This post kicks off a running series of thoughts we’ll be sharing on earn-outs.  But first, some basics.

Earn-out provisions appear to solve several problems in the M&A space: they might provide the grease needed to close a sticky transaction, easing a buyer’s concerns over the target’s strategic fit or expected performance.  They could also alleviate financing pressure by reducing the buyer’s cash at closing requirements. 

But their initial superficial appeal is often overshadowed by the difficult realities of enforcing these agreements over time.  Despite the lofty goal of attempting to align the buyer’s and seller’s interests post-closing, they are just as likely to foster sharp disagreement over missed expectations or to engender more threshold problems such as definitional debates over whether those expectations were even met in the first place.

On occasion, they work.  Very often, they don’t.  While intended to bridge valuation gaps, earn-out agreements very often trigger the costly disputes they were intended to avoid, spawning fights over valuation metrics or unresolved questions as to just what the required thresholds really are:

  1. Post-Acquisition Realities: No amount of pre-closing drafting and planning can account for unforeseen integration challenges or real-world external events that could hamper the target’s performance.
  2. Allegations of Interference: Targets often accuse the buyer of carrying on a course of conduct that itself hinders the expected performance and thus appears to justify the buyer’s withholding of arguably earned payments.
  3. Ambiguous Metrics: despite careful drafting, the performance criteria outlined in the agreements often turn out to be vague or disputable when played out in reality.
  4. Accounting Disputes: Varied accounting practices themselves may lead to conflicting performance calculations, even where a specific accounting firm is designated or a particular accounting convention is specified.
  5. Material Adverse Changes: Unforeseen shifts in the firm, the industry or the larger economy are likely to impact business performance and spawn disagreements over whether the earn-out requirements could have been made in that climate.

It’s tempting and rather facile to argue that earn-out disputes can be solved if only the parties committed themselves to better drafting early on, at the documentation stage.  But the most experienced transactional counsel, who have been drafting sophisticated earn-outs for years if not decades, are still capable of failing to predict just what operational or mechanical difficulties will impede unambiguous acceptance by both sides of whether the requisite thresholds were met. 

It goes without saying that earn-out agreements should be carefully crafted to minimize ambiguity.  And that exhaustive pre-deal investigations is essential to mitigate potential conflicts.  Indeed, several other basic protections are necessary – but not sufficient – conditions to guard against outright failure for missing any predictable problems that would inevitably eviscerate the value of an earn-out:

  • Documented Tracking is needed to put in place robust performance systems and generate transparent progress reports along the way;
  • Open Communication is key to prevent simple misunderstandings; and
  • Mediation or Arbitration dispute resolution mechanisms are helpful to manage the parties’ control over the timing and confidentiality of any resolution procedures and can even help deter protracted litigation or arbitration by reining in the parties’ choice of forum and manner of litigating any dispute.

But thorough attention to all of these considerations is still not enough to ward off conflict.  We are hard put to find any credible M&A lawyer willing to an earn-out provision is unassailable and guaranteed to work without controversy.  The better questions to ask during the negotiation stage isn’t whether litigation will ensure over an earn-out, but when, and how costly and protracted it might be.

Indeed, the sooner the parties accept the likelihood that litigation will follow from an earn-out clause, the better their expectation management will be.  Whatever early promises of alignment and cooperation an earn-out may tantalize the parties with, those hopes are often dashed by performance and market factors – as well as basic linguistic disputes over the contractual terms – knocking the well-planned merger off course.  Yes, there are strategies to mitigate some risks, and very often there’s no better alternative to an earn-out provision, but it’s always best to go eyes wide open into the post-acquisition venture, understanding that the can of initial conflicts may have simply been kicked down the road while the closing is able to proceed. 

There’s no shame — and often no alternative — to walking through a rainstorm, but forgetting your umbrella is an unforced, unnecessary mistake that doesn’t take too much forethought and planning to avoid.

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Photo of Steve Hecht Steve Hecht

Steve Hecht is a go-to trial lawyer for hedge funds, institutional investors, family offices, university endowments, venture funds and other investors interested in utilizing the legal process to create value for their own investors. Whether by activist litigation, fiduciary duty claims, or appraisal…

Steve Hecht is a go-to trial lawyer for hedge funds, institutional investors, family offices, university endowments, venture funds and other investors interested in utilizing the legal process to create value for their own investors. Whether by activist litigation, fiduciary duty claims, or appraisal and other valuation strategies, Steve has extensive experience across the gamut of options for shareholders.  He regularly tries cases in Delaware Chancery Court and around the country for clients seeking outsized returns. Steve is a partner of Rolnick Kramer Sadighi LLP.