Introduction

In mergers and acquisitions, earn-outs often bridge valuation gaps by tying a portion of the purchase price to the target company’s post-closing performance. However, earn-outs are fraught with potential conflicts because buyers will have operational control.  This article provides a practical overview of operational and financial guardrails that sellers can consider to protect their earn-out interests.

To help avoid any outright buyers’ rejection, guardrails must be tailored to align with the unique goals, risks, and realities of the deal. They are part of the negotiation process, requiring thoughtful balancing of sellers’ need for protection with the buyers’ operational flexibility.  Sellers’ proposed guardrails must reflect a clear understanding of the current trajectory of their businesses and the risks inherent in the metrics being targeted.

Sellers should expect that buyers will not have a favorable view of guardrails (which buyers will see as handcuffs or bearhugs on their ability to operate a business that they just bought).  Thus, overreaching or poorly thought-out proposals can undermine negotiations, alienate buyers, or result in outright rejection of the guardrails. Thoughtful, well-calibrated proposals increase the likelihood of constructive engagement and counteroffers from buyers.

Set forth below are some conceptual operational and financial guardrails for Sellers to consider. Again, these are presented as high-level concepts and do not reflect how these concepts would be worded in purchase agreements.

Operational Guardrails

1. Commitment to Commercially Reasonable Practices.  Buyers to operate the acquired business in a commercially reasonable manner, prioritizing the maintenance and growth of its revenue base rather than deprioritizing it for unrelated strategic objectives.

2. Prohibition Against Intentional Harm.  Buyers to not engage in any conduct that would be reasonably likely to have a material adverse effect on meeting earn-out targets.

3. Fair Allocation of Shared Resources.  If assets or employees are shared across divisions, expenses to be allocated fairly and consistently to prevent artificial inflation of costs within the acquired business.

4. Preservation of Pre-Existing Business Relationships.  Buyers to maintain pre-existing business relationships to avoid revenue disruptions.

5. Maintenance of Key Personnel.  Buyers to take all commercially reasonable actions to retain personnel (individually or in the aggregate) who are material to the achievement of earn-out metrics.

6. Restriction on Business Model Changes.  Buyers to refrain from making material changes to the core business model and product offerings except as otherwise agreed.

7. Commitment to Marketing and R&D Expenditures.  Buyers to maintain agreed-upon levels of investment in marketing and research and development to support sustained business growth.

8. Restrictions on Divestitures.  Buyers to refrain from selling or divesting assets that are material to meeting the earn-out metrics.

9. Limitations on Mergers and Acquisitions.  Buyers to be restricted from merging (or otherwise combining) the acquired business with another business, if it would have a material adverse effect to meeting the earn-out metrics.

10. Commitment to Supply Chain Stability.  Buyers to use reasonable commercial efforts to ensure that existing material supplier relationships remain stable.

Financial Guardrails

1. Limitations on Overhead Charges.  Buyers restricted from charging the acquired business with management, consulting or other fees; and, placing their employees on the payroll of the acquired businesses.

2. Prohibition against Cash Dividends or Cash Distributions. Except for the payment of taxes, Buyers are restricted from upstreaming cash from the acquired business to Buyer or any of its affiliates.

3. Budgeting for Key Investments. Buyers to maintain agreed-upon investment levels material to ensure sufficient resources material to achieving the earn-out metrics.
4. Cap on Capital Expenditures. To prevent excessive spending that could impact the financial health of the acquired businesses, a cap on capital expenditures is established tied to an agreed upon budget or growth strategy.
5. Accounting Policies & Practices for Purposes of Earn-Out Computation. Buyers’ senior financial officer to certify all earn-metric financial reports provided to sellers; and, have year-end report reviewed by buyers’ outside accountants.
6. Restrictions on Changes to Pricing Policies. Buyers to maintain existing pricing strategies to ensure that revenue targets tied to the earn-out are achievable.
7. Working Capital. The billing and collections policies of the acquired business, as well as policies pertaining inventory purchases and valuation, to be restricted to the historical practices of the acquired businesses except as otherwise agreed.
8. Free Cash Flow Reinvestment. To ensure the business has sufficient resources to achieve earn-out targets, buyers to reinvest free cash flow generated by the acquired businesses’ assets into its operations or growth initiatives.
9. Limitations on Intercompany Transactions. To prevent manipulation of financial results, restrictions are placed on transactions between the acquired business and other entities owned by buyers.

Balancing Interests

Guardrails must strike a balance between protecting sellers’ interests and allowing buyers operational flexibility. Poorly defined provisions can lead to disputes, while overly restrictive terms can hinder the buyer’s ability to integrate the target effectively.

Additionally, the likelihood of buyers agreeing to restrictive guardrails will be tied to the specifics of the deal:

• Metrics Close to Being Achieved & Shorter Earn-Out Periods: Buyers may be more open to restrictions because the risks are lower, and the path to achieving the earn-out is clearer.

• Speculative Metrics & Longer Earn-Out Periods: Buyers may push back on restrictive guardrails to retain the flexibility needed to navigate a more uncertain and prolonged earn-out period.

The type of buyers also plays a significant role in determining the likelihood of agreeing to guardrails:

• Private Equity Buyers: Private equity buyers typically focus on operational improvements and are unlikely to agree to significant constraints unless the target is a critical platform addition.  PE buyers value operational flexibility to implement their investment thesis, which may include restructuring, reallocating resources, or merging the business with portfolio companies. Guardrails that limit their ability to take such actions are often a non-starter.

• Strategic Buyers: On the other hand, strategic buyers, particularly those needing the target to achieve synergies or enhance an existing platform, may be more willing to accept guardrails. For them, the value of the transaction often outweighs the constraints imposed by the earn-out provisions.

This dynamic underscores the importance of tailoring guardrails to the buyers’ profile and deal specifics. Private equity buyers looking to execute a turnaround strategy may resist significant constraints, while strategic buyers seeking complementary assets might find them more acceptable. Thoughtful negotiation informed by these distinctions can help align the interests of both parties.

Conclusion

By incorporating operational and financial guardrails into earn-out provisions, sellers can mitigate risks and increase the likelihood of achieving their earn-out targets. However, guardrails must be carefully calibrated to the unique circumstances of each deal. A balanced approach can build trust between the parties and help ensure the earn-out functions as intended.

Finally, sellers putting forth a comprehensive suite of guardrails soon after the LOI is entered can help determine whether an earn-out that is agreeable to both parties is even possible for the deal. If an earn-out doesn’t fit well with the transaction, identifying this upfront allows the parties to seek alternative structures or terms that hopefully won’t derail the deal.

Early identification of misalignment on earn-out expectations allows parties to address potential deal-breakers before significant negotiation time and resources are invested.

THIS ARTICLE IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSTITUTE LEGAL ADVICE

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