earn out clause and investments in Italy

Earn Out Clause: how it can protect foreign investments in Italy

NewsDecember 2, 2021

The pandemic of Covid-19 has affected our life so badly, that we now live in a situation of uncertainty. It’s not hard to believe that this situation is way more persistent in the business world, especially with sale and purhase agreements (a world marked by volatility and subject to the variation of shares value) due to the risk of lockdowns or other events capable of -in the abstract- choking a company.

But as the saying goes, the show must go on, and in this article we will show how investors, especially those willing to invest in Italy, can face this situation keeping up with M&A operations, protecting their deals from the fluctuations of the market due to the pandemic situation (but also when it will be over).

When it comes to estimate the value of the shares, buyers and sellers can use multiple tools, that we can sum up in the two macro-categories: the capital approach, and the income approach.

Those are expression of two different focus on the target company: the first one usually represents the buyer’s point of view, looks at the present of the company and its capital value, while the second one (seller’s perspective) looks to the future, to the capacity of the company to generate value.

Of course, the choice of the tool depends on the needs of the buyers and the sellers, but also by the type of company, the operating sector and many others.

In this scenario of uncertainty, a very useful contractual tool that companies can use to give the right value to the shares is the earn-out clause.

The earn-out clause states that the buyer undertakes to pay the seller an additional amount of money, over and above the purchase price, only if and when the target company will achieve in a given amount of time the goals which have been contractually agreed by the parties.

The two types of Earn-Out Clauses

There are two kind of earn-out clauses.

The first one is based on the company economic markers, and uses criteria like cashflow, revenue and EBIT (Earning before interest and tax) or EBITDA (Earning Before Interest Taxes Depreciation & Amortization).

The second kind is the “performance earn-out” clause, which is anchored to the achievement of given commercial and business goals, e.g. reaching an IPO.

There is also a special type of earn-out clause, the reverse earn-out benefitting the buyers,  providing for a price reduction in the event that the company will not reach the agreed target, provided they were reasonably foreseeable at the moment of the signature of the contract.

Of course, this clause does not come without any trouble with its application, because it may happen that the buyer, right after the closing, guides the company in certain direction far away from the goals agreed in the contract, to prevent the seller to receive his earn-out bonus.

But like any other sale-and-purchase agreement, the parties can negotiate to limit the decision-making powers of the buyer, or to maintain a form of control for the seller even after the closing. They may agree that the buyer cannot start any extraordinary operations which can affect the achievement of the earn-out goals, or to modify the structure of the company.

Anyway, there are some few steps to comply with, when the parties deal with an “earn-out” clause, like the following:

a) set the additional price for the seller;

b) target to achieve in order to activatethe “earn-out” clause and gain the additional price;

c) set a deadline to reach the goals;

d) set the accounting criteria to be used in order to determine if the target has been achieved;

e) set the duty for the buyer to give information to the seller after the closing about the company performance that can affect his opportunity to get the extra payment;

f) indicate the payment method;

g) establish criteria to nominate an expert when it comes to face controversies;

h) define the fiscal impact for both the parties following the application of the clause.

It is not rare to see this clause used in international deals.

To underline the importance and the possibility to use this clause in our country, there have been some big deals in recent times where the “earn-out” clause has been used.

The most recent and relevant is the acquisition of the Italian start-up Depop by the American e-commerce giant ETSY, for $1.625 billion.

In this case, the Italian start-up incubator H-farm, who firstly invested in Depop, will benefit of the “earn-out” clause, gaining 6 million euros.

On the other side, ETSY, who wanted to bet on the Italian “Z-generation” (born between ‘90es and late 2000es), will be able to realize if Depop has the potential they saw before the acquisition.

So, are you an investor who is interested in Italian companies? Are you worried about the volatility of the Italian market? A skilful application of the earn-out clause could mitigate legal and financial risks and protect your investments.

P&S Legal is willing to help you to negotiate the best option for your business.

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