Earn-outs Risk Unraveling Deals for 40% of Private Equity Buyers

Earn-outs: A Bridge to Troubled Waters?

Private equity firms are increasingly relying on earn-out provisions to bridge valuation gaps in acquisitions, but these structures are fraught with risk and often lead to post-completion disputes, according to legal experts.

Earn-outs require the seller to receive additional payments tied to the future performance of the acquired business, providing an incentive for them to remain engaged and help drive growth. However, the complex nature of these provisions can create tension and lead to disagreements over metrics and payouts.

"Earn-outs are becoming more common, but they require very careful drafting to avoid disputes down the line," said Ben Bruton, a partner at law firm Winston & Strawn in London. "Sellers want to maximize their upside, while buyers are focused on protecting value and ensuring the business hits its targets."

According to data provider Pitchbook, earn-out provisions were included in over 40% of U.S. private equity deals last year, up from around 30% a decade ago. The trend reflects the challenges of valuing companies, particularly in volatile or uncertain economic environments.

"Buyers are increasingly using earn-outs to bridge valuation gaps and share the risk," said Christopher Hull, also a partner at Winston & Strawn. "But they need to get the definitions and mechanics right to avoid costly litigation."

Disputes often arise over the calculation of earn-out payments, the interpretation of performance targets, or allegations that the buyer has not acted in good faith to support the business. This can lead to drawn-out legal battles that erode the value the earn-out was meant to preserve.

"Earn-outs are a double-edged sword," said Suzanne Labi, a Winston & Strawn partner. "They can incentivize sellers but also sow the seeds of discord if not properly structured."

The experts advise private equity firms to clearly define the earn-out metrics, ensure targets are achievable, and build in dispute resolution mechanisms upfront. Aligning the interests of buyers and sellers is crucial to making earn-outs work.

"Getting the earn-out right is essential to protecting the value of the deal," Bruton said. "It's a delicate balance, but one that private equity firms need to master as these provisions become more common."