Navigating Optimized Payout Structures in Today's Mergers and Acquisitions Scene
In the realm of Mergers and Acquisitions (M&A), earnouts continue to be a popular clause in deal-making. However, their complexity and potential for disputes make them a subject of careful consideration.
One of the key challenges in negotiating earnout clauses is the use of subjective financial metrics, such as EBITDA or earnings, which can be manipulated due to significant accounting discretion or judgment. In response, the trend has shifted towards relying more on revenue, as it is harder to manipulate. In 2024, around 62% of earnouts relied on revenue instead of EBITDA, a significant shift from previous years.
Another challenge arises from the buyer's post-closing efforts. The level of effort required to meet earnout milestones can be unclear or insufficient without contractual obligations that obligate the buyer to use "commercially reasonable" or "best efforts" to meet earnout goals.
Accounting policies and transparency also pose a significant challenge. Differences in accounting policies can affect earnout calculations, leading to disputes. To mitigate this, parties should agree on specific accounting principles upfront, include provisions for the examination of financial statements prepared accordingly, and allow sellers to review and verify calculations.
Earnouts can create tension post-closing due to sellers remaining involved in management, leading to potential disagreements over strategic decisions or operational control. To address this, cooperation clauses should be negotiated carefully, outlining the seller's obligations to cooperate post-closing in due diligence and integration processes, while ensuring the buyer covers related costs.
Best practices to minimize disputes include using objective, third-party standards when possible, clearly defining effort covenants, detailing accounting rules and reporting, negotiating cooperation clauses carefully, maintaining good recordkeeping, anticipating and addressing potential disputes early, and including dispute resolution mechanisms tailored to earnouts.
Sellers must also do their due diligence on the buyer, being prepared to forego cash and take a risk on the company's longer-term success when using equity as currency. Buyers may not want to part with equity for dilution and control reasons, especially as they seek to transition the asset into new management.
In 2024, only 5% of earnouts included a covenant to run the business to maximize earnout payments, and only 3% included a covenant to run the business in accordance with the seller's past practice. Disputes over earnouts can be long and expensive, with drawn-out discovery and complex arguments.
Despite these challenges, earnouts can offer benefits, such as aligning buyer and seller incentives and allowing the seller to see gains from growth in the overall business. Objective standards, such as third-party milestones, should be used to reduce the likelihood of earnout disputes.
In the past year, the Delaware Chancery Court has ruled in favor of both buyers and sellers in major earnout cases, demonstrating the court's willingness to interpret earnout clauses fairly. However, sellers should be prepared for potential disputes and have a clear understanding of the dynamics involved in each deal, including the parties, industries, and jurisdictions involved.
In summary, earnout clauses require careful drafting to establish clear, objective targets combined with firm, contractually defined buyer obligations and transparent accounting procedures to reduce ambiguity and facilitate fair earnout payments without expensive or protracted disputes when the earnout expires.
- In the M&A industry, law firms specializing in earnout disputes have seen an increase in demand for their legal services, as earnouts continue to be a complex aspect of deal-making.
- Arbitration is often a preferred method for resolution of earnout disputes due to its confidentiality, flexibility, and efficiency compared to traditional litigation.
- Some law firms offer dispute resolution events for clients to network with fellow industry professionals, exchange insights, and address common challenges in earnout resolution.
- A law firm partner specializing in M&A and earnout disputes may counsel businesses on the best strategies to minimize earnout disputes and maximize their chances of success.
- In 2025, an LLP team with extensive experience in M&A and earnout disputes was awarded "Dispute Resolution Team of the Year" by a notable finance publication.
- news headlines have warned businesses about the financial risks and complexities associated with earnout disputes, urging sellers to thoroughly understand the potential dangers when entering into earnout agreements.
- Capital markets and investment banking events often feature speeches from lawyers discussing the need for objective standards, clear contractual obligations, and transparent accounting practices to minimize earnout disputes.
- Acquisitions and business deals involving earnouts are not exclusive to large corporations; even small businesses may encounter earnout disputes that require the intervention of lawyer teams specialized in this area.
- Post-closing litigation over earnout disputes can have serious consequences for both parties, including financial losses, damage to reputation, and potential impacts on future business deals and investment opportunities.
- Sellers and buyers should carefully consider discuss and agree upon dispute resolution mechanisms early in the negotiations to avoid protracted and costly disputes, with mediation or expert determination as possible options.
- Armed with their knowledge of M&A law, accounting principles, and dispute resolution tailored to earnouts, a skilled lawyer can help their client navigate the complexities and potential pitfalls of earnouts, ensuring a more successful and equitable outcome.
