Structuring M&A Deals – Protecting the Seller’s Earnout Post-Acquisition

Earnouts, while offering the potential for additional compensation based on future performance, they also introduce a layer of uncertainty and risk for sellers. It is therefore important for sellers to strategically negotiate for safeguards that mitigate these risks to realise their earnout potential.

Indeed, as the saying goes “cash is king”, the most common form of consideration in M&A transaction is the cash payment, with payments in kind -transferring assets as full or partial discharge of the purchase price, also being not uncommon.

However, transactions not always take the form of vanilla buyouts. The negotiating strengths, positions and preferences of the parties and the nature of the target business, often require deals to be structured in other ways. For example:

• Equity in the buyer: The buyer may offer shares or equity interests in their own company as consideration. This allows the seller to become a shareholder in the acquiring company and benefit from any future growth.
• Seller Financing: The buyer may propose seller financing as part of the consideration, with the seller providing a loan/ extending credit to the buyer for a portion of the purchase price.
• Assumption of Debt or Liabilities: The buyer may assume debts or liabilities of the target company as part of the consideration.
• Earnout: It may suit the circumstances of a transaction, to apply a contingent payment structure where a portion of the consideration would be determined based on the future performance or achievement of financial targets by the acquired business. Earnouts are often used when there is uncertainty about the future performance or value of the target company, as they allow the buyer to align the consideration with post-acquisition performance.

It is on the last type of consideration stated above, the earnout, on which this article focuses. More specifically, on the approach that sellers may take, to seek protection and mitigate their risk.

Where a deferred payment/ earn-out payment is used, the payment, or part of it, to be received by the seller, depends on contingencies, after usually control of the business has passed to the buyer. In such cases, the seller must reasonably see to mitigate the risks associated with that. Thus, then, the question logically comes, what protections the seller may seek.

While there can be no exhaustive list, as each transaction is to be structured based on its specific characteristics, certain protections commonly sought by sellers can be identified, and be presented as food for thought. These typically include the following:

• Post-Completion Veto Rights: Sellers may negotiate for post-completion veto rights or approval rights over significant decisions or actions that could impact the earn-out calculation or the value of the business e.g. decisions related to capital expenditures, major contracts, acquisitions, divestitures, or changes in business strategy.
• Financial Reporting and Auditing: Sellers should request access to regular financial reports and audited financial statements of the business during the earn-out period, to monitor the financial performance and ensure transparency in the calculation of the earn-out.
• Non-Compete and Non-Solicitation Obligations: Sellers may negotiate for non-compete and non-solicitation provisions that restrict the buyer’s ability to compete with the business or solicit customers, employees, or suppliers during the earn-out period.
• Operational and Management Control: Sellers may retain certain operational and management control during the earn-out period to ensure that the business continues to operate in a manner that maximises the earn-out potential e.g. retaining key management personnel, having a seat on the board of directors, or maintaining decision-making authority over specific matters.
• Escrow Accounts: The seller may require the buyer to deposit the deferred consideration or a part of it into an escrow account.
• Security or Collateral: In certain cases, sellers may require the buyer to provide security or collateral to secure the deferred payment or earn-out obligation.
• Combination of the above:  In certain transactions one or some of the above would suffice, while in others, more, or even all, or others in addition may need to be applied.

As M&A deals continue to evolve and diversify, the use of earnouts has become increasingly customary, to bridge valuation gaps and align the interests of buyers and sellers.

Earnout arrangements, indeed, can pose risks to sellers. However, with strategic and proactive mindset, sellers can negotiate safeguards to mitigate risks for the realisation of their earnout potential.

It follows, that collaborative effort between buyers and sellers, trust, and transparency, are fundamental, and that the earnout success, depends on careful negotiation and structuring for the implementation of appropriate measures.