Insights

By: Scott A. Schonfeld

Valuation gaps are a defining feature of middle-market M&A transactions. Buyers price risk conservatively, discounting forward-looking projections and underwriting downside scenarios, while sellers—armed with historical performance and growth trajectories—seek compensation for value they believe is already embedded in the business. To bridge this divide, transactions increasingly employ “earn-out” provisions: contractual mechanisms that defer payment of a portion of the purchase price and condition payment of it upon the post-closing performance of the acquired business (typically measured by revenue, EBITDA, gross profit, or other financial or operational metrics).

Earn-outs are no longer exotic deal features. In 2023, approximately twenty-six percent (26%) of middle-market transactions (generally defined as deals with enterprise values between $30 million and $750 million) included an earn-out component, a six percent (6%) increase from 2021. [1][2] But the same structural features that make earn-outs attractive also make them inherently susceptible to dispute. Publicly available M&A dispute surveys consistently show that a substantial percentage (up to 26%) of earn-out transactions end up in formal post-closing disputes. [3]

The cause of such disputes should not come as a surprise to any experienced dealmaker.

Upon closing, operational control of the acquired business shifts entirely to the buyer, while a material portion of the seller’s consideration remains vulnerable to how that buyer chooses to operate, integrate, account for, and report on the acquired business. Earn-out consideration—ever sensitive to the buyer’s accounting judgments, cost allocations, revenue recognition practices, and strategic prioritization—can be diluted, deferred, or effectively engineered out of existence through the buyer’s post-closing decisions and operation of the business.

For sellers, the “parade of horribles” plays out as follows: the transaction closes, the target company actually performs during the earn-out period, and yet the seller never actually receives any (or a material portion of its) earn-out consideration.

This risk can be mitigated, but only through careful and detailed drafting and negotiation during the preparation of the definitive transaction documents. Four areas, in particular, require every Seller’s careful attention, and this article details each:

(i) the definition of earn-out metrics and governing accounting principles;

(ii) post-closing operational covenants;

(iii) information and dispute-resolution mechanics; and

(iv) the strategic use of earn-out floors and caps.

We should note that, in the current landscape, obtaining many of these protections represents an extremely uphill challenge.  Thus, it does bear some emphasis that the below measures are, collectively, something of a Seller “wish list” rather than a comprehensive and prescriptive set of protections which every Seller must “get” in its deal documents in order to have adequately protected itself.  Still, every Seller should exhaust every avenue in obtaining the below measures before relenting.  As such, we advise that prudent Sellers prioritize obtaining any number of these protections and consult with counsel in determining the likelihood of obtaining such protections.

I. Defining Earn-Out Metrics with Precision and Accounting Consistency

The single most important protection for a seller is the elimination of ambiguity in how the earn-out is ultimately calculated during the earn-out period. Vague references to “GAAP,” “EBITDA”, or loosely described revenue concepts create opportunities for post-closing disputes. We recommend, wherever possible, the inclusion of any specific nuances related to the Seller’s business and the use of numerical examples.

Every commonly used earn-out metric is vulnerable to dispute:

• Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”) can be depressed through overhead allocation, management fees, integration expenses, transfer pricing, and reclassification of operating costs.
  • E.g., a buyer might choose to allocate corporate overhead costs (such as executive salaries, legal fees, or IT infrastructure expenses) to the acquired business where such expenses were not historically charged to it (and rightfully belong to other affiliate and/or parent entities), thereby artificially reducing reported EBITDA and the corresponding earn-out payment.
• Gross profit can be affected by changes in sourcing, inventory valuation, and cost capitalization.
  • E.g., a buyer might change the business’s inventory valuation method from first-in-first-out (FIFO) to last-in-first-out (LIFO) during an inflationary period, increasing cost of goods sold and reducing gross profit, or might reclassify certain direct labor costs as overhead expenses that are excluded from the gross profit calculation.
• Revenue can be distorted through credit policy changes, shipment timing, “channel stuffing”, return reserves, and modifications to recognition practices.
  • E.g., a buyer might tighten credit approval standards, resulting in fewer sales being recognized during the earn-out period, or delay shipments until after the earn-out period ends (commonly known as “channel stuffing”), or increase return reserves based on overly conservative assumptions, all of which would reduce recognized revenue.

Accordingly, Sellers should insist that for the following protections (which include illustrative sample language for each such item):

1. Accounting Lockbox. The Accounting Principles governing such earn-out should be carefully defined.
   • Accounting Principles means United States Generally Accepted Accounting Principles as in effect on the Closing Date, applied on a basis consistent in all material respects with the historical accounting practices, policies, procedures, methodologies, and classifications used by the Business during the twelve (12) month period immediately preceding the Closing Date (the “Historical Accounting Practices“), as set forth on Schedule [●], and without giving effect to any changes in accounting policies, interpretations, methodologies, estimates, or classifications adopted by Buyer or any of its Affiliates after the Closing Date.
2. Enumerated Adjustments Only. Any adjustments to be used by the Buyer should be pre-negotiated before the Closing and, ideally, scheduled.
   • No costs, expenses, reserves, accruals, or charges shall be included in the Earn-Out Calculation other than those expressly set forth on Schedule [●], and no adjustments shall be made except as specifically provided therein. Without limiting the foregoing, the Earn-Out Calculation shall exclude all (i) transaction expenses, (ii) integration and reorganization costs, (iii) purchase accounting adjustments, (iv) affiliate management or monitoring fees, and (v) non-recurring or extraordinary items.
3. Intercompany and Overhead Protections. Similarly, Sellers should spell out precisely what types of intercompany and/or shared services allocations can be allocated to the target.
   • All intercompany charges, transfer pricing arrangements, shared services allocations, corporate overhead allocations, and any other costs or expenses allocated to or charged to the Business by Buyer or any of its Affiliates shall be charged to the Business only to the extent such charges are: (a.) consistent in type, methodology, and amount with the Historical Accounting Practices; (b.) calculated using the same allocation methodologies, bases, and rates used during the twelve (12) month period immediately preceding the Closing Date; (c.) no less favorable to the Business than those charged to Buyer’s other operating units of similar size, revenue, and business model (with supporting documentation to be provided upon Seller’s request); and (d.) commercially reasonable and at arm’s length rates. Any charges that do not satisfy all of the foregoing requirements shall be excluded from the Earn-Out Calculation.
4. No Unilateral Changes. During the earn-out period, the Buyer cannot unilaterally change its accounting or revenue recognition policies.
   • Buyer shall not change any accounting methods, revenue recognition policies, capitalization policies, or reserve methodologies of the Business during the Earn-Out Period without Seller’s prior written consent, which may be withheld in the Seller’s sole and absolute discretion.

II. Operational Covenants and Efforts Standards

Because the seller surrenders control of the business at closing, operational covenants are the only mechanism by which the seller can meaningfully police the buyer’s post-closing conduct. Sellers should push for “best efforts” covenants where leverage permits and, at a minimum, tightly defined “commercially reasonable efforts” standards.[4]

We note that, in the current M&A environment, buyers are typically extremely hesitant to provide substantial and expansive operating covenants.  Thus, we concede that it may well be that Sellers must accept limited and constrained “commercially reasonable efforts”-based operating standards.

Any such covenant must ultimately be carefully and tightly operationalized. Courts defer to the buyer’s judgment absent explicit contractual constraints. Accordingly, seller-favorable agreements tie efforts obligations to concrete prohibitions and affirmative duties imposed on the Buyer, such as:

• Minimum staffing and budget covenants.
• Non-diversion of customers, contracts, and key personnel.
• Restrictions on pricing, discounting, and credit policy changes.
• Limitations on integration, consolidation, and business model changes.

 

A very robust Seller-side operational covenant intended to maximize the Seller’s earn-out might read:

Seller-friendly agreements should also include anti-sandbagging language:

III. Information Rights and Dispute Resolution

Given the frequency of earn-out disputes, sellers should draft as though litigation or expert proceedings are inevitable. Key seller-protective features include the following (along with illustrative sample language for each):

1. Certified, Burden-Shifting Statements.
   • Buyer shall deliver a detailed Earn-Out Statement, certified by its Chief Financial Officer as true, correct, and complete, and prepared in accordance with the Accounting Principles. The burden of proving the accuracy of the Earn-Out Statement shall rest with Buyer.
2. Expansive Audit Rights.
   • Seller and its Representatives shall have full access to all books, records, working papers, source systems, and personnel reasonably related to the Earn-Out Calculation, and Buyer shall cooperate fully in any audit or review.
3. Tolling of Objection Periods.
   • The Seller’s objection period shall not commence until Buyer has delivered a complete Earn-Out Statement together with all supporting documentation reasonably requested by Seller.
4. Expert vs. Court Carve-Out.
   • Disputes solely concerning the mathematical application of the Accounting Principles shall be resolved by an independent accounting firm acting as expert. All disputes concerning compliance with operational covenants, efforts standards, or bad faith shall be resolved by arbitration or court, and the accounting expert shall have no jurisdiction over such matters.

IV. Floors and Caps

Sellers should seek both economic protection via a “floor” for its downside, as well as flexibility to the extent that Buyer’s conduct has artificially depressed the actual earn-out achieved:

Caps can also be paired with anti-manipulation language:

V. Conclusion

Earn-outs are critical for capturing the full value of a business, especially when buyers and sellers differ in evaluating the value of the business at Closing. The economic value of an earn-out depends almost entirely on how aggressively the seller constrains buyer discretion after closing. Sellers who rely on vague language leave money on the table and themselves vulnerable to post-closing disputes which occur with startling frequency.

For sellers, protection comes from detailed covenants, defined and clear metrics, rigorous audit rights, bifurcated dispute resolution, and economic floors and caps.

For middle-market sellers, it is essential to front-load these conversations. Thoughtfully negotiated earn-out provisions not only bridge valuation gaps between buyers and sellers but also ensure that the value the seller built up is fully recognized, protected, and realized. A well-structured earn-out turns years of the seller’s work into a reasonably secure post-closing stream of income, rather than a gamble on the buyer’s discretion. If you have any questions regarding an earn-out provision, please call or email Scott Schonfeld at Fox Swibel Levin & Carroll LLP.

 

[1] American Bar Association Business Law Section, 2023 Private Target Mergers & Acquisitions Deal Points Study (Dec. 18, 2023), https://www.bassberry.com/news/2023-aba-deal-points-study

[2] Grant Thornton LLP, M&A Dispute Survey 2023 Report (2024), https://www.grantthornton.com/content/dam/grantthornton/website/assets/content-page-files/advisory/pdfs/2024/ma-dispute-survey-2023-report.pdf (PDF).

[3] Grant Thornton LLP, Survey: M&A Deals and Disputes Are on the Rise (Dec. 7, 2023), https://www.grantthornton.com/insights/press-releases/2023/december/survey-ma-deals-and-disputes-are-on-the-rise?

[4] We note that, in the current M&A environment, buyers are typically extremely hesitant to provide substantial and expansive operating covenants.  Thus, we concede that it may well be that Sellers must accept limited and constrained “commercially reasonable efforts”-based operating standards.

 

Scott A. Schonfeld

Scott Schonfeld is a partner in the Corporate & Securities Group and Co-Chair of the Real Estate Group. He maintains a broad-based transactional practice with a particular focus on mergers and acquisitions, private equity, venture capital, securities matters, and complex commercial real estate transactions. Scott has substantial experience advising clients on sophisticated real estate matters, including complex acquisitions and dispositions, ground-up development projects, and commercial leasing transactions across a wide range of asset classes. His real estate practice also includes representing sponsors, investors, and operating partners in real estate joint ventures, structured equity investments, and other complicated capital arrangements, frequently involving bespoke governance, promote structures, and risk-allocation mechanisms.

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This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.”