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June 13, 2022
By Nicholas P. Flint

Notwithstanding the straggling effects of Covid-19 lockdowns, supply chain issues resulting from a workforce that was incentivized not to return to work, and an economy facing the highest inflation in 40 years, merger and acquisition (M&A) activity in 2022 remains on pace to eclipse last year’s all-time high in closed deal value. The red-hot M&A market is primarily being fueled by private equity investors who are flush with cash and looking for new industries in which to invest.

Unlike strategic buyers (i.e. players already in an industry who acquire a business to increase synergies or eliminate a competitor), private equity buyers in the M&A context typically do not intend to actually operate the companies they acquire. Instead, the private equity model involves a “rolling up” process of acquiring and merging a number of smaller companies in the same industry, leaving the existing operational teams in place, and then selling the consolidated business to a larger private equity firm or institutional investor. Of course, there are variations on the approach, but there is almost always one common denominator: The business owner/seller is expected to remain on board and continue operating the company post-acquisition.

To induce sellers to remain with the acquired company after a deal closes, private equity buyers are increasingly offering sellers rollover equity (i.e. an ownership stake in the consolidated business), lucrative earn-outs, or both. Earn-outs are not anomalous to M&A transactions—they have been around for years, but historically were used as a middle-ground approach when parties could not agree to an up-front purchase price—as opposed to a retention tool. However, given the prevalence of earn-outs in today’s M&A market, the business owner who has been approached by private equity must be aware of the legal implications and key considerations associated with tying up value in an earn-out arrangement.

What are earn-outs?
An earn-out is a payment mechanism providing for a portion of the purchase price for a target business to be calculated and paid to a seller after closing, based on the financial performance of the target company post-closing. Typically, earn-out payments are structured as a number of contingent payments which are payable when specified EBITDA thresholds are satisfied within specified periods. This not only motivates a seller to remain with the business after the acquisition, but it also incentivizes the seller to maximize profits during the specified period post-closing, which frequently aligns with the lifespan of the private equity buyer’s roll up and hold period.

What are some of the key considerations in earn-outs?
When negotiating earn-outs, there are a number of critical issues, both from a legal and a finance and accounting perspective, including the following:

• Determining the earn-out targets of the business post-closing
• Establishing the earn-out time periods and financial metrics to be used
• Setting the payment structure (e.g. all or nothing vs. graduated payments, minimum and maximum payments, and percentage of earnings that is paid) once earn-out targets have been achieved
• Including covenants that require a buyer to operate the acquired business in the ordinary course and in good faith (i.e. to not take any actions with the intent of avoiding earn-out payments)
• Setting forth a formula to calculate earnings and whether earn-out thresholds have been achieved which excludes specified expenses and overhead costs
• Providing a specified time and procedure for the seller to review and object to the buyer’s calculation of whether an earn-out target has been met and the resulting payment
• Including provisions that permit or require the acceleration of earn-out payments upon the occurrence of certain triggering events (e.g. early achievement of a milestone or a sale of the consolidated business)

In today’s deal market more than ever, it is essential for business owners who are considering a sale of their business to retain legal counsel and tax professionals with significant M&A experience. Earn-outs represent just a single example of the vast number of complexities that arise in the context of M&A transactions which, if overlooked, can result in not only a bad deal, but also a legal nightmare.

Nicholas Flint is an associate attorney with Flint, Connolly & Walker, LLP who represents domestic and international clients on a variety of corporate and transactional matters, including mergers and acquisitions, joint ventures, private equity and venture capital transactions, financing and lending arrangements, and debt and equity offerings. Mr. Flint routinely works with accounting professionals and M&A consultants and advisors in connection with his transactional work. In addition, Mr. Flint serves as a general business and legal advisor to his clients, counseling on matters such as corporate governance, executive compensation, regulatory compliance, and commercial contracts.