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Resolving Deadlock in M&A: Deferred Consideration Structures as a Bridge Between Expectations

Dalma Capital

Resolving Deadlock in M&A: Deferred Consideration Structures as a Bridge Between Expectations

15 March 2023

By Zachary Cefaratti

Deadlock in mergers and acquisitions (M&A) transactions arises when buyers and sellers have divergent expectations regarding valuation and future performance of the target company. One effective solution to address these gaps is the use of deferred consideration structures, such as earn-outs. Deferred consideration structures can help resolve deadlock by aligning the interests of both parties and facilitating a successful transaction. In this article, I will focus on earn outs and the challenges they resolve in overcoming deadlock.

Understanding Deferred Consideration Structures

Deferred consideration structures involve the payment of a portion of the purchase price at a future date or upon the occurrence of specific events or milestones. These structures can be particularly useful in bridging the valuation gap between buyers and sellers and addressing concerns about future performance and risk.

  1. Earn-Outs

An earn-out is a deferred payment structure that links a portion of the purchase price to the target company’s future financial performance. Earn-outs can be structured based on various financial metrics, such as revenue, EBITDA, or net income, and are typically paid out over a predefined period. As a sell-side adviser, generally prefer earn-outs to be as close to the top line as possible — linked to revenue or net income, which are objective, observable and least likely to arise conflicts or disagreement later on. Buyers generally prefer linking earn-outs to linked as close to the bottom line as possible, however these measures include various subjective and accounting based adjustments — which can lead to conflict and dispute. I plan to write a more detailed article on earn-outs in the future.

Aligning Expectations on Valuation

When sellers are seeking a higher valuation than buyers are willing to pay, earn-outs can be used to bridge the gap. By tying a portion of the purchase price to future performance, buyers can ensure that they only pay for the additional value if the target company meets specific financial targets. This approach allows sellers to potentially achieve their desired valuation while providing buyers with a mechanism to mitigate risk.

Reducing Risk for Buyers

Earn-outs can be particularly useful in situations where buyers are concerned about the target company’s future performance, especially in cases involving high-growth companies or those operating in rapidly changing industries. By deferring a portion of the purchase price, buyers can effectively reduce their risk exposure if the target company underperforms. Sellers also find earn outs can help them benefit from growth the company will experience in the near future, and to benefit from that additional value addition.

Incentivizing Sellers and Management

Deferred consideration structures can also serve as an incentive for sellers and the target company’s management to work towards achieving the agreed-upon financial targets. This alignment of interests can help to ensure the success of the transaction and the ongoing growth of the business. Earn outs are particularly useful when the seller is an entrepreneur whose identity and personal relationships are closely intertwined with the business, and oftentimes the entrepreneur will serve as an officer of the company for a period.

  1. Seller Notes

A seller note is a form of seller financing in which the buyer issues a promissory note to the seller, committing to pay a portion of the purchase price over time with interest. Seller notes are less commonly used to deal specifically with dead-lock than earn outs, but can be useful particularly when the buyers financing constraints are a limitation on unlocking value. In another article, I will take a deeper dive into seller notes, earn outs, and hybrid structures combining seller notes and earn outs.

Challenges and Considerations with Deferred Consideration Structures

While deferred consideration structures can be effective in resolving deadlock in M&A transactions, there are potential challenges and considerations that both buyers and sellers should be aware of:

Complexity

The implementation of deferred consideration structures, particularly earn-outs, can add complexity to the transaction. It is essential to carefully define the terms and conditions of the earn-out, including the financial metrics to be used, the duration of the earn-out period, and the method for resolving disputes. It is very important to set clear expectations for both sides.

Potential for Conflict

Earn-outs can sometimes create conflicts between buyers and sellers, particularly when there is a disagreement over the calculation of the earn-out payment or the management of the target company during the earn-out period. To minimize the potential for conflict, clear communication and a well-defined earn-out agreement are crucial.

Tax Implications

Deferred consideration structures can have tax implications for both buyers and sellers, and it is important to seek professional tax advice to understand the potential impact on the transaction. This is particularly the case when there are material differences in tax rates from capital gains vs income, or if there are transaction related taxes, withholdings taxes etc.

Deferred consideration structures, such as earn-outs, can be an effective tool for resolving deadlock in M&A transactions by bridging valuation gaps, reducing risk for buyers, and aligning the interests of both parties. However, they significantly increase the complexity in the deal and thoughtful advice from experienced legal, financial and tax advisors.

In a separate article, I take a deeper dive into earn outs and how to deal with pitfalls.

 

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