Earn-Outs in M&A: Key Deal Tool or Source of Post-Closing Disputes?

Introduction

In M&A, agreeing on the purchase price is a crucial part of the deal. However, significant value components often remain uncertain at the time of negotiations, leading to differing valuations by buyers and sellers. This is where earn-outs come into play.

Earn-outs—a form of contingent consideration—are commonly used in private M&A transactions to bridge the valuation gap. These contractual agreements allow the seller to receive additional future consideration if the acquired business meets specified post-closing performance targets, which can be financial or nonfinancial. They can be a particularly useful tool in transactions involving early-stage companies where significant uncertainty and divergent views about future performance and valuation exist.

Earn-outs can help prevent disagreements when negotiating mutually acceptable deal terms. However, if not structured properly, they can become a source of contention between the buyer and seller later and lead to post-M&A disputes. This article explores different types of earn-outs, their benefits, challenges and associated issues that arise in post-M&A disputes. 

B. Types of Earn-Outs

Parties use different varieties and features of earn-outs, depending on the transaction structure and the specific needs of the buyer and seller. Common types include:

Earn-Outs and Post-M&A Disputes 

Despite their benefits, earn-outs frequently lead to disputes over performance measurement and target achievement. Over many years in my role as an M&A investment banker and deal principal, I have gained firsthand experience with the intricacies of devising and negotiating earn-out structures, as well as their post-closing challenges. 

Common Issues With Earn-outs in Post-M&A Disputes

Earn-outs can be complex, prone to ambiguity, and difficult to administer. This can lead to disagreements over the interpretation of the agreed earn-out terms, the performance measurement, and the calculation and timing of the payments owed to the seller. They can also influence how the acquired business is being run, possibly leading to disputes. 

A. Ambiguity in Earn-Out Terms and Differences in Interpretation

Earn-out terms, like other contractual agreements, may contain ambiguous language and be subject to different interpretations. They can also suffer from incomplete coverage of possible scenarios and relevant factors. 

Ambiguous or incomplete earn-out provisions often lead to differing interpretations between the parties over performance measurement and target achievement, resulting in disputes over the earn-out amount and the reasons for any shortfalls.

When using financial metrics, there may be uncertainty about what accounting basis or hierarchy of accounting bases should be utilized. For instance, are the metrics defined in GAAP accounting standards and included in the target’s prior financial accounts, as audited or as prepared for management purposes, or are special-purpose schedules being prepared for the calculation of the earn-out metrics? 

Disagreements also often arise over which income and expenses should be included, adjusted, or excluded in earn-out calculations. The parties may have diverging views on which expenses should be excluded  (e.g., for ongoing litigation or other known factors that were inadequately addressed in the earn-out agreement). In addition, unforeseen events or issues that arise during the earn-out period can further complicate matters and lead to differing interpretations.

Metrics lower in the profit and loss statement, especially those involving more adjustments, are generally more prone to ambiguity in definition and measurement. On the other hand, a revenue or gross profit metric may be a good start and ostensibly more straightforward, but on its own may not properly reflect value creation.

Information asymmetry and lack of transparency can also be major concerns for sellers. In M&A deals, the buyer is usually responsible for tracking and reporting the earn-out performance metrics, leaving the seller with limited access to verify the calculations. This can lead to disputes if the seller suspects that the buyer is misreporting metrics. 

The parties should therefore carefully consider the following accounting areas when designing an earn-out mechanism, to make disputes less likely to arise: 

• It is essential to be clear on the applicable basis of preparation, including to what degree the parties are relying on audited financial statements, specifically prepared schedules; the application of accounting methods consistent with the acquired business’s past practices, any adjustments and the inclusion or exclusion of expected and unexpected specified items.
• Accounting policy choices are another important consideration. For example, under IFRS, entities have the flexibility to choose between alternative accounting treatments in certain areas, such as inventory valuation or depreciation methods. These choices, where management judgment is exercised, can have a significant impact on the earn-out metrics.
• Accounting items that are subject to estimates also require careful consideration when designing an earn-out mechanism. Financial accounting items may require management to make estimates based on available information, such as the useful life of assets and provisions (e.g., for doubtful debts, warranties, restructuring costs or legal claims). Management discretion to determine these estimates (within limits of applicable accounting standards) and their choices can substantially affect the earn-out metrics.
• Revenue recognition is another critical aspect where management may have room to use their judgment in specific situations such as long-term contracts, multiple-element arrangements, and performance obligations. Such judgment can affect the timing and amount of revenue recognition, ultimately impacting reported revenue and profits in the earn-out period.