In today’s mergers and acquisitions (M&A) market, a challenge for dealmakers is the gap in valuation expectations between buyers and sellers. Economic uncertainty and a high-interest rate environment have made buyers more cautious, while sellers often hold firm on valuations based on historical performance or optimistic projections.
Parties are increasingly relying on creative deal structures to bridge this divide and facilitate transactions. Two deal structures that our M&A team at Tarter Krinsky & Drogin has seen frequently in our recent deals are: (1) deferred consideration in the form of an earnout, and (2) representation and warranty insurance.
- Earnouts: A Contingent Payment Mechanism
An earnout is a contractual arrangement where a portion of the purchase price is contingent upon the target company’s future financial performance. The earnout is a mechanism to bridge a valuation gap, allowing a buyer to pay a lower up-front price while giving the seller an opportunity to realize a higher valuation if the target company’s business performs as promised over a specified period post-closing.
Benefits to Both Parties
- For the Seller: An earnout allows a seller to realize a higher value for its business, particularly when current valuation metrics do not fully reflect the target company’s business growth potential. It also provides an incentive for the seller to stay involved in the business to help achieve the performance targets.
- For the Buyer: an earnout can mitigate risk by linking a portion of the purchase price to the target company’s actual performance. It reduces the buyer’s upfront capital cost and ensures the buyer is not overpaying for a business that fails to meet its expectations.
Key Considerations
While conceptually straightforward, earnouts are a frequent source of post-closing disputes. Key considerations to avoid litigation are:
- Defining the Metrics: The performance targets must be objective, clearly defined, and easy to measure. Common metrics include revenue, gross margin, or EBITDA. Parties should avoid vague or subjective goals and consider including an illustrative calculation to the purchase agreement.
- Buyer’s Covenants: The purchase agreement must clearly define the buyer’s obligations with respect to operating the target company’s business post-closing. The seller’s fear is that the buyer will intentionally or unintentionally reduce the performance of the target company’s business to avoid paying the earnout. Parties should consider specific covenants on business operations, such as capital expenditures, management team changes, or new product or service launches.
- Setoff Rights: The buyer will often seek the right to set off any indemnification claims against future earnout payments, a point of negotiation that can affect the seller’s ultimate recovery under the earnout.
- RWI: De-risking the Deal
Representation and warranty insurance (RWI) shifts the risk of loss from the seller’s breach of representations and warranties to a third-party insurer. The past years, we have seen that RWI has become more accessible and competitive, with lower minimum premiums and retentions (deductibles). Whether RWI is suitable for a deal is a deal specific decision.
Benefits to Both Parties
- For the Seller: RWI allows the seller to achieve a “clean exit” and cap its post-closing liability. This provides a competitive advantage in a competitive auction process by enabling the seller to distribute proceeds to its investors more quickly and with greater certainty.
- For the Buyer: The buyer receives a more reliable and robust source of recourse than a claim against the seller, who may have distributed the proceeds or be difficult to pursue. RWI also offers a higher claims limit than a traditional escrow arrangement, which is often capped at a smaller percentage of the purchase price.
RWI Considerations and Exclusions
- Underwriting: An RWI insurer requires robust due diligence by the buyer and its advisors, including financial and legal reviews. The insurer’s review process adds time to the deal timeline and often brings diligence findings to light that may not have otherwise been addressed in the purchase agreement.
- RWI Exclusions: While RWI policies are broad, they do not cover all risks. Common exclusions include known issues, forward-looking statements and financial projections, disputes related to purchase price adjustments, and certain specialized risks like pension underfunding.
- Increased Transaction Costs: While RWI may simplify deal negotiations, it introduces new transaction costs. These include the one-time, non-refundable policy premium and the underwriting fees charged by the RWI insurer. These costs can be substantial and are a point of negotiation between the buyer and the seller as to who bears the cost.
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