For buyers and sellers in M&A transactions, the purchase price is typically the single most important deal term. Sellers view their companies through the lens of years of commitment, sacrifice, invested capital, customer relationships, intellectual property, reputation, and expected growth. Buyers, however, view the same business through historical financial performance, projected cash flow, industry and customer concentration risk, integration cost, return on invested capital, and the likelihood of a successful future exit.
Those competing views of the same business rarely land on the same purchase price, resulting in a valuation gap. Purchase price creativity among the dealmakers can bridge the pricing gap and enable a transaction to proceed on mutually beneficial terms where it would have otherwise simply collapsed in the discussions phase. This article examines the most common alternatives to all-cash consideration: earnouts, seller notes, rollover equity, and other performance-based and contingent payments.
Valuation Gaps
Understanding alternative forms of consideration requires understanding why the gap exists in the first place.
Buyers generally price a business as a multiple of normalized earnings, usually EBITDA. Before signing, most buyers commission a quality of earnings (QoE) analysis, which reconstructs reported earnings on a normalized basis. A QoE will typically add back owner compensation above market, discretionary personal expenses, and genuinely non-recurring items, but it will also adjust downward for deferred maintenance, below-market related-party rent, unrecorded liabilities, unsustainable margins, and revenue that is not truly recurring. The resulting figure, not the seller’s internal financial statements, usually becomes the basis for the buyer’s valuation.
Sellers, by contrast, price the business on trajectory, including the pipeline, contracts recently signed, expansion underway, investments that have not yet shown up in earnings, and sometimes personal factors such as sweat equity or the history of family ownership. The multiple itself is equally contested, driven by company size, growth rate, customer concentration, revenue recurrence, management depth beyond the owner, and industry dynamics.
The gap, in other words, is structural rather than a product of bad faith. Deferred and contingent consideration addresses this directly. If the business performs the way the seller predicts, the seller receives the additional value. If it does not, the buyer does not overpay.
Earnouts
An earnout is the most common mechanism for bridging a valuation gap. A portion of the purchase price is paid after closing, but only if the business achieves specified financial or operational metrics. Common metrics include revenue, EBITDA, gross profit, net income, new customer acquisition, and other defined milestones. Precise definition of the metrics is critical. Revenue-based metrics are simpler to calculate and harder to manipulate, but they can reward growth that is unprofitable. EBITDA-based metrics track value more closely but import every judgment call about expense allocation into the payment calculation.
A simple structure might provide $15 million in cash payable at closing and up to an additional $6 million over three years if EBITDA exceeds agreed thresholds. Earnouts do not need to be all-or-nothing. Tiered structures can pay graduated amounts across performance ranges for each year:
| EBITDA | Earnout Payment |
| Less than $1,000,000 | $0 |
| $1,000,000 – $1,499,999 | $1,000,000 |
| $1,500,000 or more | $2,000,000 |
The above contemplates a simple tier structure where EBITDA is measured against the same scale each year and the seller receives either $0, $1,000,000, or $2,000,000 depending on that year’s EBITDA. Each factor (the number of tiers, the earnout amounts, the measurement periods, thresholds, etc.) can be structured in an infinite number of ways.
Earnouts bridge meaningful valuation disagreements, reduce buyer risk, reward sellers for post-closing performance, and materially increase the likelihood that a transaction closes at all.
The main risk to the seller with earnouts is that after closing, the buyer controls the business that generates the earnout. Accounting methodology, allocation of corporate overhead, integration decisions, capital expenditures, staffing, pricing, and changes in business strategy all affect the metric, and all sit within the buyer’s discretion. If litigated, courts generally enforce earnout provisions as written and are reluctant to imply operating obligations the parties did not negotiate. Many buyers go further and expressly disclaim any implied duty to operate the business so as to maximize the earnout.
Sellers should treat the following as core negotiating points:
- Definition of the metric. Specify the accounting principles to be applied and require consistency with historical practice. Address add-backs, allocation of corporate overhead and management fees, intercompany charges, transaction and integration expenses, and the treatment of acquisitions completed during the earnout period. A worked sample calculation attached as an exhibit is the most effective way to eliminate ambiguity.
- Operating covenants. Require the business to be operated in the ordinary course, with separate books and records, and restrict the actions that predictably suppress the metric, such as reduced capital expenditures, staffing cuts, reallocation of customers or personnel to affiliates, and material changes in pricing or strategy.
- Provide that the earnout accelerates and becomes payable on a change of control, a sale of the acquired business, termination of key personnel without cause, or the buyer’s breach.
- Information and dispute rights. Require delivery of periodic financial statements and a calculation statement, with inspection or audit rights and a defined dispute process resolved by an independent accountant.
- Forfeiture and employment conditions. Earnouts conditioned on the seller’s continued employment create two problems. First, the buyer controls whether the condition is satisfied. Second, the payment may be recharacterized as compensation taxable as ordinary income rather than capital gain.
- Credit and priority. Earnout obligations are typically unsecured and frequently subordinated to the buyer’s senior lender. Sellers should confirm where they sit in the capital structure and should limit any buyer setoff right to indemnification claims that have been finally determined.
Seller Financing – Promissory Notes
A portion of the purchase price may also be paid through a seller-financed promissory note issued by the buyer, either alone or alongside the structures discussed in this article. The seller is, in substance, lending the buyer part of the purchase price and is repaid over time with interest and seller notes may create tax advantages for sellers.
The commercial terms include principal, interest rate, amortization schedule or balloon maturity, term, and prepayment rights. Those terms are the starting point, but they are rarely where the risk lies. The real risk is that the seller becomes an unsecured creditor of the buyer, ranking behind the senior lender that financed the acquisition.
The following are key terms that sellers should consider:
- Most seller notes are subordinated to senior debt. Key subordination terms include payment blockage periods, standstill periods during which the seller cannot enforce, caps on permitted senior debt, and whether the senior lender must consent to any amendment. Together they determine whether the note is a real obligation or a contingent one. This is usually the most consequential negotiation in the instrument.
- Where possible, obtain a lien on assets (typically junior to the senior lender) or a pledge of equity in the acquiring entity.
- Consider guaranties from a parent entity, the sponsor, or individual principals, and confirm the guarantor actually holds meaningful assets.
- Buyers commonly reserve the right to offset indemnification claims against note payments. Limit that right to finally determined claims and require continued payment of undisputed amounts in the interim.
- Defaults and remedies. Negotiate acceleration on payment default, default interest, and recovery of enforcement costs, along with reporting covenants that give the seller visibility into the buyer’s financial condition.
- Payments under a note may qualify for installment method reporting, which defers gain recognition until payments are received. Interest is ordinary income. Imputed interest rules apply if the stated rate is inadequate. These consequences should be modeled with tax counsel before the structure is fixed.
Rollover Equity
Rather than receiving all cash, a seller may retain an ownership stake in the post-closing enterprise by reinvesting a portion of the proceeds into the buyer or its parent. On a $40 million enterprise value, for example, the seller might receive $32 million in cash at closing and roll $8 million into the buyer’s holding company. The seller becomes both a seller and an investor.
Private equity buyers use rollover equity heavily because it aligns management and investor incentives and reduces the cash required at closing. For sellers, this is the opportunity to take a ‘second bite at the apple’ by participating in the sponsor’s eventual exit. In a successful investment, that second payout can exceed the value of the first.
The analysis a seller should perform here is an investment analysis, not a sale analysis:
- Valuation Parity. Confirm the rolled equity is valued at the same enterprise value as the cash consideration. Rolling in at a premium to what the sponsor pays for its own equity quietly reduces the seller’s economics.
- Class and Priority. Determine whether the rollover is the same security the sponsor holds or common equity sitting behind a preferred return. Common equity beneath a large preferred stack can be worth considerably less than its nominal amount, and it may be worth nothing in a modest exit.
- Negotiate board or observer representation, consent rights over major decisions, and ongoing information rights. Absent these, the seller is a passive minority holder.
- Liquidity and Transfer. Address transfer restrictions, tag-along rights (the ability to participate in a sponsor sale), drag-along obligations, rights of first refusal, and any put or call rights. Pay particular attention to the valuation formula applied if the seller’s employment ends.
- Understand how follow-on acquisitions, additional capital raises, and the management incentive plan will dilute the position over the hold period.
- Rollovers are frequently structured to defer tax on the rolled portion, but the deferral depends on the entity types involved and on the form of the transaction, and it is easily lost if the structure is not planned in advance. Structure this with tax counsel at the term sheet stage, not at closing.
Performance-Based and Other Contingent Consideration
Beyond conventional earnouts, consideration can be tied to almost any catalyst event the parties expect to drive value. Examples include regulatory (e.g., FDA approval)approval, issuance of a patent, completion of a development project, award of a large contract, resolution of litigation, or the sale of a division. These structures fit situations where value is binary rather than incremental.
The drafting discipline is the same as for earnouts: an objective, defined trigger; a clear measurement and payment mechanism; and allocation of control over the process that produces the event, including an obligation to pursue it with defined diligence.
The Control Problem
Every structure in this article shares a common tension. Deferred consideration depends on future performance, but the seller has given up control of the business that must perform.
Sellers who remain as employees rarely retain real decision-making authority, and employment can end. A seller whose earnout depends on EBITDA has no practical ability to prevent the buyer from adding overhead, cutting the sales force, or redirecting the growth strategy unless the purchase agreement says otherwise. The protections that matter are contractual and must be negotiated before signing. They include operating covenants, information and audit rights, acceleration triggers, and an efficient dispute mechanism.
Sellers should also evaluate offers on a risk-adjusted, after-tax basis. A $20 million transaction consisting of $12 million in cash and $8 million in contingent consideration is not a $20 million transaction. The contingent components should be discounted for the probability of payment, the time value of money, the buyer’s credit, and the tax treatment of each element. Measured in that way, a lower headline price with more cash at closing is frequently the better deal. Sellers should ask themselves, “If I walked away with only the cash after taxes and transaction costs, would I still be happy with the deal?”
Conclusion
Successful acquisitions are rarely the product of simply agreeing on a purchase price. They result from deliberate negotiations over how, when, and under what circumstances that price will be paid. Earnouts, seller notes, rollover equity, and milestone payments allow buyers and sellers to bridge valuation gaps without requiring either side to abandon its view of the business.
For business owners contemplating the purchase or sale of a company, a significant gap in purchase price expectations does not necessarily mean the deal is dead. In today’s M&A market, creative structuring can often bridge valuation differences and align the parties’ competing views of risk and future performance. Earnouts, seller notes, rollover equity, milestone payments, and other forms of contingent consideration can transform an otherwise unworkable transaction into one that is economically attractive for both sides. At the same time, the highest headline purchase price is not always the most valuable deal. The timing of payments, the conditions attached to future consideration, the seller’s continuing role, tax consequences, credit risk, and the contractual protections built into the acquisition agreement ultimately determine whether the parties realize the economics they expect. For that reason, experienced M&A counsel should be involved early in the process. Advisors who regularly structure complex transactions and represent both buyers and sellers are often able to identify practical solutions, distinguish market terms from negotiating positions, and help parties bridge valuation gaps that might otherwise prevent a successful closing.
Related Practice Areas
Corporate Law | Mergers & Acquisitions
About the Authors
Bill Rosin is a member of Dickinson Wright and practices out of the firm’s Troy office. He advises multinational, national, and local businesses on mergers and acquisitions, joint ventures, international transactions, and general corporate matters, with additional depth in complex real estate transactions. Bill is regularly invited to speak at M&A conferences and has been recognized by Best Lawyers in America, DBusiness Magazine, and Michigan Super Lawyers.
David Craan is an associate in Dickinson Wright’s Chicago office, focusing on corporate, M&A, private equity, and securities matters. He earned his J.D. from the University of Illinois College of Law and was a former baseball student-athlete at the University of Illinois.