Key Takeaway
In many private M&A transactions, buyers and sellers usually reach an impasse on valuation. Buyers may be unwilling to pay the seller’s full asking price at closing, particularly where future growth projections are uncertain. These days, two common tools used to bridge that gap are seller notes and earn-outs. While both defer a portion of the purchase price, they allocate risk very differently.
For sellers, understanding those differences and negotiating appropriate protections is critical, especially when the buyer has sufficient leverage to dictate transaction terms.
Seller Notes: Fixed Payment, Credit Risk
A seller note is a debt obligation. Generally, the buyer agrees to pay a fixed amount over time, usually with interest, pursuant to a promissory note.
The principal advantage is certainty. Once the deal closes, the amount owed is generally fixed and does not depend on future business performance. The seller bears primarily credit risk meaning, whether the buyer will have the financial ability to pay.
Key risks include:
- Buyer insolvency or financial distress.
- Subordination to senior lenders.
- Limited practical recovery if the buyer defaults.
To mitigate those risks, sellers should negotiate for:
- Parent or affiliate guarantees.
- Security interests where feasible.
- Financial reporting covenants.
- Restrictions on additional indebtedness.
- Cross-default and acceleration provisions.
When properly structured, a seller note typically provides greater payment certainty than an earn-out because the seller is not dependent on future operating results.
Earn-Outs: Potential Upside, Performance Risk
An earn-out is contingent consideration. Payment depends on achieving specified post-closing performance targets, such as revenue, EBITDA, recurring revenue, customer retention, or other metrics.
The primary benefit is upside. Earn-outs can allow sellers to receive additional value if the acquired business performs as expected or better. They are particularly common in technology, life sciences, and other growth-oriented businesses where future performance is difficult to predict.
The principal challenge is that following closing, the seller ordinarily no longer controls the business.
Among other things, a buyer may:
- reallocate personnel or other pertinent resources;
- change marketing priorities;
- integrate operations;
- alter pricing strategies;
- shift costs among business units; or
- adjust or modify accounting methods.
Even decisions made in good faith can materially affect earn-out achievement.
Unlike seller notes, earn-outs expose sellers to multiple layers of risk:
- Performance risk.
- Buyer control risk.
- Accounting and calculation disputes.
- Credit risk if payments ultimately become due.
Why Sellers Often Prefer Seller Notes
If a seller is presented with a choice between a seller note and an earn-out for the same amount, the seller note is often the safer alternative.
With a seller note, the seller’s primary concern is collectability. With an earn-out, the seller must first prove entitlement to payment and then collect it.
Stated differently, seller notes generally involve one significant risk, that being buyer creditworthiness, while earn-outs involve several.
Delaware Earn-Out Litigation: Recent Drafting Lessons
Delaware courts continue to see a steady stream of earn-out disputes, and the cases consistently highlight a common theme: most litigation arises from drafting ambiguities rather than bad conduct.
Several recurring trends emerge from relatively recent Delaware decisions.
1. Courts Closely Follow the Contract
Delaware courts generally refuse to rewrite earn-out provisions after closing. If parties fail to define operating obligations, accounting methodologies, or performance metrics with precision, courts will typically enforce the agreement as written.
In Winshall v. Viacom International Inc., 76 A.3d 808 (Del. 2013), the Delaware Supreme Court emphasized that earn-out disputes are governed primarily by the specific contractual language negotiated by the parties. Winshall illustrates the proposition that sophisticated parties should expect courts to enforce the bargain they drafted rather than rewrite it after closing.
2. Implied Covenant Claims Remain Difficult
Sellers frequently argue that a buyer operated the business in a manner that unfairly reduced earn-out payments. Delaware courts have repeatedly emphasized that implied covenant claims are narrow and cannot be used to create protections the parties failed to negotiate expressly.
In Lazard Technology Partners, LLC v. QinetiQ North America Operations LLC, 114 A.3d 193 (Del. 2015), the Delaware Supreme Court held that the implied covenant of good faith and fair dealing cannot be used to create obligations that the parties could have negotiated expressly but did not. Lazard is glaring support for the drafting lesson that sellers should negotiate explicit operating covenants rather than rely on implied protections. Another landmark Delaware case on point is Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126 (Del. Ch. 2009). Airborne Health recognizes that buyers generally retain discretion to operate the acquired business after closing unless the purchase agreement imposes specific limitations. Airborne Health further supports the notion that sellers should negotiate express post-closing operational protections.
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3. Ambiguous Financial Metrics Create Disputes
Many earn-out cases center on EBITDA calculations, expense allocations, intercompany charges, or changes in accounting practices.
While not a pure earn-out case, Chicago Bridge & Iron Co. N.V. v. Westinghouse Electric Co. LLC, 166 A.3d 912 (Del. 2017) emphasizes the fact that Delaware courts place significant weight on the accounting procedures and dispute-resolution mechanisms specifically negotiated in an acquisition agreement. Chicago Bridge also reinforces the importance of carefully defining financial metrics and calculation procedures.
In an earn out situation, the drafting takeaways are to:
- define all financial terms as precisely as possible;
- specify applicable accounting principles;
- address cost allocations; and
- include sample calculations whenever possible.
4. Information Rights Matter
Disputes become significantly more difficult for sellers when they lack access to financial information. Delaware cases frequently underscore the value of detailed reporting obligations and audit rights.
Winshall is the poster child case for supporting the premise that sellers should negotiate detailed reporting obligations, access to supporting records, audit rights, and a clear objection and dispute-resolution procedure involving an independent accounting expert. These provisions often prove as important as the earn-out formula itself because Delaware courts generally enforce the contractual framework negotiated by the parties.
Mitigating Earn-Out Risk
When a buyer insists on an earn-out, sellers should focus on reducing uncertainty through contract drafting.
Particularly important protections include:
- Objective performance metrics where possible.
- Consistent accounting methodologies.
- Periodic reporting obligations.
- Audit and inspection rights.
- Covenants prohibiting actions primarily intended to avoid the earn-out.
- Expert determination procedures for accounting disputes.
- Acceleration or deemed achievement provisions upon a sale of the acquired business or other change-of-control event.
Buyers often resist broad operational restrictions, but even limited protections can materially improve the seller’s likelihood of receiving the expected consideration.
Conclusion
Although seller notes and earn-outs are both forms of deferred purchase price, they allocate risk in fundamentally different ways. Seller notes primarily expose sellers to credit risk, while earn-outs add performance, operational, accounting, and collection risks.
For sellers, the most important question is not how much deferred consideration is being offered, but what must occur before that consideration becomes payable. When leverage permits, sellers should generally favor fixed payment obligations over contingent consideration. Where earn-outs are unavoidable, careful drafting, particularly regarding business operations, financial metrics, information rights, and dispute procedures, remains the best protection against becoming the next Delaware earn-out case.
