Earn-Outs in M&A Transactions: Red Flag Issues that Government Contractors Should Avoid

April 27, 2017

Government contractors who wish to grow by purchasing an existing business are aware of one simple truth:  The value of the target is linked directly to its ability to transfer its existing contracts. If there is a high risk profile—for example, if assets of the target are subject to novation in connection with the acquisition—then a purchaser is likely to seek either a downward adjustment in the purchase price or to propose deferred compensation, such as an earn-out, in order to close the deal.

An earn-out is a pricing construct set out in the purchase agreement, which provides that the seller will receive additional post-closing compensation, but only if the acquired business achieves stated financial goals, such as a percentage increase in gross sales or earnings. Earn-outs can be attractive in situations where the transfer of assets—particularly government contracts—is partially dependent upon the seller’s ability to influence its business interests and relationships post-closing, with the end goal of transitioning those relationships to the purchaser. While attractive from this perspective, it is important to note that earn-outs carry with them inherent risks, and a conservative approach to their structure and implementation is likely to result in a more manageable risk profile. Following is a brief discussion of some of the key risks of earn-outs from the perspective of government contractors, along with some suggested mitigation techniques.

Many of our clients are consulting businesses with government contracts. Often, an important part of the sale, in addition to the transfer of the contracts themselves, will involve tying up key personnel under employment or consulting agreements. If you are a seller under these circumstances, you will generally want to minimize amounts paid out as consulting fees and maximize earn-out amounts. This is because amounts characterized as deferred purchase price payments will be subject to the lower capital gains tax rate, and will not be impacted by payroll taxes. The opposite is true for a purchaser, however, because compensation for his/her services may be desired in order to obtain a tax deduction. Because of this inherent tension, it is critical to ensure that certain rules of thumb are followed when structuring earn-out payments. 

In sum, an earn-out should:

  • represent the reasonable value of the acquired business;
  • not be conditioned on services to be performed by target’s key employees/consultants;
  • be proportional to each seller’s sale of his/her equity interests; 
  • complement a robust negotiation of the purchase price; and
  • ideally, should not extend past 1-2 years.

With respect to the final bullet, I’m aware that, in a technical sense, an earn-out may last for up to 3 years. However, the longer an earn-out extends, the more likely it becomes that litigation will arise. My advice to clients is that an earn-out period should ideally last between 6 months and a year. The longer the timeframe, the more attenuated and difficult to predict it becomes to accurately predict a future revenue stream or other earn-out targets. 

Another “best practice” is to ensure that each of target’s key employees or consultants to receive payment for post-closing services is paid reasonable compensation. This will further make it less likely that an earn-out payment will be recharacterized, in whole or in part, as deferred compensation.

To conclude, earn-outs can be useful tools for getting to yes during an otherwise difficult pricing negotiation. However, government contractors—whether buying or selling their business—should be aware of the potential pitfalls of earn-outs and consult their attorneys and financial advisors. As I’ve written in earlier pieces, having the right team in place is a crucial part of growing your business by closing a strategic transaction.

About the author: Michael A. de Gennaro is a partner with PilieroMazza and heads the Business and Corporate Law Group.  He may be reached at mdegennaro@pilieromazza.com.

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