The Israeli M&A landscape in 2024 demonstrated a strong recovery following a challenging 2023, with deal volume increasing by 24% and deal value rising by 35% compared to the previous year. This resurgence is attributed to macroeconomic stability, a global decline in interest rates, and increased investor appetite for acquisitions, particularly in the technology sector, which remains a dominant force in the Israeli economy.
However, despite these positive indicators, geopolitical volatility continues to shape investment strategies, affecting both investor sentiment and deal structuring. Ongoing conflicts with Hamas in Gaza and Hezbollah in Lebanon, broader regional instability, and rising tensions between global superpowers have introduced heightened risks for investors considering M&A opportunities in Israel.
Considering these challenges, dealmakers are increasingly turning to flexible structuring mechanisms to mitigate valuation uncertainty and post-closing risks. Among these, earnout provisions have gained significant traction, particularly in technology-driven transactions, where future revenue projections are inherently challenging to quantify.
Earn-What?
An earnout is a contractual provision in an M&A transaction that defers a portion of the purchase price, making it contingent upon the acquired business achieving predefined financial or operational milestones within a defined post-closing period.
Unlike deferred consideration, which guarantees payment at a later date regardless of business performance, earnouts introduce contingent consideration, meaning the seller’s additional compensation depends on actual post-closing results.
Earnouts are especially common in industries with high valuation uncertainty, where future growth is difficult to predict. By linking a portion of the purchase price to future performance, earnouts allow buyers to mitigate overpayment risk, while enabling sellers to capture additional value if the business meets expectations.
As further elaborated below, utilizing an earnout mechanism entails significant risks that must be carefully evaluated. For sellers, key risks include the buyer’s control over financial and operational decisions post-closing, financial uncertainty, and potential disputes regarding performance targets, accounting methodologies, or external factors that could delay or reduce payouts. For buyers, key risks include sellers prioritizing short-term performance to meet earnout targets, potentially at the expense of long-term business stability, as well as challenges in effectively integrating the acquired business.
Earnouts in the Israeli M&A Market
Prolonged geopolitical instability in Israel and the Middle East, coupled with macroeconomic fluctuations and sector-specific downturns, complicates investments, particularly for foreign investors. Despite these challenges, Israeli M&A remains resilient, with dealmakers increasingly adopting flexible structuring mechanisms to mitigate risk and facilitate transactions.
As the ‘Startup Nation,’ Israel is home to numerous advanced technology startups, where future revenues are difficult to predict. Earnout mechanisms help bridge valuation gaps by tying part of the purchase price to post-closing performance, aligning the interests of buyers and sellers.
Given the region’s volatility and Israel’s dynamic tech ecosystem, earnouts have become especially relevant in Israeli M&A, offering a structured approach to managing valuation uncertainty and post-closing risks. Although precise data on earnout usage in Israel remains elusive, their prevalence in volatile market conditions suggests they have become a standard feature of deal negotiations.
Key Considerations for Buyers and Sellers in Earnouts
Earnouts offer both opportunities and risks, requiring careful structuring to align incentives and minimize potential disputes. While sellers perceive earnouts as a means to maximize post-closing value, buyers rely on earnouts to mitigate valuation uncertainty and reduce upfront costs. However, the inherent tension between these objectives can create challenges, particularly when it comes to post-closing decision-making, financial reporting, and the integration of the acquired business into the buyer’s operations.
In light of these challenges, it is crucial that legal counsel specializing in M&A be involved from the earliest stages of negotiations, starting with the memorandum of understanding or term sheet, to ensure that the earnout mechanism is properly structured, mitigating risks and avoiding unintended financial, operational, and legal consequences.
4.1. Sellers’ Considerations
A key risk for sellers is buyer control over post-closing financial and operational decisions, which may impact earnout payments. Buyers may adjust accounting policies to defer revenue recognition, reallocate expenses to the acquired business, or delay major contracts until after the earnout period, artificially reducing reported performance. These actions can diminish or eliminate earnout payouts, making it essential for sellers to negotiate safeguards that ensure fair measurement of performance.
To protect against these risks, sellers must actively negotiate specific safeguards in the transaction agreement. These may include audit and information (and perhaps even inspection) rights, enabling the seller to review relevant buyer materials for accurate earnout calculations, as well as operational covenants that restrict significant business changes affecting the earnout.
Another challenge for sellers is the uncertainty surrounding the timing and reliability of earnout payments. Even if performance targets are met, disputes over milestone achievement, accounting methodologies, or unforeseen external factors may delay or reduce the final payout. To mitigate these risks, sellers often secure escrow arrangements, where a portion of the earnout funds is held by a neutral third party until certain conditions are met. Parent company guarantees are also commonly used to ensure that a financially stable entity backs earnout obligations.
4.2. Buyers’ Considerations
Buyers must carefully manage the risks associated with earnouts, particularly the potential for sellers to prioritize short-term financial performance over long-term business health. Since earnout payments depend on specific metrics, sellers involved post-closing may use strategies that temporarily boost results but harm the business’s future, such as aggressive discounting, delaying capital expenditures, or cutting investments in product development and marketing.
To counteract these risks, buyers should structure earnouts to encourage sustainable growth rather than short-term gains. This can be achieved by incorporating multi-year performance milestones, balancing financial and operational metrics, and retaining oversight over major business decisions that could impact long-term stability. Aligning incentives with the target business’ success helps prevent distortions and ensures a smoother post-closing transition.
Another challenge for buyers is the impact of earnouts on post-closing integration, particularly when standalone performance metrics limit their ability to implement strategic changes or realize synergies. If the acquired business must operate independently to meet earnout conditions, operational flexibility may be restricted. Buyers can mitigate this by structuring earnouts to allow phased integration.
4.3. Aligning Buyers and Sellers Incentives for Long-Term Success
The key challenge in earnout negotiations is not just mitigating risks but actively designing mechanisms that foster collaboration and align financial outcomes with the long-term success of the business. To ensure fair treatment, sellers must negotiate for transparent performance metrics, consistent financial reporting standards, and reasonable operational oversight to prevent artificial suppression of results. Buyers, on the other hand, must ensure that earnout structures do not incentivize short-term revenue maximization at the expense of long-term sustainability.
Furthermore, post-closing disputes, particularly when the buyer does not acquire full ownership, can delay payments, increase costs, and disrupt operations. To mitigate such risks, earnout provisions should include clear, objective financial criteria and well-defined dispute resolution mechanisms. Many agreements require arbitration or an independent forensic accountant to ensure neutrality, avoid litigation, and preserve both business continuity and the integrity of the earnout structure.
Additionally, earnout arrangements must account for potential exit scenarios, such as a change in control of the buyer or a material shift in business operations. Many agreements include acceleration clauses that require immediate payment of the earnout if the buyer is acquired or significantly alters the business model. These provisions provide sellers with greater certainty while allowing buyers to retain necessary flexibility in case of strategic realignment.
Ultimately, when structured correctly, earnouts can facilitate smoother post-closing integration, foster mutual confidence in business performance, and create more substantial long-term value. The most effective earnout mechanisms incorporate tiered payout structures, weighted performance indicators, and governance provisions that prevent manipulation on either side.
Structuring Earnout Provisions
A well-structured earnout aligns incentives, mitigates risks, and ensures fair post-closing performance measurement. Building on the buyer and seller considerations discussed earlier, this Section outlines key structural elements – performance metrics, duration, payment mechanisms, and post-closing control – that determine an earnout’s effectiveness:
· Performance Metrics: The choice of performance metrics determines payment conditions. Financial metrics like revenue, net profit, or EBITDA are the most common due to their relative clarity and ease of measurement. In certain industries, non-financial metrics are equally relevant. In fintech, life sciences, healthcare, and pharmaceuticals, earnouts may be tied to regulatory approvals or clinical trial results. In technology and SaaS, they may depend on customer acquisition, recurring revenue growth, or product development milestones. Defense and aerospace may be contingent on securing government contracts, meeting compliance standards, or achieving specific technological advancements. Given the wide range of potential performance metrics across industries, earnout structures offer significant flexibility and can be tailored to the transaction’s specific needs.
· Duration: Typically, earnouts last between one and five years following the completion of the transaction, depending on industry-specific factors and the level of uncertainty surrounding future performance. In Israeli technology M&A transactions, earnout periods are often limited to one to three years to reflect the sector’s rapid pace of change and frequent market disruptions. Usually, buyers prefer shorter earnout periods to ensure price certainty and complete control over the business. Prolonged earnouts may restrict strategic flexibility, delay integration, and create conflicts over operational priorities. In some cases, an earnout period may be extended as a remedy period if targets are not met, allowing sellers additional time to achieve milestones. However, buyers generally limit such extensions to avoid prolonged uncertainty.
· Payment Structures: Earnout payments can be structured in different ways to reflect the specific needs of the transaction and the earnout period. Some agreements use a binary structure, where payments are made only if a particular milestone is met within the earnout period. In contrast, sliding-scale earnouts provide incremental payments based on varying performance levels, ensuring that sellers receive at least partial compensation even if targets are only partially met. Another common approach is the use of cliff-based earnouts, in which a lump sum is paid if a specific threshold is reached, but nothing is paid if performance falls below that level.
· Post-Closing Control: Earnout provisions must strike a careful balance between buyer flexibility and seller protection, as post-closing decisions can significantly impact earnout outcomes. Buyers seek the autonomy to operate and integrate the acquired business as they see fit, while sellers aim to ensure that performance metrics are not artificially suppressed through discretionary financial or operational changes. These competing interests and considerations underscore the importance of structuring earnouts in a way that aligns incentives and minimizes potential disputes.
Valuation-Related Considerations
Determining the transaction value in M&A deals is a complex process with significant financial, tax, and regulatory implications. The inclusion of earnout provisions may further complicate valuation, as contingent payments impact not only the deal structuring but may also have implications on other deal-related aspects such as tax liabilities, insurance premiums, reporting obligations, etc.
6.1. Tax Treatment of Earnout Payments
Naturally, under Israeli tax laws, the sale of corporate rights constitutes a taxable event, generally triggering tax liability based on the total consideration stipulated in the transaction. However, when a portion of the consideration is contingent on future performance, its classification as either deferred consideration or contingent consideration may impact the timing of taxation of such future consideration, and such classification may result in the future consideration being taxed before the receipt thereof.
The Israeli Tax Authority’s Circular 19/2018 provides guidance on the tax treatment of such payments. Deferred consideration – a fixed and ascertainable amount payable at a later date – is generally taxed at signing, even if the funds are received later. Contingent consideration, which depends on future events, is typically taxed only when received, unless it falls into specific predefined categories that the ITA considers deferred payments, including:
· Regulatory Approvals – Consideration withheld pending regulatory approvals (e.g., Antitrust Authority, Bank of Israel).
· Near-Certain Conditions – Payments contingent on conditions highly likely to materialize.
· Fixed Consideration with Uncertain Timing – Predefined payments are not subject to external conditions but lack a set payment date.
· Non-Cash Consideration – Earnouts paid in assets (e.g., intellectual property, equity) rather than cash, even if the valuation is complex.
· Reliably Estimable Earnout – Transactions where an earnout can be reasonably estimated at signing, even if the exact figure remains undetermined.
· Escrowed Consideration for Representations & Warranties – Funds are held in trust to secure the seller’s representations, provided that the release is not linked to business performance.
In cases where earnout payments are truly contingent – i.e., dependent on achieving operational or financial milestones – sellers may defer capital gains tax until the payment is received or becomes determinable. However, tax liabilities are still calculated as of the original sale date, potentially affecting applicable tax rates and available deductions.
Given these complexities, buyers and sellers must carefully structure earnout provisions to avoid misclassifying contingent consideration as deferred consideration, ensure compliance with Israeli tax regulations, and optimize the transaction’s financial and cash flow implications. Impact on Representations & Warranties Insurance (RWI)
In M&A transactions, in Israel and globally, Representations & Warranties Insurance (RWI) is commonly used to protect against financial losses from breaches of contractual representations. The premium is usually a derivative of the transaction value/enterprise value, as the transaction value increases, the premium will typically rise accordingly. This directly influences the insurance premium, making the treatment of earnouts a key factor in policy pricing. RWI premiums are typically calculated as a percentage of the insurance coverage amount. Premium rates vary, ranging from 1–2% in European transactions to 3% or more in U.S.-style deals.
If an earnout payment is classified as contingent and uncertain, parties may negotiate its exclusion from the insured transaction value, thereby reducing the premium. However, if the earnout is structured as a deferred but certain payment, insurers may include it in the total insured amount, which may result in an increased premium. Given that normally, the premium is shared by the seller and the buyer, this matter may be of interest to both parties. This distinction highlights the strategic importance of how earnouts are structured in negotiations with insurers.
6.2. Transaction Reporting in Israeli Public Companies
Israeli public companies are required to disclose significant transactions, ensuring transparency for investors and regulatory compliance. The inclusion of contingent consideration in the transaction value can influence whether a deal qualifies as a “material event” requiring immediate disclosure.
Reporting obligations generally apply to transactions that materially impact the public company’s financials, business operations, or capital structure. If contingent payments represent a substantial portion of the deal value, their treatment may affect how the transaction is reported relative to the public company’s revenue or market capitalization.
Accurate valuation and transparent disclosure of earnout provisions are critical in maintaining investor confidence and meeting regulatory standards. Public companies must carefully assess whether to include earnout payments in initial transaction announcements or disclose them separately upon realization.
Conclusion
Persistent geopolitical instability, economic unpredictability, and rapid industry shifts have made valuation increasingly challenging in Israeli M&A transactions. These difficulties are further compounded by macroeconomic fluctuations, market corrections, and evolving regulatory landscapes, particularly in high-growth sectors. As a result, earnouts have become an essential structuring tool, helping bridge valuation gaps by allowing buyers to mitigate risk while enabling sellers to maximize deal value based on actual post-closing performance.
Nonetheless, while earnouts offer significant advantages, they also introduce complexity and can be a significant source of post-closing disputes. A well-structured earnout requires more than just clearly defined performance metrics, it demands a balanced approach that protects both parties’ interests while preserving operational flexibility. Considering the intricacies involved, the early involvement of experienced M&A legal counsel is essential to structuring earnouts that align with both business and regulatory considerations, reducing potential disputes, and ensuring smooth execution.
As Israeli M&A activity continues to expand, earnouts are likely to remain a key feature in deal structuring. However, as transactions grow more complex and regulatory scrutiny intensifies, buyers and sellers must take a strategic, forward-thinking approach to ensure earnouts enhance value creation rather than become a point of contention. By prioritizing clarity, fairness, and long-term alignment, parties can leverage earnouts effectively, transforming them from a risk-mitigation tool into a driver of sustainable success.
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