In mergers and acquisitions (M&A) involving Chinese listed companies, Earn-back mechanisms are often standard practice. However, some portfolio companies fail to meet performance targets due to subjective or objective reasons[1]. When compensation obligations arise, promisors may default, forcing listed companies to resort to litigation or arbitration to enforce commitments[2]. Even after prevailing in court, recovery may prove challenging[3]. Consequently, listed companies have increasingly adopted Earnout mechanisms in recent years[4]. Indeed, Earn-outs are a common transactional arrangement in international M&A.
I. Definition of Earn-out Mechanism
An Earn-out mechanism is employed when parties to an M&A transaction cannot agree on the valuation of target assets or entities. It provides that the Acquirer will pay additional consideration if the target achieves predetermined objectives (the "Target Metrics") within a specified post-closing period. Payment is contingent solely on achieving these metrics; if unmet, no further payment is due. Thus, it constitutes contingent consideration.
Similar to Earn-back mechanisms, Earnouts are typically used in transactions where valuation disagreements arise from information asymmetry or divergent views on the portfolio companies’ future profitability. To bridge this gap, the Transferor commits to future performance under an Earn-back structure, compensating the Acquirer if targets are missed. Conversely, under an Earnout, the Acquirer pays an initial sum reflecting its valuation at closing, with additional consideration payable only if the target achieves metrics advocated by the transferor. This balances the transferor’s interests. While financial metrics (e.g., profitability) are common, nonfinancial targets, such as R&D milestones in pharmaceutical acquisitions, may also serve as Earn-out criteria.
Notably, Earn-outs afford greater control to Acquirers compared to Earn-back structures. Thus, transferors must carefully consider risk mitigation strategies under such mechanisms.
II. Earn-out Provisions
Though prevalent in cross-border M&A, Earn-out clauses are among the most dispute-prone contractual terms. Disputes typically center on: (a) whether Target Metrics were achieved, and (b) the causes of any failure. Consequently, the drafting of Earn-out terms mandates meticulous attention to: (i) determinacy of performance targets; (ii) coherence of contractual logic; (iii) mitigation protocols for achievement barriers.
1. Precisely definition of Financial Metrics
Target Metrics may be financial (e.g., net profit, EBIT/EBITDA, revenue growth over 2–3 years) or nonfinancial. Despite their quantitative nature, financial metrics are susceptible to interpretive conflicts arising from accounting methodologies. In one cross-border deal we advised on, the parties used a three-year gross profit compound annual growth rate (CAGR) to determine contingent payments. To preempt disputes, we:
- Explicitly defined gross profit, base gross profit, and gross profit CAGR;
- Detailed calculation methodologies (including relevant accounting line items) and pricing formulas via tables and notes;
- Instituted an independent expert resolution process for pricing disputes.
In another transaction involving EBITDA CAGR targets, bespoke adjustments (e.g., excluding government subsidies, rent modifications) were incorporated.
2. Objective, Operable, and Logically Sound Non-financial Metrics
Non-financial metrics may include KPIs, production/sales volumes, market share, daily active users (DAU), R&D milestones, key contract executions, product launches, or clinical trial phases. Metric based targets should emulate the precision applied to financial metrics. Milestone based targets require multidimensional definitions to ensure objectivity and operability. Where multiple milestones exist, logical sequencing must avoid ambiguity.
In a share transfer dispute we handled, the agreement included both net profit targets and phased DAU metrics. While cumulative DAU and net profit were achieved, one interim DAU phase was missed. The Transferor argued for aggregate assessment; the Acquirer insisted on phased compliance. The dispute arose from insufficient logical integration of the metrics.
In another deal involving a lithium iron phosphate cathode producer, the Transferor claimed ongoing negotiations with CATL for a long-term supply agreement. Given uncertainty, the Acquirer proposed tying a lumpsum payment to the execution of such an agreement. In drafting the Earn-out provisions, we established the following conditions from the Acquirer’s perspective for the long-term supply agreement: required duration, minimum annual sales volume, minimum annual sales value as well as operational performance commitments. While the Transferor negotiated expansions to product categories and permitted buyer scope. Such considerations culminate in a definitive agreement between the Parties.
3. Critical for Target Achievement: Operational Control
Acquirers often retain the transferor’s management or R&D team during the Earn-out period to ensure transition stability. However, if the management rights of the parties are not clearly delineated in the M&A agreement, disputes will inevitably arise.
In a share transfer dispute, the parties verbally agreed that the Transferor (Mr. Xu) would remain as General Manager (GM) for three years post-closing. The agreement, however, merely appointed him to the five-member board, which retained GM hiring/firing authority. Post-closing, irreconcilable conflicts between Xu and the board-chair (appointed by the Acquirer) led to Xu’s removal and termination. Deprived of operational control, Xu failed to meet the Earn-out targets, finally the Acquirer withheld 40% of the consideration.
While the Acquirer’s actions were legally defensible under corporate law, they undermined the transferor’s interests. Such cases, common under Earn-back mechanisms[5] highlight the need to explicitly define operational rights and remedies for interference.
In a cross-border deal we advised, the Acquirer proposed standard corporate governance (shareholder supremacy). Representing the transferor, we:
- Exhaustively enumerated shareholder and board powers;
- Reserved all residual authority to the GM (to be appointed by the transferor);
- Stipulated that Acquirer interference with GM authority would trigger deemed Earn-out achievement and full payment;
- Negotiated liquidated damages for specified interference (subject to dispute resolution).
This balanced solution accounted for the parties’ bargaining power and operational priorities. Where Acquirers demand operational control, defining both metrics and management boundaries becomes paramount.
4. Other Factors Impacting Target Achievement
Any variable affecting Target Metrics warrants quantification. For instance, during negotiations for an 2018 cross-border deal amid escalating Sino-US trade tensions, we analyzed potential tariff impacts and incorporated tiered adjustment mechanisms for each tariff scenario into the Earn-out terms.
Conclusion
Earn-outs are increasingly prevalent in both cross-border and domestic M&A. It is suggested that transferors should formulate realistic projections of target profitability, collaborate on balanced valuations, as well as diligently draft and perform agreements with legal counsel. These steps are essential to achieve Target Metrics and secure expected returns.
About the Author
Chambers (Chunbao) Yang, a Senior Partner, Head of the Capital Markets Department, and Director of the State-Owned Fund Research Center at Dacheng Law Offices LLP (Shanghai). He also serves as the Leader of the Private Equity and Investment Funds Practice Group for Dacheng China and is a member of the Shanghai Foreign-Related Legal Talents Pool. He holds a Bachelor of Laws from Fudan University (1992), a Master of Laws from the University of Technology Sydney (2001), and a Master of Laws from East China University of Political Science and Law (2001).
With 30 years of legal practice, Mr. Yang has long been engaged in legal services related to private equity funds, investment and financing, and mergers and acquisitions, covering industries such as large finance, large health, real estate and infrastructure, TMT (Technology, Media, and Telecommunications), exhibition industry, and manufacturing. Since 2004, he has been repeatedly listed in The Legal 500's rankings for "Private Equity" and "Corporate and Commercial" sectors, and has been specially recommended or commented on by Asia Law Profiles on multiple occasions. Since 2016, he has been continuously selected into the "Top 100 PRC Elite Lawyer" by China Business Law Journal. He was awarded the title of "China Corporate Law Expert of the Year" at the Leaders in Law - 2021 Global Awards, and has been consistently listed in the Recommended Directory of Excellent Lawyers Recommended by General Counsel of Well-Known Chinese Enterprises. He has also won awards such as "China TMT Lawyer of the Year" and "China M&A Lawyer of the Year" from Lawyer Monthly and Finance Monthly on multiple occasions.
Mr. Yang is qualified to serve as an independent director of listed companies. He is a part-time professor at the School of Law of East China University of Science and Technology, a practical tutor at the Law School of Fudan University, a part-time graduate tutor at East China University of Political Science and Law, a lecturer for the Private Equity CEO Program at Shanghai Jiao Tong University, and a lecturer for the Transnational Operation Talent Training Program of the Shanghai Municipal Commission of Commerce. He has published 16 monographs, including Practical Operations for Risk Prevention and Control in Private Equity Investment Funds, Practical Operations and Case Analysis of Enterprise-Wide Legal Risk Prevention and Control, and Winning Capital 2: A Complete Operation Guide to Corporate Investment and Financing Modes and Processes.
Mr. Yang's practice areas include: corporate law, investment, mergers and acquisitions, and private equity funds, capital markets, TMT, real estate and construction engineering, as well as dispute resolution in the aforementioned fields.
Email: chambers.yang@dentons.cn
Tel: +86 13901826830
Footnotes:
[1]: See 24 Listed Companies’ M&A Targets Defaulted on Earn-back Obligations; Litigation Ensues, Xinhua News Agency (Dec. 14, 2017).
[2]: E.g., DunAn Environment announced on Aug. 28, 2019, that it filed a lawsuit with Shaoxing Intermediate People’s Court against the target’s former controller Qiu Shaojie for compensation.
[3]: Hongda Mining announced a favorable court judgment on June 19, 2019, but noted that enforcement against shares held by the defaulting shareholder faced challenges due to third-party liens.
[4]: E.g., Shanghai Shenkai’s acquisition of 60% equity in Hangzhou Fenghe, with Earnout payments tied to net profit.
[5]: See M&A disputes involving listed companies such as Shinva Medical and Blue Focus.
