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Market Standards: Trends in Earn-Out Covenants

February 07, 2023 (3 min read)

Despite intensive due diligence and financial analysis, many buyers may remain concerned about financial performance and profitability of a target company post-closing. Earn-out payments can help buyers balance concerns of overpaying for the target with a seller’s concern that the business is being undervalued, though, such provisions can be subject to extensive negotiation. Few parts of an earn-out mechanics are negotiated as extensively as post-closing covenants, and for good reason. Although a target’s financial success post-closing benefits both buyers and sellers, sellers will seek to set limits on buyer’s operation and support of the business during the measurement period, while buyers will want to reserve their right to run the business as they see fit.

Reflective perhaps of broader market forces, earn-out covenants were used infrequently last year. According to Market Standards, just 35 transaction agreements were filed between December 1, 2021 and January 1, 2023 that imposed explicit conditions on the buyer’s operation of the target post-closing, compared with a total of 1,375 transaction agreements that imposed no conditions or requirements on buyer whatsoever. Of those 35 agreements:

Notwithstanding those covenants, a full 91% (32) of the filed transaction agreements that addressed a post-closing earn-out covenant still reserved buyer’s right to operate the business in its reasonable, good faith, or absolute discretion, regardless of the appearance of other covenants.

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Learn more about drafting and negotiating earn-out covenants and provisions in this practice note.

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