional $200,000. (hypothetical example)
State-by-State Differences
State
Notes
California
Commonly uses earn out clauses in tech acquisitions to account for future growth.
New York
Frequently includes earn outs in financial services transactions to align seller incentives.
Texas
Less common in small business sales, but used in larger transactions.
This is not a complete list. State laws vary and users should consult local rules for specific guidance.
Comparison with Related Terms
Term
Definition
Earn Out Clause
A provision linking part of the sale price to future business performance.
Contingent Payment
A payment that depends on certain conditions being met, which may not be tied specifically to business performance.
Seller Financing
A situation where the seller provides financing to the buyer, which is different from an earn out that is based on performance metrics.
Common Misunderstandings
What to Do If This Term Applies to You
If you are considering an earn out clause in a business transaction, it's essential to clearly define the performance metrics and payment structure in your agreement. You may want to consult with a legal professional to ensure the clause is enforceable and meets your needs. Additionally, US Legal Forms offers templates that can help you draft an appropriate earn out clause.
Quick Facts
Typical duration: One to three years after the sale
Common metrics: Revenue, profit margins, or customer acquisition
Potential additional payment: Varies based on performance
Legal jurisdiction: Governed by state contract law
Key Takeaways
FAQs
An earn out clause is a provision in a business sale agreement that ties part of the payment to the future performance of the business.
It can help bridge valuation gaps between buyers and sellers, especially when there are differing opinions on the business's worth.
The calculation is based on the performance metrics defined in the agreement, such as revenue or profit targets.
Yes, if they are clearly defined and comply with state contract laws.
While it is possible, consulting a legal professional or using a template can help ensure it meets legal requirements.
