ABSTRACT
In this article, the content of the “earn-out” mechanism, which has an important place in the world of mergers and acquisitions, the various types encountered in practice, the elements included in earn-out agreements and the legal nature of the earn-out mechanism, which is not directly regulated under Turkish law, will be discussed.
I. INTRODUCTION
In order to manage the valuation discrepancies between the buyer (acquirer) and seller (transferor) and to balance the risks, earn-out mechanisms are a strategic payment method used in M&A transactions, particularly when acquiring businesses with strong growth potential or uncertain future performance. The parties to the transaction may agree on a different base price at the time of signing the relevant agreements or at the time of closing, with the payment of additional fees if various criteria, such as reaching a certain revenue and/or profit, are met. This is because the “real” value of companies with high growth potential may not become apparent for some time.
II. ADVANTAGES AND DISADVANTAGES OF THE EARN-OUT MECHANISM
The earn-out mechanism, in general terms, offers certain advantages and disadvantages for both parties, but mainly favors the buyer. Thanks to the earn-out arrangement, the buyer can manage its cash flow more flexibly by keeping the initial payment amount low, which provides financial flexibility, especially in high-risk and high-cost acquisitions.
At the same time, the earn-out mechanism encourages the seller, who is familiar with the operation of the company, to actively contribute to the process during the transition period when the buyer, who has just taken over the company, establishes a new structure over the company. In practice, the mechanism, which is usually subject to arrangements of approximately two to three years and is used simultaneously with the clauses stipulating that the seller will take on various tasks in the new period of the company, enables the company to continue its operations during the aforementioned period.
Some of the challenges posed by the mechanism for the buy-side are the need to allocate additional resources to monitor and evaluate the regulated performance criteria and the fact that the seller, to the extent that it retains management authority, may adversely affect the long-term strategies of the company by making short-term decisions in order to achieve the regulated earn-out targets.
From the seller’s perspective, the earn-out mechanism facilitates the seller’s transfer of the company, but it contains issues to its detriment due to the fact that it is dependent on the performance of a company whose management is no longer fully under its control after the closing.
III. EARN-OUT MODELS
Although the most common model in practice is the traditional earn-out model, as will be discussed below, many other models have been developed in accordance with the requirements of commercial life. When choosing between these models, the parties often prefer the model that will result in the least liability in terms of the tax legislation to which they are subjected to.
A. Traditional Earn-out Model
The model described in this article under the heading “Advantages and Disadvantages of The Earn-Out Mechanism” is the traditional model, in which the seller is paid mostly in cash and/or shares if the target agreed upon by the parties is reached.
B. Reverse Earn-out Model
The reverse earn-out model is a model in which the buyer pays the fee on the closing date that would be paid if the target is reached in the traditional earn-out model. If the agreed targets are not reached, the seller pays the relevant amount back to the buyer. Although the model is clearly unfavorable to the buyer, it may be in the buyer’s favor if the amounts are paid earlier at the closing date and recorded in a different financial year.
C. Tranche Earn-out Model
Earn-out mechanism may be organized in such a way that a certain portion of the shares are sold if the targets are achieved, rather than only making a payment if the targets are met. If such an arrangement is made, the price of the shares is calculated according to the relevant target, and the mechanism can be set up in such a way that the price is determined automatically.
IV. ELEMENTS OF EARNOUT AGREEMENTS
The elements of Earn-out agreements are largely determined by the commercial strength of the parties and are agreed after extensive negotiations, and the elements in most arrangements are as follows.
A. Target Criteria
Financial criteria, primarily based on financial indicators such as revenue, net profit, EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization); operational criteria for the realization of specific business processes or operational achievements, which may include targets such as reaching a certain production capacity, launching a new product or acquiring a certain customer base; and strategic objectives such as achieving a competitive advantage in a specific market, which are relatively rare because they are long-term objectives, are the most fundamental elements of earn-out agreements.
B. Duration
The time periods for both the achievement of the target criteria mentioned in the paragraph above and the payments to be made in case of achievement of the relevant criteria are regulated in earn-out agreements. While short-term arrangements are generally preferred for highly uncertain and therefore high-risk situations, medium-term arrangements are preferred for relatively stable targets, and long-term arrangements are generally preferred for complex, long-term and large-scale targets.
C. Miscellaneous Aspects
In addition to target benchmarks and deadlines, earn-out agreements include many other elements such as how the benchmarks will be measured and monitored, how and in what form the payments arising from the agreement will be made, the dispute resolution process in case of a possible dispute, and the distribution of tax liabilities arising under the agreement.
V. EARN-OUT MECHANISM IN TURKISH LAW
There are only general provisions regarding earn-out in Turkish law, and the delaying condition regulated under Articles 170 et seq. of the Turkish Code of Obligations (“TCO”) constitutes the basis of the earn-out mechanism in Turkish law. The parties concretize the detailed provisions specific to the earn-out mechanism with the provisions they include in the contract concluded between them. Apart from this, it will be possible to apply the earn-out mechanism in outcomes-based contracts in the result, which is not regulated in Turkish law, to the extent of its compliance with the general provisions of the TCO1.
A. Delaying Condition in Turkish Law
One of the provisions regulated in the TCO in order to regulate the debt relations between the parties and to secure the rights of the parties is the delaying condition. Delaying condition means that the results of a legal transaction are conditioned on the realization of a certain event. In Turkish law, the most important distinction in terms of the legal consequences of conditions is the distinction between delaying conditions and impairing conditions2. Just as a delaying condition is mentioned when the parties condition the realization of all or part of the transaction between them on a condition that is likely to occur in the future, a disruptive condition is mentioned when the parties condition the termination of all or part of the transaction between them on a condition that is likely to occur in the future. However, among these conditions, it is the delaying condition that forms the basis of the earn-out mechanism in Turkish law3.
According to TCO 170, a delaying condition is a condition set for a contract to become effective. Upon the fulfilment of this condition, the contract enters into force and the debt relationship between the parties begins. Since the delaying condition depends on the realization of an uncertain future event, the onset of the legal consequences of the contract is left at an indefinite time. The realization of the delaying condition means that the legal consequences of the contract begin to be realized. This situation plays an important role in determining the rights and obligations of the parties. With the realization of the delaying condition; the debt relationship between the parties starts, the rights and obligations specified in the contract enter into force, and the parties can exercise their rights and fulfil their obligations arising from the contract. If the entire contract is conditional, the contract shall become effective when the relevant condition is fulfilled, but it is also possible to condition one or more of the obligations in the contract4.
In order for a delaying condition to be possible, certain conditions must be fulfilled. The condition must be an event that is not certain to occur in the future. Certain events or events that occurred in the past do not constitute a delaying condition. The condition must be determined by the will of the parties. The parties must have linked the realization or non-realization of a certain event to the birth or termination of the debt relationship. Finally, the condition must not be contrary to law and public morality. Otherwise, a condition contrary to law and public morals will be invalid.
If the delaying condition is fulfilled, the legal transaction becomes effective and the parties become obliged to perform their obligations. If the condition is not fulfilled, the obligation is deemed not to have arisen and no debt relationship is established between the parties. Pursuant to Article 171 of the TCO, the possibility of the condition to be fulfilled is evaluated within the period of time in which the condition is expected to be fulfilled. The debtor is obliged to refrain from any behavior that may delay the performance of the obligation until the condition is fulfilled. The realization of the delaying condition is usually proved by different methods depending on the nature of the condition. In some cases, evidence such as witness statements, official documents or expert reports may be used. If the non-fulfilment of the condition is caused by the behavior of one of the parties contrary to the rule of good faith, the condition will be deemed to have been fulfilled according to Article 175/1 of the TCO.
Upon the realization of the delaying condition, the legal transaction becomes effective and the parties are obliged to perform their obligations. In this case, the debt arises and the obligation of performance commences. However, if the condition is not fulfilled, the debt is deemed not to have arisen and no debt relationship is established between the parties. The parties shall not be under any obligation of performance, provided that the behaviour of one of the parties against the rule of good faith does not cause the condition not to be fulfilled5. Likewise, according to Article 175/2 of the TCO, if one of the parties ensures the fulfilment of the condition through behaviors contrary to the rule of good faith, the condition shall be deemed not to have been fulfilled and therefore no obligation shall arise and the parties shall not be under any performance obligation.
Delaying condition is encountered in many different contracts in practice. In sales contracts, if the sale of the relevant goods is to be made according to the market price at a future date determined in the contract, the existence of a delaying condition may be mentioned here. Likewise, if the lease agreement is concluded on the condition that the tenant will be assigned to that city, the existence of a delaying condition is also in question here6. The Earn-out mechanism operates in a similar manner to the delaying condition concept in the TCO. Earn-out payments are generally conditional on the fulfilment of certain performance criteria. This situation, like the delaying condition, provides a structure that waits for the realization of a certain event or performance. However, the performance criteria in the earn-out mechanism are usually related to financial targets or specific performance measures of the company and are usually considered as events to be completed after a period of time. As with the delaying condition, in the earn-out mechanism, the fulfilment of obligations is conditional on the occurrence of a specific event. This can help to avoid disputes between the buyer and seller and to define the expectations of the parties more clearly. However, the earn-out mechanism usually involves a more complex performance assessment and has a more extensive structure than the standard delaying clause in the law of obligations. Lastly, the application of the Article 175/1 of the TCO mentioned in the delaying clause will be very difficult in terms of earnout, as it will not be easy to prove that the acquired company would have performed much better financially if it had been better managed, and that it performed poorly due to the buyer’s mismanagement7.
Consequently, the earn-out mechanism and the delaying condition in the TCO refer to situations where the fulfilment of obligations depends on the occurrence of certain events. However, the earn-out mechanism offers a more complex structure, often based on performance evaluations and financial targets. Both mechanisms can help parties to better manage their expectations and avoid disputes. In this context, understanding both concepts are important for more effective management and negotiations in financial and legal processes.
B. Outcomes-Based Contracting in Turkish Law
In Turkish law, outcomes-based contracts in the result are contracts based on the achievement of a certain result based on the agreements reached between the parties. In such contracts, one party undertakes to achieve a certain result, while the other party agrees to pay a certain price in the event that this result is realized. Outcomes-based contracts in the result are widely used especially in construction, engineering, software development and similar projects.
The main obligation of the contractor in outcomes-based contracts in the result is to achieve the result specified in the contract. The party undertaking to achieve the result is obliged to provide the knowledge, skills and resources necessary to achieve this result. The other party, on the other hand, is obliged to pay the price determined if the contracting party achieves the promised result. The parties must fulfil their obligations within the period specified in the contract and under the conditions specified.
An outcome-based sales contract is an agreement that provides for an additional payment to the seller if certain performance targets are met during the sale of a company or asset. In such agreements, the buyer pays additional consideration to the seller if the specified targets are met. An outcomes-based sales contract with earn-outs enable the parties to share future uncertainties and reduce the buyer’s risk while increasing the seller’s potential gain. The application of the principle of outcomes-based sales contracts is a common method, especially in the sale of commercial enterprises or company shares8. This method envisages the payment of both a fixed amount and an additional fee based on future revenue in determining the sales price. The TCO provides a general framework for both outcomes-based contracts in the outcome and the earn-out mechanism.
Some elements must be present in order for the sales outcomes-based contracts in the result to be valid. Clear and measurable performance targets must be set for the agreement to be valid. These targets can often be financial indicators, sales figures, profit margins or specific achievements. The amount of additional payment to be made if the targets are met and the terms of payment must be clearly defined. The timeframe within which performance targets are to be realized and when payment is to be made should be clearly stated. Audit and reporting mechanisms should be established for the objective evaluation of performance; independent auditors can be utilized for this purpose.
Contracts of sale with outcomes-based require an additional payment if specified performance targets are met. If the targets set in the contract are met, the buyer becomes obliged to make additional payments. Audit and reporting processes are important for the objective assessment of whether the targets are met and for the resolution of disputes that may arise in this process. The agreement provides for the sharing of future uncertainties between the parties, so that the buyer shares the performance risk of the purchased asset with the seller.
Earn-out agreements are encountered as earn-out agreements in mergers and acquisitions. In the process of acquisition of a company, earn-out agreements provide for additional payments in the event that the acquired company reaches certain financial targets. In these agreements, the buyer agrees to pay a fixed price to the seller as well as an additional fee based on the revenues of the acquired company at a certain time9.
As a result, sale outcomes-based contracts in the outcome are flexible and dynamic agreements that enable the parties to make or receive additional payments based on future performance. Within the framework of the TCO and other relevant legal regulations, the validity of such agreements requires that performance targets are clearly defined, payment terms are clear and control mechanisms are in place. Earn-out agreements, especially with their application in M&A transactions, enable the parties to share the risks and rewards in a balanced manner.
VI. CONCLUSION
Earn-out mechanism plays a critical role in M&A transactions to balance the valuation differences and risks between the buyer and seller. This mechanism is particularly preferred for the acquisition of companies with high growth potential or uncertain future performance. By agreeing on a certain base price between the buyer and seller, a fair valuation is ensured between the parties by making additional payments based on future performance criteria. However, the earn-out mechanism is not directly regulated under Turkish law and the legal nature and implementation details of such agreements are shaped depending on the terms of the parties’ agreement and contractual provisions.
BIBLIOGRAPHY
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FOOTNOTE
1 Yeşim M. Atamer/ Zahide Altunbaş Sancak, p. 113-116.
2 Kemal Oğuzman/ Turgut Öz, p. 511.
3 İsmail Türkyılmaz, p. 62.
4 Oğuzman/ Öz, p. 522.
5 Oğuzman/ Öz, p. 526-527.
6 Oğuzman/ Öz, p. 513.
7 İsmail Esin, p. 48
8 Emrehan İnal, p. 50.
9 İnal, p. 50.
