Seller’s Guide to Earn-Outs: Best Practices for Structuring Earn-Outs to Minimize Conflicts in M&A Transactions
22 March 2023
By Zachary Cefaratti
Earn-outs play a crucial role in bridging valuation gaps and aligning interests in mergers and acquisitions (M&A). However, if not structured carefully, they can lead to conflicts and challenges post-transaction. In this article, I will share best practices for structuring earn-outs with a focus on the interests of the seller, providing insights on how to minimize conflicts and ensure a successful outcome.
Define Clear and Relevant Performance Metrics
Selecting the right performance metrics is essential for structuring an earn-out that protects the seller’s interests. The chosen metrics should be:
- Specific and measurable: Both parties should agree on quantifiable financial targets, such as revenue, EBITDA, or net income. As I spend most of my time on the sell-side, I lean towards top-line metrics such as revenue and net-income.
- Relevant to the target company’s industry and growth trajectory: Metrics should be aligned with the company’s business model and expected performance.
- Easy to calculate and verify: Complex metrics can lead to disputes over calculation methods and results. Keep metrics straightforward and verifiable.
Best Practice: Engage in open discussions with the buyer to establish mutually agreed-upon performance metrics, ensuring that the metrics are tailored to the target company’s unique characteristics and industry.
Set Realistic and Achievable Targets
Establishing realistic and achievable targets for the earn-out is crucial for protecting the seller’s interests. Unrealistic targets can lead to disappointment and disputes if the target company fails to meet them. When setting targets:
- Consider historical performance and projected growth: Targets should be based on a thorough analysis of the company’s past performance and reasonable future expectations.
- Strike a balance between ambition and realism: Targets should be ambitious enough to incentivize performance but not so high that they become unattainable.
Best Practice: Collaborate with the buyer to set targets that are grounded in data and reasonable expectations, ensuring that they provide a fair opportunity for the seller to earn the deferred consideration.
Establish a Clear Governance Framework
A well-defined governance framework is crucial for minimizing conflicts during the earn-out period, particularly when the seller retains a role in the target company’s management. To protect the seller’s interests:
- Clarify the seller’s involvement: Outline the level of involvement the seller will have in the company’s management and decision-making.
- Define decision-making authority: Clearly establish the buyer’s and seller’s respective rights and responsibilities, including any veto rights or approval requirements.
- Set communication guidelines: Establish clear communication channels and reporting requirements to ensure transparency and collaboration.
Best Practice: Negotiate a governance framework that balances the seller’s need for involvement with the buyer’s need for control, ensuring that the seller can effectively contribute to the company’s success during the earn-out period.
Address Potential Conflicts Proactively
I generally recommend to start with the assumption that conflicts will arise. The more consideration there is for conflicts before may arise before completion, the easier they will be to resolve during the earn-out period, particularly when the seller has a role in the target company’s management. To minimize potential conflicts:
- Identify areas of potential disagreement: Analyze the earn-out structure and identify potential areas where conflicts may arise, such as resource allocation, strategic direction, or calculation disputes.
- Incorporate dispute resolution mechanisms: Include provisions for resolving disputes in the earn-out agreement, such as mediation or arbitration clauses. Try to have as many mechanism to resolve conflicts without arbitration or litigation.
Best Practice: Address potential conflicts proactively during the negotiation process, and establish clear dispute resolution mechanisms to ensure that any disagreements can be resolved quickly and fairly.
By following these best practices for structuring earn-outs, sellers can protect their interests, minimize conflicts, and maximize the value of their M&A transactions. By focusing on clear performance metrics, realistic targets, a well-defined governance framework, and proactive conflict resolution, sellers can successfully navigate the complex world of M&A and ensure a mutually beneficial outcome.
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