Earn-out as Insurance Against Uncertainty: Why the “Fair Price” in M&A Is a Myth

Under high uncertainty, the “fair price” of a business does not exist as a single objective number – it exists only as a range of probabilistic expectations. An earn-out (a deferred portion of the price tied to future results) works not as a payment deferral, but as a contractual hedge against forecast error: it converts the dispute from “whose valuation is correct” into “how to allocate future risk.” But the same mechanism, once control has passed to the buyer, creates the opposite problem – moral hazard, where the beneficiary controls the very metric on which the payment depends. Whether an earn-out creates value or conflict is determined not by the mere fact that it is used, but by the quality of its engineering: the metric, covenants, control rights, and dispute-resolution mechanism.

Executive Summary

The “fair price” is a range, not a point. This is the position of the valuation standards themselves: IFRS 13 defines fair value as the point within a range that is most representative in the circumstances (IFRS 13.B40). Under Knightian uncertainty, a valuation model does not “find” the price; it formalizes assumptions.

An earn-out is a derivative on a forecast, not a price concession. A contingent payment allocates prospective (future) risk; warranties, escrow, and indemnities address retrospective risk. These are different classes of risk – an earn-out cannot be replaced by warranties.

An earn-out solves adverse selection before the deal, but creates moral hazard afterward. Before closing, it screens out “bluffing” sellers (a contingent structure is incentive-compatible); after closing, control over the metric shifts to the buyer.

Deal structure matters more than the multiple. Under high uncertainty, risk allocation, metric selection, and governance affect value creation more than the agreed valuation coefficient.

Legal protection does not equal incentive alignment. Delaware practice shows that implied good faith does not rescue a poorly drafted agreement; what works are specific affirmative covenants and an incentive-compatible metric.

Earn-outs pay, on average, ~21 cents on the dollar and are disputed in at least 28% of cases (SRS Acquiom). This is a structurally conflict-prone mechanism: a Delaware judge described it as an instrument that turns today’s price dispute into tomorrow’s litigation over the outcome.

For Ukraine in 2024-2026, the conclusion becomes stronger. In an environment of war, currency and regulatory shocks, and low market transparency, a fixed “fair price” is especially illusory; an earn-out is rational, but where enforcement is weak, private safeguards (escrow, audit rights, expert determination), not reliance on court protection, become critical.

Key concepts: M&A · earn-out · contingent consideration · EBITDA · valuation gap · risk allocation · adverse selection · moral hazard · Nash equilibrium · prisoner’s dilemma.

What Is an Earn-out, and How Is It Different from a Deferred Payment?

An earn-out is the portion of the transaction price that the buyer pays only if the business achieves pre-agreed indicators (revenue, EBITDA, retention, milestone) during a specified period after closing. The difference between an earn-out and a simple deferred payment is fundamental: a deferral shifts a fixed amount in time, while an earn-out makes the amount itself a function of future performance.

Economically, this turns the contingent payment into a derivative on a forecast: the seller buys an option on the upside, while the buyer hedges the downside. This is also reflected in accounting: IFRS 3 “Business Combinations” requires contingent consideration to be recognized at fair value at the acquisition date as part of the consideration transferred and to be remeasured in subsequent periods. An earn-out is part of the deal economics, not an external bonus.

It is therefore incorrect to describe an earn-out as “we will pay 30% of the price later.” A more accurate formulation is: “70% is the price for the confirmed base; 30% is the price for future performance, if achieved under the agreed methodology.”

Basic definitions:

• Valuation gap – the gap between the price the seller is willing to accept and the price the buyer is willing to pay, caused by different forecasts of the future.
• Risk allocation – the allocation of a specific class of risk (past or future) between the parties through the transaction structure.
• Adverse selection – the risk of acquiring a business whose true quality is known to the seller but not to the buyer (Akerlof’s “market for lemons”).
• Moral hazard – the risk that a party changes its behavior after the contract is signed when control and economic interest diverge.

Why, Under High Uncertainty, Is the “Fair Price” Not a Point?

The “fair price” is not a point because the valuation standards themselves do not claim it is. IFRS 13 explicitly states that, when multiple valuation techniques are used, different techniques produce different results, and fair value measurement is the selection of a point within a range that is most representative in the circumstances (IFRS 13.B40). If an objective point existed, the standard would define fair value as a number, not as a judgment about selecting a point within a range.

The foundation of the range is Frank Knight’s (1921) distinction between risk (measurable, known probabilities) and uncertainty (unknown probabilities). A forecast of future EBITDA in an unstable environment is closer to uncertainty than to risk. Under these conditions, a valuation model is an epistemic, not a computational, instrument: it does not reduce uncertainty; it makes assumptions explicit.

A numerical example makes this tangible. A business generates EBITDA of €2 million. The seller forecasts €4 million in two years, relying on already signed contracts; the buyer assumes €2.5 million because part of the contracts is tied to the founder, whose motivation may decline after the deal. Both valuations are professionally prepared – the divergence lies not in the numbers, but in the distributions of future outcomes and in the interpretation of the risk that those outcomes will not be achieved.

This leads to the methodological conclusion. DCF is sensitive to terminal value and the discount rate, both of which are assumptions; market multiples are a distribution, not a constant; comparable transactions suffer from the non-observability of private terms. The EBITDA multiple creates an illusion of precision – the appearance of accuracy while the underlying base is discretionary, because the very concept of “normalized” EBITDA is a matter of dispute.

“A valuation without a story behind it is soulless and untrustworthy,” – Aswath Damodaran, Professor of Finance, Stern School of Business (NYU). A financial model without a business narrative is Excel, not proof of price.

The International Valuation Standards Council institutionalizes the same position: value uncertainty is an embedded property of valuation, not a defect in the process (IVSC, Managing and Communicating Value Uncertainty).

How Does Information Asymmetry Distort Price Negotiations?

Information asymmetry distorts negotiations because the seller systematically knows more about the business than the buyer, and due diligence reduces but does not eliminate this gap. The seller has a better view of the resilience of the customer base, real churn, quality of revenue, dependence on the founder, the “one-off” nature of past results, and hidden discounts. Future effort, transferability of customer relationships, and sensitivity to the departure of key people remain unobservable.

Here, an earn-out functions as a screening mechanism. Empirically, contingent structures are used more often where the target has more private information: in private, smaller, service-oriented, and intangible-intensive companies, as well as where the buyer and seller operate in different industries (Datar, Frankel & Wolfson, 2001). The logic is simple: if the seller believes in its forecast, it accepts a linkage between price and performance – the earn-out screens out bluffing sellers.

For the Ukrainian market, the problem is structurally sharper. According to KPMG M&A Radar 2025: Ukraine (February 2026), the share of transactions with disclosed value decreased from 64% in 2024 to 57% in 2025. Only slightly more than half of transactions disclose their value; lower transparency means fewer public benchmarks and higher information asymmetry between the parties than in mature markets. This makes a fixed “fair price” an especially vulnerable construct and explains the growing demand for contingent mechanisms.

Why Does EBITDA as an Earn-out Base Become a Source of Conflict?

EBITDA becomes a source of conflict because both the numerator and the denominator of the metric depend on judgments, and after closing those judgments are controlled by the buyer. Allocation of group and management costs, transfer pricing of service centers, capitalization of expenses, treatment of extraordinary items, timing of revenue recognition – each of these levers changes EBITDA without changing the economics of the business.

The market has responded by shifting toward more robust metrics. According to SRS Acquiom (outside the life sciences sector), in 2024 approximately 62% of earn-outs were based on revenue and only ~22% on profit or EBITDA. Revenue is harder to “tweak” than EBITDA – but it encourages the seller to sacrifice margin for the top line through discounts and low-margin customers. The choice of metric is the choice of who retains the lever of control after closing.

“Target EBITDA growth is particularly problematic: both the numerator and the denominator are a matter of management judgment at best and manipulation at worst,” – White & Case M&A practice (Building Better Earnouts in the Current M&A Climate, 2025).

What Risks Arise for the Seller After Control Is Transferred?

The seller’s main risk arises not in the price, but in the period after closing: the buyer controls the business and the accounting and has an incentive to depress the metric on which the payment depends. This is not a theoretical construct but a measured effect – academic research documents downward earnings management during the earn-out period, primarily through real operations rather than only accounting entries.

Typical manipulation scenarios:

• Corporate allocation. The buyer transfers the target’s IT, HR, and legal functions to an internal service center at an inflated transfer price; EBITDA falls and the earn-out is wiped out. Countermeasure – ring-fencing and a prohibition on allocating group costs.
• Sales cannibalization. The buyer’s sales representatives sell the buyer’s own products instead of the target’s products (higher commission); the target’s revenue does not reach the KPI. Countermeasure – seller governance rights over the sales function.
• Artificial restraint. The buyer delays marketing and funding until the end of the earn-out period, planning growth only afterward. Countermeasure – an ordinary-course covenant and acceleration.

At the same time, the market protects sellers weakly. According to White & Case, in 2024 around 90% of earn-outs included a reporting requirement and a covenant “not to cause direct harm to the earn-out,” but strong protections are rare: a covenant to operate the business consistent with past practice appears in only ~3% of deals, an obligation to maximize the earn-out in about 5%, and a “commercially reasonable efforts” standard in roughly 10%. Most earn-outs are structurally vulnerable. A further illustration of the balance of power: SRS Acquiom finds that, among earn-outs with at least a partial payment, ~17% required amendment of the terms to avoid litigation.

Which Behavioral Biases Intensify the Conflict Around Price?

Behavioral biases intensify the conflict because the parties defend not only a financial model, but also their own narrative about the business – price becomes a symbol of being right. These biases explain why even good-faith parties do not converge on a point.

• Anchoring. The seller anchors on the maximum multiple; the buyer anchors on the downside scenario.
• Overconfidence. The seller overestimates the probability of EBITDA growth; the buyer overestimates its integration capabilities.
• Loss aversion. The seller perceives a price concession as the loss of future upside and resists it disproportionately.
• Confirmation bias. Due diligence turns into a search for evidence supporting a preselected position.
• Endowment effect. The owner values the business more highly because it is “his” or “her” business, its history, and the owner’s own effort.

An earn-out functions as a behavioral bridge: the seller retains the right to the upside, while the buyer does not pay for it until it is confirmed. But the bridge holds only when the parties trust not each other, but the formula, the reporting, and the control mechanism.

How Does Game Theory Explain the Conflict Through the “Prisoner’s Dilemma”?

Without protective mechanisms, an earn-out reproduces the “prisoner’s dilemma” – a game in which individually rational behavior leads to a collectively worse outcome. The seller can manage honestly or “squeeze” the short-term metric at the expense of sustainability; the buyer can operate the business in good faith or depress the metric. Each party fears the other’s opportunism – and mutual distrust becomes the rational defense.

Base matrix without protective mechanisms (payoffs are conditional, status is an illustrative model; the direction of inequalities is based on the consensus of contract theory):

If defection yields a higher payoff regardless of the opponent’s action (8 > 7 and 3 > 2), then mutual opportunism (D, D) becomes the equilibrium in dominant strategies, even though cooperation (C, C) Pareto-dominates it. This is the core of the problem: it is rational not to trust.

The operational goal of earn-out structuring is to design the payoffs so that honest cooperation becomes the dominant strategy, that is, a Nash equilibrium. Each protective mechanism is an operation on the payoff matrix: accounting discipline and audit rights reduce the buyer’s gain from defection; an objective metric narrows the room for manipulation; acceleration and change-of-control protection remove the incentive to “squeeze”; expert determination makes delaying a dispute pointless; the seller’s involvement in management increases observability.

Matrix with protective mechanisms (defection is punished by penalty/claim):

Now cooperation is the dominant strategy for both parties (7 > 4 and 5 > 1). The purpose of earn-out design is not to force the parties to “trust,” but to change the payoffs so that honest behavior becomes rationally preferable.

Why Does Legal Protection Alone Not Solve the Trust Problem?

Legal protection does not solve the trust problem because it mainly works ex post – after a breach, claim, or lawsuit – whereas incentive alignment must work ex ante by making honest conduct rationally beneficial from the outset. Warranties, indemnities, and escrow protect against past distortions; they do not configure the future behavior of the buyer who controls the metric.

Delaware practice shows the boundary. In Lazard Technology Partners v. Qinetiq (Del. 2015), the court read the earn-out covenant literally: the implied covenant of good faith merely fills gaps and does not rescue a seller who failed to negotiate specific affirmative covenants.

A recent precedent reinforces this lesson while also refining its scale. In Johnson & Johnson v. Fortis Advisors (the acquisition of Auris Health, $3.4 billion upfront plus up to $2.35 billion in earn-out payments tied to FDA milestones), the Court of Chancery awarded the seller more than $1 billion in 2024. On January 12, 2026, the Delaware Supreme Court affirmed the findings of breach of contract and fraud, but reversed the finding of breach of the implied covenant as to the first milestone: the change in the FDA regulatory pathway was foreseeable and had already been allocated by the contract, so there was no “gap” for good faith to fill. After remand, the Court of Chancery’s final judgment (January 2026) amounted to approximately $811 million – still the largest earn-out dispute award in Delaware history.

The managerial takeaway from the updated case law is unambiguous: courts take earn-out covenants seriously, but the seller is protected not by general “good faith,” but by specific obligations and an incentive-compatible metric expressly set out in the contract. That is why the wording becomes the battlefield of years-long disputes.

Earn-outs often turn today’s disagreement over price into tomorrow’s litigation over outcome, – Vice Chancellor J. Travis Laster, Delaware Court of Chancery (Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126, 132 (Del. Ch. 2009)).

How Does This Work in Ukrainian Law?

Ukrainian law does not have a separate legal institution for earn-outs, but the mechanism fits closely into the construct of a правочин з відкладальною обставиною – a legal transaction subject to a condition precedent – under Article 212 of the Civil Code of Ukraine (No. 435-IV dated January 16, 2003). The parties may make the emergence or change of rights and obligations conditional upon a circumstance whose occurrence is uncertain – which is precisely the linkage of part of the price to a future result.

The key point is that Article 212 contains a built-in analogue of anti-manipulation protection. Under part 3, if the occurrence of the circumstance was prevented in bad faith by the party for whom it is disadvantageous, the circumstance is deemed to have occurred; under part 4, if the occurrence was facilitated in bad faith by the party for whom it is advantageous, the circumstance is deemed not to have occurred. This is the Ukrainian legal basis against a buyer depressing the metric and against a seller artificially “inflating” it; the Supreme Court of Ukraine, through its Civil Cassation Court, has already applied part 3 of Article 212 in the logic of the prohibition of inconsistent conduct (venire contra factum proprium).

At the same time, the construct is not self-sufficient. As in the Delaware lesson from Lazard, a general rule of good faith does not replace specific covenants: the metric, the rules for its calculation, restrictions on cost allocation, and control rights must be written expressly. The instrument for governance, audit, and veto rights after the transaction is the corporate agreement – Article 7 of the Law of Ukraine “On Limited and Additional Liability Companies” (No. 2275-VIII dated February 6, 2018): it must be in writing, is confidential, and its parties may include both the company itself and third parties. (The applicability of parts 3-4 of Article 212 to metrics that partly depend on the parties’ conduct requires legal assessment for the specific transaction and does not constitute a legal opinion.)

Practice confirms growing demand. Ukrainian lawyers observe that, under conditions of uncertainty about the future, price arrangements increasingly include provisions on conditional payments linked to the target company’s financial results or other metrics (Marian Mokryk, lawyer in the corporate law practice at Bachynskyi & Partners, Yurydychna Gazeta, 2023). At market level, this is consistent with the dominance of domestic, less public transactions: according to KPMG, in 2025 around half of the market’s disclosed value was accounted for by only three transactions exceeding $100 million.

When Is an Earn-out Useful, and When Does It Create More Risk Than Benefit?

An earn-out is useful when future uncertainty is high, the metric is objective, and the seller remains involved in managing the business; it is dangerous when control over the metric fully passes to the buyer while the metric is manipulable and the seller has weak rights.

Appropriate when: cash-flow uncertainty and information asymmetry are high; the seller’s efforts are critical and the seller remains involved; the metric is objective and weakly manipulable; the degree of integration is low (the business can be operated separately); the parties have different but good-faith forecasts.

Dangerous when: integration is high (costs and revenue are mixed with the group -> EBITDA becomes disputed); the seller exits (no control and no governance rights -> pure hold-up); the metric is easily manipulable; the earn-out exceeds ~40% of total consideration (the risk profile turns into a “bet on someone else’s management”); the term is longer than ~3 years under high volatility.

How Should an Earn-out Be Structured So It Does Not Become a Source of Conflict?

An earn-out does not become a source of conflict when each protective mechanism reduces the payoff from opportunism. It must be designed simultaneously as a financial model, a legal contract, and an incentive system – not “added” at the end of the agreement after the headline price has been agreed. A minimum working checklist:

1. Calculation formula – thresholds, target level, payout curve (linear / tiered / cliff / catch-up), cap and, where necessary, floor; a linear curve is preferable to “all or nothing”; sample calculation as an exhibit to the agreement.
2. Earn-out period – market median is around 24 months (typical range 12-36); long periods (>3 years) intensify both manipulation and “drift” in accounting policy.
3. Metric – selected under the principle of controllability + verifiability: revenue/ARR where revenue risk dominates; EBITDA only with strict accounting safeguards; milestone for R&D/biotech; retention for founder-led businesses; gross margin as a compromise between growth and revenue quality.
4. EBITDA normalization rules – accounting principles fixed in the agreement (not “GAAP/IFRS generally”); consistency with the target’s past practice; list of excluded items; treatment of synergies and integration costs.
5. Restrictions on cost allocation – prohibition on loading the business with group and management expenses; separate accounting (stand-alone reporting) if the KPI depends on autonomous reporting.
6. Operational covenants – ordinary-course covenant; objective efforts standard (“commercially reasonable efforts” with a definition); restrictions on changes to the model, pricing, and restructuring; retention of key employees; minimum sales/marketing/R&D budgets.
7. Prohibition on artificially impairing performance – an explicit anti-manipulation clause (in the Ukrainian context, reinforced by parts 3-4 of Article 212 of the Civil Code of Ukraine).
8. Audit and information rights – regular earn-out reports; the seller’s right to audit the calculation; seller involvement / board observer where the result depends on the seller.
9. Financial protection – caps/floors, catch-up rights, acceleration, and change-of-control protection; restrictions on indemnity set-off against the earn-out.
10. Dispute resolution – independent expert determination for calculation disputes (faster and cheaper than court); separation of roles: expert for calculations, arbitration/court for interpretation; strict deadlines for objection notices and final determination.
11. Consequences of reorganization and integration – pre-agree changes in accounting policy, intra-group M&A, discontinuation of the product/business line (deemed achievement), and integration of the target.
12. Earn-out abuse test before signing – model manipulation scenarios (allocation of HQ costs, aggressive discounts, delayed milestone, revenue pull-forward) and verify that honest cooperation gives both parties no lower payoff than opportunism.

FAQ

What is an earn-out in M&A? An earn-out is the portion of the transaction price that the buyer pays only if the business achieves agreed indicators (revenue, EBITDA, retention, milestone) during the post-closing period. In accounting terms, it is contingent consideration recognized at fair value at the acquisition date (IFRS 3).

Why is the “fair price” of a business not a precise number? Because under uncertainty, value is a range of scenarios. IFRS 13.B40 explicitly defines fair value as the selection of a point within a range, not as an objective number. DCF and multiples do not produce a single price; they formalize assumptions.

How is an earn-out different from a deferred payment? A deferral shifts a fixed amount in time; an earn-out makes the amount itself a function of future performance. It is a derivative on a forecast, not a payment schedule.

What risks does an earn-out create for the seller? After control is transferred, the buyer controls the metric and has an incentive to depress it (cost allocation, operating decisions, timing). Empirical evidence shows downward earnings management during the earn-out period; the average payment is about 21 cents on the dollar.

When is it better not to use an earn-out? Where the business is highly integrated into the group, the seller exits without governance rights, the metric is easily manipulable, the earn-out exceeds ~40% of consideration, or the period exceeds ~3 years under high volatility – in these configurations it amplifies moral hazard and migrates into litigation.

Conclusion

The “fair price” under uncertainty is not an objective point – this is the position of the valuation standards themselves and a consequence of Knightian uncertainty. A point price does not eliminate the range; it merely conceals it. An earn-out is not a price concession, but an instrument for risk design: it moves the conflict from “whose valuation is correct” to “how to allocate future risk,” solving adverse selection before the deal and creating moral hazard afterward.

Therefore, under high uncertainty, deal structure affects value creation more than the agreed multiple. An earn-out reduces risk only when the metric is objective, the seller’s rights are protected, accounting is disciplined, and disputes are resolved cheaply and quickly – that is, when the engineering shifts the game toward a cooperative equilibrium. In the Ukrainian context, with war, currency shocks, and low market transparency, this is especially relevant: enforcement is weak, so private safeguards work better than reliance on court protection. The winner is not the party that more accurately “guessed the price,” but the party that structured the risk better.

The author of the article is Sergey Lipatnikov

Sources

Market data and earn-out practice:

– SRS Acquiom, Deal Terms Study / M&A Claims Insights: ~21 cents on the dollar; ≥28% disputes; ~17% of paid earn-outs with amendments to terms; ~62% revenue vs ~22% EBITDA (2024).

– White & Case, Building Better Earnouts in the Current M&A Climate (2025): covenants 90% / ~3% / ~5% / ~10%.

– The Harvard Law School Forum on Corporate Governance, The Art and Science of Earn-Outs in M&A (2025).

– IVSC, Managing and Communicating Value Uncertainty; A. Damodaran (NYU Stern), Narrative and Numbers.

– Datar, Frankel & Wolfson (2001), JLEO 17(1); Cain, Denis & Denis (2011), JAE 51(1).

Ukrainian market:

– KPMG, M&A Radar 2025: Ukraine (February 2026): 63 deals >$5 million (+26%), $1.2 billion of disclosed value (+17%), average deal $34 million, transparency 57% (down from 64% in 2024); largest deals – MHP/Uvesa (~$300 million), Kyivstar/Uklon ($155 million), Bunge/ViOil ($138 million).

– Yurydychna Gazeta (2023), M. Mokryk, Bachynskyi & Partners: growth of earn-outs in Ukrainian M&A during wartime.

Law and standards:

– IFRS 3 “Business Combinations”; IFRS 13 “Fair Value Measurement” (IASB).

– Civil Code of Ukraine, Article 212 (No. 435-IV dated January 16, 2003) – legal transactions subject to a condition precedent/subsequent; practice of the Civil Cassation Court within the Supreme Court of Ukraine.

– Law of Ukraine “On Limited and Additional Liability Companies,” Article 7 (No. 2275-VIII dated February 6, 2018) – corporate agreement.

– Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126 (Del. Ch. 2009); Lazard Technology Partners v. Qinetiq (Del. 2015); Johnson & Johnson v. Fortis Advisors LLC (Del. 2026, ~$811 million).