Foundations for Corporate M&A Professionals

Contingent Consideration

Earn-outs offer an appealing concept: providing contingent consideration tied to a target's post-closing performance.

While seemingly attractive as a pricing solution, earn-out provisions are often custom-tailored, heavily negotiated, and can result in disputes if not meticulously structured.

 Corporate M&A teams frequently consider earnouts for private acquisition targets to bridge valuation gaps and address:

  • Uncertainty or volatility in the target’s revenue, earnings, or growth prospects
  • Align the interests and incentivize the sellers to remain involved and committed
  • Reduce the risk and burden of an upfront payment

Foundations for Corporate M&A Professionals

Earnout Prevalence

Earnouts appear in ~25% of private target deals. 

They typically represent ~30% of closing payments, though this figure can be significantly higher in life sciences transactions. 

The standard duration for earnouts is two years, with a potential range of one to three years, according to the Institute's survey of public and large private corporate acquirors.

Foundations for Corporate M&A Professionals

Earnout Metrics

Typical financial metrics for earn-outs include revenue, EBITDA, and net income milestones. 

In addition, some corporate M&A teams design the earn-out formulation around strategic operational objectives and metrics, for example:

  • Customer retention
  • Product development
  • Regulatory approval

Advanced Topics for Corporate M&A Professionals

Selecting an Earn-out Metric

Buyers favor net income-based metrics, which consider post-closing investment, synergies, and integration issues. 

Sellers favor revenue-based metrics because they are less susceptible to manipulation via alterations in cost structure or accounting treatment.

EBITDA-based metrics have been viewed by some corporate M&A teams as optimal as it includes operating costs and excludes items that are subject to account adjustments and changes in policy (accelerated depreciation). 

A best practice is to define the accounting treatment and provide a sample calculation in a table format.

Foundations for Corporate M&A Professionals

Buyer’s Negotiation Points for Earnouts

A buyer will generally resist post-closing covenants and restrictions that interfere with its ability to operate and invest in the target company. 

Some examples are below, which will vary depending on the level of integration, autonomy, and control in each transaction.

  • Overhead expenses may need to be allocation including charges for corporate services
  • Increasing pay or benefits may need to be provided to be competitive with market conditions
  • If reserves have to be set-side or impairment charges recorded, the earnout may be reduced
  • Severance and restructuring charges may be incurred
  • The seller must follow the buyers policies
  • Maintenance and capital investments will need to be made

Foundations for Corporate M&A Professionals

Sellers Negotiation Points for Earnouts

The seller typically will press for a series of post-closing covenants. These covenants will obligate the buyer to take, or refrain from taking, certain actions that may prevent the earnout from being paid. 

According to the latest ABA Deal Points Study, more than half of the private target deals contained some other language protecting the seller’s right to the earn-out.

 If a dispute arises, questions will include (a) did the buyer have reasonable grounds, and (b) did the buyer work collaboratively with the seller. Common claims against the buyer include:

  • Lack of marketing and / or sales support
  • Limited investment or access to capital
  • Integration complications and delays

Advanced Topics for Corporate M&A Professionals

Taxation of M&A Earnouts

Buyers and sellers may have adverse interests in the character of earn-out payments. 

  • Earn-outs tied to the seller's performance of services are typically subject to higher ordinary income tax rates and employment taxes. For the buyer, this is a deduction.

  • If an earnout is part of the purchase price, then it will likely be taxed at a more favorable capital gains rate for the seller. For the buyer, an earn-out that is tied to the purchase price is not deductible. 

Special rules applicable to “installment sales” apply for calculating the gain or loss on the transaction and the timing of that gain or loss for US federal income tax purposes. The rules provide that the gain is recognized in proportion that the gross profit bears to the purchase price. If the earnout formula has a “maximum sales price” the gross profit ratio is calculated and applied to each payment.

Deal parties should also be aware the earn-outs can invite scrutiny if the payments are inconsistent with the services delivered and compensation provided to others for similar services. This can originate from language in the LOI. However, the earnout can be decoupled from the seller’s employment agreements with appropriate documentation.

Sellers may also be responsible for additional transaction advisory fees when earn-outs are paid.

Advanced Topics for Corporate M&A Professionals

Earnout Ambiguity and the Good Faith Standard

It’s best to engineer the earnout with specificity and clarity.

> Buyers typically prefer an "inward-facing" efforts obligation, based on their standard practices. This is often favored, particularly if the buyer incurs above-average investment and expense for areas like safety, investment in human capital, and compliance.

> Conversely, sellers often advocate for an "outward-facing" standard, comparing the buyer's efforts to similar companies with similar products under similar circumstances. However, sellers would need to demonstrate a clear deviation from the peer group to support a claim.

Members of the Institute’s speaking faculty have recommended including illustrative examples within the agreement. 

It’s also important to make sure you can document “efforts” taken [defined below].

Corporate M&A teams should also be aware that, under Delaware law, there is an implied covenant of good faith and fair dealing that is applicable for earnouts. This goes beyond the contract to prohibit “arbitrary or unreasonable conduct”. 

In other words, the buyer can’t sabotage the earnout.

“....since value is frequently debatable and the causes of underperformance equally so, an earn-out often converts today’s disagreement over price into tomorrow’s litigation over the outcome.” 

Vice Chancellor J. Travis Laster of the Delaware Court of Chancery
Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126 (Del. Ch. 2009).

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Glossary of Earn-out Terms

Best Efforts

A "best efforts" clause within an earn-out provision imposes a stringent obligation on the buyer. It is generally understood to be the highest standard of commitment, requiring more than just a good faith or reasonable attempt.

While the precise definition can be ambiguous and vary by jurisdiction, courts often interpret "best efforts" to mean that the buyer must take all reasonable and diligent actions to maximize the potential for the earn-out to be paid.

This does not typically require the buyer to act against its own significant business interests or incur substantial, unforeseen costs. However, it does imply a proactive and dedicated approach.

For example, a buyer under a "best efforts" obligation may be expected to adequately fund the acquired business, dedicate sufficient managerial resources, and not take actions that would knowingly hinder the achievement of the earn-out targets.

Reasonable Best Efforts

While often viewed as a step below the more stringent "best efforts" standard, its precise meaning can be ambiguous and is a frequent point of negotiation and, at times, litigation.

Generally, a "reasonable best efforts" clause obligates the buyer to take diligent and commercially reasonable actions to help the acquired business meet its performance goals.

Unlike the more demanding "best efforts," this standard explicitly allows the buyer to balance its obligations to the seller with its own economic interests and operational considerations. The buyer is not typically required to take actions that would be financially detrimental or significantly disrupt its existing business.

However, "reasonable best efforts" is not a passive commitment. It requires more than just good faith and prohibits the buyer from intentionally or negligently hindering the earn-out's achievement.

For example, a buyer would likely be expected to provide adequate resources and not divert opportunities from the acquired business.

Reasonable Best Efforts

In M&A earn-out provisions, "reasonable efforts" is another common standard of conduct imposed on the buyer. It is generally considered less demanding than "best efforts" and is often viewed as being at the lower end of the "efforts" clauses hierarchy.

While legal interpretations can vary, this standard typically requires a party to act in a commercially reasonable manner to achieve the earn-out targets.

A "reasonable efforts" clause means the buyer must take some diligent action, but it allows for a significant degree of discretion. The buyer can heavily weigh its own costs, benefits, and commercial interests against the seller's interest in receiving the earn-out payment.

A buyer under this standard is not expected to incur substantial or unreasonable expenses, take actions that could harm its own business, or fundamentally alter its post-acquisition plans to help the seller achieve the earn-out.

Essentially, the buyer must not act in bad faith or intentionally sabotage the earn-out's potential, but it is not obligated to go to great lengths or make significant sacrifices. Because the term is inherently vague and affords the buyer considerable latitude, sellers often negotiate for more specific, objective covenants instead of relying solely on a "reasonable efforts" standard.

Commercially Reasonable Efforts

In an M&A earn-out, a "commercially reasonable efforts" clause sets a standard of conduct for the buyer that is explicitly tied to business and economic practicalities. It is often seen as synonymous with "reasonable efforts" as this standard obligates the buyer to take steps to achieve the earn-out targets that a sensible business person would take in similar circumstances.

The key feature of "commercially reasonable efforts" is the explicit permission for the buyer to consider its own economic interests, including costs, profitability, and potential risks. The buyer is not required to spend unreasonable sums of money, sacrifice its own more profitable opportunities, or act in a way that is detrimental to its overall business strategy simply to help the seller achieve the earn-out. The focus is on prudent, sensible business conduct rather than exhaustive or heroic measures.

While this standard gives the buyer significant discretion, it does not permit complete inaction or bad faith. The buyer must still operate the acquired business in a manner consistent with reasonable commercial practices. Because of the emphasis on the buyer's own financial well-being, sellers often seek to bolster this clause with specific, objective covenants to ensure meaningful actions are taken to support the earn-out's success.

Good Faith Efforts

A "good faith efforts" clause generally represents the lowest affirmative standard of conduct for the buyer. In many jurisdictions, an obligation to act in good faith is already implied in all contracts, meaning this clause may not add substantial duties beyond what the law already requires.

A "good faith" standard primarily focuses on the buyer's subjective intent. It obligates the buyer to act with honesty and fairness, and most importantly, not to act in a manner specifically intended to prevent the seller from achieving the earn-out milestones.

This means the buyer cannot deliberately sabotage the business, divert revenue, or otherwise actively work against the earn-out's success.

However, "good faith efforts" does not typically require the buyer to take any specific, proactive steps to help achieve the earn-out. The buyer can generally prioritize its own business interests, make decisions that might negatively impact the earn-out (as long as they are not made in bad faith), and is not obligated to spend extra money or resources.

Because it is a relatively weak standard, sellers usually negotiate for a higher "efforts" clause to ensure the buyer is more proactively engaged in making the earn-out successful.