The pricing challenge
How much is a property worth when it is still being developed or is still going through the licensing process, or when it has potential for renovation or its future occupancy is uncertain? How can you make sure that the purchase price reflects the asset’s true potential?
These are common questions in real estate transactions, and the answers are rarely straightforward.
The difficulty in setting a fair price often stems from the many unpredictable factors that affect the property’s value and the level of trust between the parties. It is precisely in this context that earn-outs have become a valuable strategic tool to create value, reduce risk and help the parties reach agreement.
Dynamic valuation
When the seller and buyer cannot agree on the value of a transaction, an earn-out mechanism can be an effective way to break the deadlock.
This contractual tool allows part of the purchase price to be deferred, with payment being made only if certain future objectives are met. These objectives are usually linked to the performance of the property or the target company. Therefore, the full transaction value is only paid if and when the agreed objectives are met.
For example, in a transaction involving the sale of a newly built office building, the seller seeks to maximise the sale price based on the expectation of full occupancy.
The buyer, on the other hand, seeks to mitigate the risk of actual occupancy being lower than projected. This safeguards them from the possibility of the asset being overvalued, and consequently from paying a price that is out of line with its real value.
They therefore agree on a base price of €10 million, to be paid on the closing date of the transaction, supplemented by an earn-out of up to €2 million. This will be determined based on the property's occupancy rate in the six months following the transaction. The maximum earn-out amount is payable if the property is fully occupied, with proportional adjustments down to a minimum threshold of 30%, below which no additional payment is due.
If full occupancy of the building is confirmed at the end of the six-month period (Scenario A), the buyer must pay the maximum earn-out amount, bringing the total transaction value to €12 million. In Scenario B, where the building is 40% occupied, the earn-out is adjusted proportionally, resulting in an additional payment of €800,000 and a total price of €10.8 million. In Scenario C, if occupancy reaches only 20%, the price remains at the €10 million paid on the closing date (without earn-out).
This simple illustration shows how this mechanism aligns incentives, expectations and positions. It bridges differing perspectives by reducing the buyer’s risk of overpayment while allowing the seller to retain the property's potential for added value.
Legal validity and due diligence
The earn-out clause is generally classified as an improper suspensive condition. Unlike a traditional suspensive condition, where the effects of the contract are suspended until the event occurs, an earn-out contract takes effect upon signing. However, part of the purchase price only becomes payable once a future and uncertain event takes place.
The validity of the earn-out clause depends, in particular, on the following legal requirements:
a) Determinability: The price cannot be undetermined or undeterminable. In other words, it must be possible to calculate the price based on clear, objective, and pre-defined factors, even if these depend on future and uncertain events. The formula used to calculate the earn-out must allow for the price to be determined precisely once the condition is fulfilled.
b) Non-discretionary: The earn-out clause cannot depend solely on the will of one of the parties. To ensure its validity and effectiveness, the definition and application of the earn-out must be based on objective and verifiable criteria, rather than vague and open-ended promises of future negotiations (“agree to agree”).
c) The possibility and legality of the object: An earn-out is only valid if it is associated with lawful objectives or conditions, and it must not depend on facts or behaviour that are contrary to the law. Furthermore, it must not contravene any applicable mandatory rules, such as those for the protection of creditors.
d) Formal requirements: If an earn-out is included in a contract that requires a special legal form, such as a public deed, the earn-out clause must be expressly included in the text of the deed and must comply with the same formal requirements as the contract itself.
This analysis highlights the close relationship between legal validity and commercial practice. The strength and effectiveness of an earn-out depend not only on its theoretical classification but, above all, on its practical implementation.
The due diligence phase therefore plays a crucial role in negotiating an earn-out. This is when the assumptions and metrics that underpin the contingent payment are examined. A thorough review of the financial, operational and legal data of the target company or the property makes it possible to identify material risks, to validate the assumptions behind the earn-out and ensure that the agreed objectives are both realistic and measurable.
Careful preparation also requires a clear definition of performance indicators, the selection of assessment periods that reflect the asset’s dynamics, and the identification of external factors that could affect the achievement of targets. Gathering and verifying historical and projected information is essential to ensure the mechanism works effectively.
Between theory and practice
Negotiating and drafting earn-out clauses can be complex, given the difficulty of predicting future events and accounting for all the factors that influence the agreed targets.
As a rule, the seller loses operational control of the asset but retains a strong economic interest in its performance. The buyer, meanwhile, who takes ownership and control, may have an incentive, or even a temptation, to limit the payment of the earn-out. This tension shows that, at the end of the day, the effectiveness of an earn-out ultimately depends as much on careful drafting as on the level of trust between the parties.
Indeed, despite its advantages, the earn-out often leads to litigation between the seller and buyer. It is therefore advisable to adopt good practices to reduce this risk. These include:
a) Clear and objective indicators: Agree on measurable, factual and precise targets, such as turnover, EBITDA, operating cash flow, or specific milestones (e.g. obtaining licences, completing works or starting operations). International practice increasingly favours hybrid structures that combine financial and operational indicators, for instance, completion of the property’s refurbishment works within the agreed deadlines and specifications, and the achievement of a minimum EBITDA.
b) Explicit mathematical formulas: Use clear, objective and, wherever possible, directly applicable calculation formulas to avoid any scope for subjectivity.
c) Timeframes and quantitative parameters: Define the earn-out period and set limits (caps or floors) on its value.
d) Behavioural aspects and moral hazard: Include clauses that restrict each party from engaging in opportunistic conduct after completion, aimed at undermining the achievement of the targets that determine earn-out payments, such as:
e) Dispute resolution: Include arbitration or expert determination clauses that clearly define the competent authority and the scope of the appointed third party’s role, with the same degree of precision and rigour applied to defining and assessing the earn-out metrics.
Within the scope and creativity of commercial negotiation, an earn-out can take many different forms, including vesting mechanisms, call or put options, step-in or lock-in clauses, or even the continued involvement of the seller’s commercial team with the asset – at least until the end of the earn-out period. Hybrid structures are also possible, combining fixed and variable components, different payment frequencies (e.g. quarterly, annual or bullet payments) and staggered timeframes.
The earn-out arrangement can also be enhanced with complementary clauses, such as:
More than just price: a value-enhancing tool
An earn-out can be a very useful mechanism for adjusting the price of a transaction according to the future performance of real estate assets. It sits alongside other options such as: (i) simple price retention (holdback); (ii) the deposit of conditional amounts in escrow; and (iii) price adjustment clauses. The suitability of an earn-outs or any of these alternative solutions should be carefully assessed in light of the specific features of each transaction.
In recent years, the use of earn-outs in real estate transactions has evolved significantly, both in Portugal and internationally. Parties are increasingly turning to bespoke metrics tailored to the nature of the asset and the business context, as well as to stronger monitoring and audit mechanisms. The earn-out has moved beyond being merely a price adjustment tool to take on a strategic role in risk management and in aligning the interests of buyer and seller.
Its effectiveness depends on clear drafting, the definition of predictable indicators, and the existence of mechanisms that ensure security and certainty in implementation. Beyond the financial metrics, it is also essential to consider the ongoing relationship between the parties and the potential for moral hazard.
When well-structured and drafted, the earn-out ceases to be seen as a potential risk and becomes a strategic advantage – a genuine tool for creating and unlocking value in real estate transactions.