In M&A transactions, valuation gaps often arise because buyers and sellers have fundamentally different views of a business’s worth. Buyers focus on historical performance and risk, while sellers emphasize future growth potential. To bridge these gaps, parties turn to tools like earn-outs, contingent value rights (CVRs), and seller financing—but these mechanisms are not without their own complexities and risks.

Earn-outs are a source of disputes due to their reliance on post-closing financial performance metrics coupled with Buyer’s operational control. CVRs and seller financing offer alternatives, but each has their own limitations.

1. Why Are Creative Structures Necessary?

Valuation gaps stem from differing views on the value of future performance:

• Buyers are cautious, focusing on proven historical EBITDA and minimizing risk.
• Sellers are optimistic, seeking to capture the full value of their business’s future potential.

Bridging these gaps requires deferring or contingent pricing mechanisms. However, not all structures are created equal:

• Binary contingencies (e.g., CVRs) are the simplest and least likely to lead to disputes, but they have limited applicability.
• Earn-outs are versatile and widely applicable, but they are the most complex and dispute-prone.
• Seller financing offers flexibility but can blur into contingent mechanisms when tied to performance.

Each tool has strengths and weaknesses, and careful structuring is essential to minimize risks.

2. Earn-Outs: Universally Applicable, Universally Problematic

What Are Earn-Outs? Earn-outs tie additional payments to the financial performance of the acquired business post-closing. The most common metrics are Revenue or EBITDA.

Challenges of Earn-Outs: Buyer’s Discretionary Operational / Accounting Decisions and/or Accounting Manipulation

Unless very carefully crafted, the achievement or not of the earn-out criteria will unduly rest in the hands of the buyer who will have control of the operations of the business leaving room to make decisions both operational and financial that can negatively impact achieving the metrics which trigger the earn-out payment(s).

The Grant Thornton 2023 M&A Dispute Survey provides valuable insights into some of those accounting practices:[l]

• 54% of the purchase agreements had an earn-out provision.
• 26% of earn-out deals resulted in disputes, making them one of the most contentious deal components.
• Common causes of EBITDA metric disputes include: Revenue Recognition: The buyer may delay recognizing revenue or adopt stricter policies post-closing, reducing the amount eligible for the earnout. Reserves for Bad Debt and Warranties: Buyers might inflate these reserves, reducing reported profitability. Excess and Obsolete Inventory: Misclassifying or excessively writing down inventory can significantly impact earnings. Allocation of Shared Expenses: Buyers may allocate higher costs to the acquired business post-closing, artificially lowering EBITDA. Nonrecurring Expenses: Classifying ongoing costs as “one-time” expenses can skew financial results.

With respect to Revenue-Based Earn-Outs:

• Should unprofitable revenue count toward the earn-out?
• Buyers may prioritize low-margin sales or delay pricing adjustments to minimize profitability while meeting revenue targets.
• Revenue-based earn-outs can work well in industries like SaaS or subscription businesses, where recurring revenue reflects customer growth and is a critical value driver. However, this requires clear definitions of what qualifies as “revenue” (e.g., gross vs. net revenue, timing of recognition).

Industry Context

The use and structure of earn-outs often depend on the industry. For example:

• Tech and Life Sciences: Earn-outs may focus on achieving specific product or regulatory milestones.
• Traditional Manufacturing: Financial metrics such as revenue or EBITDA are more common.

These nuances emphasize the importance of tailoring earn-outs to the specifics of the business and industry.

3. CVRs: Simpler but Limited in Scope

What Are CVRs? Contingent value rights (CVRs) link payments to binary outcomes, such as achieving regulatory approval, completing a product launch, or securing a patent. Because CVRs are tied to specific milestones rather than ongoing financial performance, they are simpler and less prone to disputes.

Strengths:

• Simplicity: Payments are tied to clear, measurable outcomes, minimizing ambiguity.
• Low Dispute Potential: Since milestones are typically external (e.g., FDA approval), there’s less room for manipulation.

Limitations:

• Limited Applicability: CVRs only work when value depends on discrete events. They are less effective for deals where broader financial performance is uncertain.
• External Risks: Milestone delays or failures, often outside both parties’ control, can leave sellers with nothing.

4. Seller Financing: Flexible but Blurry Boundaries

What Is Seller Financing? Seller financing involves the seller lending part of the purchase price to the buyer, repaid over time with interest. While primarily used to manage cash flow, seller financing overlaps with earn-outs or CVRs when repayments are contingent on performance or milestones.

Strengths:

• Cash Flow Flexibility: Reduces the buyer’s upfront burden while ensuring steady income for the seller.
• Trust Signal: Shows the seller’s confidence in the business.

When It Works Best:

Seller financing is most effective for smaller valuation gaps or when the buyer has liquidity constraints. Combined with other tools (e.g., earn-outs or CVRs), it can also address larger valuation gaps by splitting risk and payment timing.

5. Relational Impact of Structuring

Beyond litigation risks, structuring an earn-out thoughtfully can foster trust between buyer and seller. By aligning expectations and mitigating ambiguity, parties can ensure smoother transitions and a more collaborative post-closing environment. This relational aspect is critical in deals where the seller and buyer need to work together closely during or after the transition period.

6. Conclusion

Earn-outs are by their nature ripe for potential disputes, given the reliance on post-closing performance metrics and the buyer’s operational control. While earn-outs are frequently a source of disputes, this does not mean they should or can be avoided if a deal is to get done. Metrics, even when seemingly straightforward, can become contentious if accounting methodologies aren’t aligned or if operational dynamics that can unfavorably impact an earn-out are not addressed. Accounting disputes—whether tied to earn-outs, working capital, or other financial terms—are a common challenge in M&A transactions and highlight the importance of careful planning and risk mitigation. However, with proper structuring and protections, they can serve as a necessary tool for bridging valuation gaps.

Part of the solution may involve the post-closing involvement of the seller. Whether this is practical depends on the dynamics of the deal, including the buyer’s operational preferences and the seller’s willingness or ability to remain engaged.

Finally, earn-outs are not just something that the parties should just outsource to the lawyers to draft. They demand early and thorough attention from all parties—legal, financial, and operational—during negotiations. Failing to prioritize their structuring from the outset can lead to unpleasant surprises and significant post-closing conflicts.

My next article will do a deeper dive into how to lessen the risk of litigation over earn-outs. This will include practical considerations, such as whether the target will operate as a standalone entity, whether overhead will be allocated, and how the buyer’s existing operations or competitive landscape could influence earn-out dynamics. These considerations are critical to creating an earn-out structure that aligns with the realities of the transaction while protecting the interests of both parties.

[1] The following quote from the survey provides some key background information about the survey as follows:

“The 2023 survey reflects the views of 1 50 active deal participants on both the buy-side and sell-side of transactions, who worked on a total 3,668 deals in calendar year 2022 — across a broad range of industries and of varying deal sizes, from under $250 million to over $1 billion. It also conveys a spectrum of M&A experience: Respondents included M&A investment bankers, CFOs and corporate development teams, M&A attorneys and litigation counsel, private equity investors, and professional services accountants (M&A dispute experts, arbitrators and financial due diligence specialists). The majority of deals (61 ⁰/0) took place in the United States.”

While surveys provide valuable insights, it’s important to note that there is limited comprehensive empirical data on the overall prevalence of earn-out disputes across all M&A transactions. Many disputes are resolved informally through renegotiation or mediation, which are not always captured in formal survey data. Nevertheless, even informal disputes can harm relationships and incur significant costs, emphasizing the need for thoughtful structuring.

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