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arnou s n ransac ons
June22,2011KeyStructuresandRecentDevelopmentsPaulCrimmins13127017068 JessieWaller13127018761BenGray13127018644
MayerBrownisagloballegalservicesorganizationcomprisinglegalpracticesthatareseparateentities("MayerBrownPractices").TheMayerBrownPracticesare:MayerBrownLLP,alimitedliabilitypartnershipestablishedintheUnitedStates;
MayerBrown
International
LLP,
alimited
liability
partnership
incorporated
in
England
and
Wales;
and
JSM,
aHong
Kong
partnership,
and
its
associated
entities
in
Asia.
The
Mayer
Brown
Practices
are
known
as
Mayer
Brown
JSM
in
Asia.
InBrazilMayerBrownisinassociationwithTauil&ChequerAdvogados,aBrazilianpartnership.
pcrimmins@mayerbrown.com jwaller@mayerbrown.combgray@mayerbrown.com
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What is an Earnout?
as c e n t on: AnearnoutisariskallocationmechanismusedinanM&A
transaction
whereby
aportion
of
the
purchase
price
is
deferred
and
is
calculatedbasedontheperformanceoftheacquiredbusinessovera
spec e meper o o ow ng ec os ng.
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Reasons for Use of Earnouts
ValuationGap:Earnoutscanbridgethebusinessvaluationgapbetweenanoptimisticsellerandaskepticalbuyer.
Allows
asset
to
prove
its
worth.
Financing:Useofanearnoutinstructuringanacquisitionprovidesbuyerwith
anadditionaloptiontofinancetheacquisition(i.e.,buyermaybeabletopayfor
theacquisitionwithfutureprofitsofthetargetbusiness).
Thisattribute
is
particularly
important
in
economic
climates
where
third
party
financingcanbedifficulttoobtainonfavorableterms.
IncentiveBasedCompensation:Earnoutscanalsobeusedasaformofincentivebasedcompensationtosellerswhoarecontinuingasemployeesofthe
acquiredcompany.
Startups: Earnoutsareoftenusedforcompanieswithlittleoperatinghistorybut
.
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Key Structural Considerations
Principalconsiderationswhennegotiatinganddraftingan
(1)thedefinitionandscopeofthetargetbusiness;
(2)theselectionoftheperformancemetric;
(3)theselectionofappropriateaccountingmeasurementstandards;
(4)the
determination
of
the
payout
structure
and
establishment
of
the
earnou per o ;
(5)postclosingoperation(i.e.,theallocationofcontrolbetweenbuyerand
sellerandthelevelofsupport,ifany,thatbuyerwillcommittoassistthe
arge
us ness
nac ev ng
searnou
o ec ves ;
an
(6)disputesandresolution.
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Key Structural Considerations (contd)
1)DefiningtheTargetBusiness
escopeo e arge us nesss ou ec ear y e ne s nce s e
performanceof
this
business
that
will
determine
whether
earnout
requirementsaresatisfied.
e a ve yeasyw enacqu re us nessw eopera e asan
independentsubsidiaryordivision,butmoredifficultwhenthetargetis
tobeintegratedintobuyersexistingbusiness. Insuchsituations,the
performanceofthebusinessmaybemoredifficulttotrackandspecialaccountingallocationsmayberequired.
Segregatedfinancialstomeasureperformanceoftheacquired
businessshouldbeestablished.
Particularmatterstobeaddressedinclude:(i)thedefinedlineof
business,(ii)whetherexpansionofthebusinessbeyondthedefinedline
willcounttowardtheearnoutand(iii)salestocommoncustomers.
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Key Structural Considerations (contd)
2)PerformanceMetric
FinancialMetrics:Themostcommonfinancialmetricsare(i)revenue,(ii)net
income,(iii)EBITDAand(iv)earningspershare. Sellersoftenpreferrevenue
andbuyersoftenprefernetincome.
Sellerspreferrevenuebecauseitislesseasilymanipulatedbybuyer(and
easiertoachieve). Usingrevenueasthemetricmayincentivizesellers
managementtograntunprofitabledealstocustomers.
Buyersprefernetincomebecauseitprovidesamorecompletepictureof
performanceandincentivizessellersmanagementtocontrolcosts.
PartiesoftencompromiseonEBITDA(whichfactorsinoperationalcosts
butexcludescertainnonoperationalcosts).
,
appropriatebecausethereisnohistoricalinformationtouseasabasisfor
financialprojections. Inthesecases,productdevelopmentmilestones,
numberofcustomers,numberofproductssoldorlaunchofanewproduct
maybeusedasthemetric. Ingeneral,nonfinancialmetricscanleadtofewer
disputes
regarding
calculations
of
benchmarks.
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Key Structural Considerations (contd)
3)AccountingPrinciples
Itisimportanttoestablishappropriateaccountingprinciplesformeasuring
theperformancemetric.
ReferencetoGAAPinandofitselfisusuallynotsufficient.
, ,
consistentwitheitherbuyersorsellershistoricpractices.
Parties
should
also
consider
stipulating
aspecific
set
of
accounting
.
Somespecificaccountingmatterstobeconsideredare(i)useofcashor
accrualrevenuebasis,(ii)revenueandexpenseallocation,(iii)timingof
, ,
othernonrecurringitems,(vi)treatmentofintercompanytransactionsand(vii)treatmentofuncollectedreceivables.
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Key Structural Considerations (contd)
4)PayoutStructureandEarnoutPeriod
Installmentsvs.
lump
sum
Percentageofearnoutpaymentuponpartialsatisfactionofbenchmarks
vs.allornothingapproach
Earnoutconditionedonparticipationbysellerinacquiredbusiness
Offsetofindemnificationclaims
Adjustmentswithrespecttopaymentsmade(ormissed)inprevious
installmentsbased
on
subsequent
performance
(e.g.,
carry
back/carry
forwardofEBITDAfromonemeasurementperiodtoother
measurementperiods)
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Key Structural Considerations (contd)
Earnoutperiod:
Anearnoutperiodthatistooshortrisksperformancedistortionby
shorttermfactorsorthatsellerswillsacrificethelongterminterestsof
thebusiness.
Sellers
may
seek
ashorter
period
in
order
to
receive
full
paymentsoonerandmitigaterisk.
Alongerearnoutperiodwillallowtimetoensurethattheacquired
businessprovestobeaworthylongterminvestment.
Partiesshouldconsiderincludingaccelerationrights,whichresultinanimmediatepaymentandterminationoftheearnoutarrangement.
Sellermayhaveaccelerationrightuponcertaineventsthat
negativelyimpactsellersabilitytosatisfyearnouttargets(e.g.,
buyerssubsequent
sale
of
acquired
business,
bankruptcy
or
changeofcontrol).
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Key Structural Considerations (contd)
5)PostClosingOperationofAcquiredBusiness
Twoimportantquestionsthatmustbeaddressedare(i)howwillpost
acquisitioncontrolbeallocatedbetweenbuyerandsellerand(ii)whatlevelof
support(if
any)
will
buyer
be
obligated
to
provide
the
acquired
business?
(i)AllocationofControloverOperations
Sellerwillsometimesretainalevelofcontrolovertheoperationsofthe
acquiredbusiness(e.g.,approvalrightsovermajordecisions).
,
howtheacquiredbusinessmaybeoperatedtopreventbuyerfrom
makingsignificantchangesthatreducetheearnoutamount,suchas(a)
discontinuingproducts,(b)reducingsalesforceor(c)shiftingsalesand
costs.
Buyermayberequiredtooperatethebusinessconsistentlywith
howitwasoperatedpriortoclosing.
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Key Structural Considerations (contd)
Thepartiesshouldaddressthetreatmentofbuyersexistingcompeting
businessesandafteracquiredbusinesses.
(ii)LevelofSupport
Affirmativerequirementsforbuyerinsupportingthetargetbusiness(e.g.,
marketing,salesforceincreases,adequatecapitalization).
Requirementthatbuyeruseaspecifiedlevelofeffortstomaximizethe
earnout.
businessinitssolediscretionandnotbeobligatedtoachievetheearnout.
Buyershouldincludelanguageintheacquisitionagreementthat(i)
ives bu er absolute discretion over o eration and ii ne ates an
obligation(express
or
implied)
toward
supporting
the
acquired
businessorachievingtheearnout.
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Key Structural Considerations (contd)
6)DisputesandResolution
Financial
statements
and
earnout
calculations
are
typically
prepared
bybuyeranditsaccountants.
statementsandearnoutcalculation.
Arbitrationprocedures
should
be
established
in
advance
to
resolve
futuredisagreementsconcerningtheearnoutcalculationinafairand
expeditiousmanner.
Oftenaninde endentaccountantservesasthearbitrator.
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Earnouts Case Law
TheEarnout:ADisputePostponed?
Dueto
the
complexities
of
structuring
an
earnout,
earnouts
often
lead
to
futuredisagreementsandlitigation.
s ce ance or as ers a e n erecen r orne ea ec s on, ...anearnoutoftenconvertstodaysdisagreementoverpriceintotomorrows
litigationoveroutcome.
o a y,cour s ave eenw ng ouse e mp e covenan o goo a o
imposeobligationsorrestrictionsonbuyerwithrespecttoitspostclosing
operationoftheacquiredbusinessintheabsenceofexpresscontractual
terms.
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Implied Covenant of Good Faith
OToolv.GenmarHoldin s Inc. 387F.3d1188 10thCir.2004
The10th
Circuit,
applying
Delaware
law,
upheld
ajury
verdict
in
favor
of
sellersofaboatmanufacturingbusiness. Theopinionwassignificantinthatit
was not based on a breach of ex ress rovisions in the urchase a reement
butontheimplieddutyofgoodfaithandfairdealing.
The
implied
covenant
of
good
faith
and
fair
dealing
inheres
in
every
contract.
The im lied covenant rotects the s irit of an a reement when without
violatingtheexpresstermsoftheagreement,onesideusesoppressiveor
underhandedtacticstodenytheothersidethefruitsofthepartiesbargain.
Theimpliedcovenant,however,cannotcontravenethepartiesexpress
agreemen
an
canno
e
use
o
orge
a
new
agreemen
eyon
e
scope
o
thewrittencontract.
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Implied Covenant of Good Faith (contd) OToolv.GenmarHoldings,Inc.,387F.3d1188(10thCir.2004)
(contd)
Specifically,thecourtheldthatthebuyerbreachedtheimpliedcovenantof
goodfaith
by
(i)
immediately
changing
known
product
names,
(ii)
requiring
theacquiredbusinesstoprioritizesalesofproductsnotsubjecttothe
,
facilities,(iv)forcingtheacquiredbusinesstobearthedesignandproduction
costsofanotherlineofbuyersbusinessand(v)failingtogivethesellersthe
necessaryoperational
control
over
the
acquired
business.
The
court
reasone t at espitet e ac o expressprovisionsrestrictingt e uyer s
actions,theobviousspiritofthecontractwastogivethesellersafair
opportunitytooperatethe[acquiredbusiness]insuchafashionasto
maximizetheearnout andu heldthe ur sfindin thatsuchan
opportunityhad
not
been
given.
Asignificantfactorinthisdecisionwasthefactthatthecourtstrongly
su estedthebu erhadanulteriormotiveandthatthebu ersstrate was
nottogrowthebusinessbuttoeliminateacompetitorandgainaproduction
facility
for
its
other
brands.
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Implied Covenant of Good Faith (contd)
AirborneHealth,Inc.v.SquidSoap,LP,984A.2d126(Del.Ch.
2009)
TheDelawareChanceryCourtrecentlyreachedadifferentresultinAirborne.
BuyerpurchasedsellersSquidSoapbusinessfor$1millionplusupto$26.5
millioninearnout a ments.
Importantly,theacquisitionagreementhadaprovisionrequiringbuyerto
returnthesoldassetsifcertainbusinesstargets,suchasadvertisingspending
andsales werenotachieved.
Shortlyaftertheacquisition,buyersufferedfromcripplinglitigationand
negativepublicitywithregardtoanunrelatedproduct,andtheearnout
tar etswerenotachieved.
Sellerallegedthatbuyerbreachedtheimpliedcovenantofgoodfaithandfair
dealingbynotspendingonmarketingoftheSquidSoapproduct.
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Implied Covenant of Good Faith (contd)
AirborneHealth,Inc.v.SquidSoap,LP,984A.2d126(Del.Ch.
2009)(contd)
Theagreementcontainednorequirementforbuyertospendfundson
marketingso
there
was
no
express
breach
of
contract.
In
addition,
the
agreementcontemplatedthattheassetswouldbereturnedifbuyerfailedto
.
Thecourtagreedthatbuyercouldnotarbitrarilyorinbadfaithrefuseto
expend
resources
and
thereby
deprive
seller
of
the
earnout.
However,
the
[buyer]failedtoexpendfundstomakethebusinessasuccessarbitrarily,in
badfaith,orfornoreason. Tothecontrary,thecourtrecognizedthatbuyer
hadsufferedacorporatecrisisandwasundoubtedlyrestrainedbythelegal
an
inancia
ur ens
o
t e
sett ement
an
systemic
mar et
amage.
T e
courtnotedthatsellerspositionwasalsoundercutbytheeasewithwhichit
couldhavecontractedforanexpenditureofresources.
Buyer smotion orsummary ju gmentwasgrante .
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Implied Covenant of Good Faith (contd)
.
,
.,
. .
Dist.LEXIS91236(D.Mass.2009).
InFireman,sellerssoldtheirmarketingbusinesstodefendantfor$2.8millionincashplusthepossibilityofadditionalearnoutpaymentsoverfiveyears.
Whenthe
acquired
business
did
not
meet
the
maximum
earnout
targets,
sellersallegedbuyerbreachedtheimpliedcovenantbyrebrandingthe
,
refusingtouseitssalesforcetopromotetheproductattradeshows.
ApplyingNew
York
law,
the
court
held
that
the
merit
of
[sellers]
claim
business]tolosemoney. Thecourtfoundthatbuyersactionswere
legitimatebusinessdecisions,andthatplaintiffsallegationsamountedto
nothingmorethandisputesconcerningstrategybetweensophisticated
businesspeople.
Therefore,
the
court
held
that
there
was
no
dispute
of
materialfactastowhetherdefendantbuyerbreachedtheimpliedcovenant
ofgoodfaith,andgrantedbuyersmotionforsummaryjudgment.
Takeaway: Ifsellerwantsbuyertotakecertainactionswhenoperatingthe
business,itshouldnegotiateforsuchprovisionsinthecontract.
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Implied Obligation to use Reasonable
SonoranScanners,Inc.v.PerkinElmer,Inc.,585F.3d535(1stCir.
2009
The1st
Circuit,
applying
Massachusetts
law,
did
not
find
abreach
of
the
implied
covenantofgoodfaith. Nevertheless,itreversedthelowercourtsgrantof
summar ud menttobu erb holdin thatbu erhadanim liedobli ationto
usereasonableeffortstodevelopandpromotesellerstechnology.
Thecourtreliedonaseriesofcasesdealingwithexclusivelicenses.
Thefollowingfactorswereimportantinfindingthatanobligationofreasonable
effortsapplied:(i)theearnoutwassubstantialinrelationtotheupfrontpayment
($3.5millionupfrontand$3.5millioninpotentialearnouts);(ii)thatmostofthe
u front a mentwenttocreditors iii thatthe urchasea reement
contemplatedacampaign
to
market
sellers
technology
and
(iv)
that
[t]here
was
nolanguageintheagreementnegatinganobligation...tousereasonableefforts
orconferringabsolutediscretionon[buyer]astotheoperationofthebusiness.
Remandedtodistrictcourttodetermineifbuyerbreachedthisobligation.
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Implied Obligation to use Reasonable
SonoranScannersseemstobeanoutlier.
Little
other
case
law
implies
a
reasonable
efforts
obligation
in
thecontextofearnouts.
Delawarecourtshavesuggestedthereisnoimpliedobligationtouse
reasonableefforts. Airborne: SquidSoapspositionisalsoundercutbythe
ease
with
which
Squid
Soap
could
have
insisted
on
specific
contractual
,
formofeffortsobligationforAirborne.
Itremainstobeseen,however,ifothercourtswillfollowtheleadofthe1st
.
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Buyers Points: Disclaimers
Inlightofthecaselaw,buyersshouldfocusonincluding
disclaimerprovisionsinanyearnoutscontract.
Buyershouldaddcontractuallanguagethatnegatesanyimpliedcovenantofgoodfaith
andanyimpliedobligationofreasonableefforts.
manner.
Implied
obligation
of
good
faith
can
only
be
disclaimed
if
done
specifically.
Includespecificcontractuallanguageacknowledgingthat,withtheexception
ofanyspecificallynegotiatedrestrictivecovenantsintheagreement,buyer
hasnoexpressorimpliedobligationsinregardstotheearnout.
Include
provisions
waiving
asellers
right
to
sue
under
an
implied
covenant
or
impliedobligation.
Buyershouldalsoincludenorelianceprovisionsandintegrationclauses.
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Buyers Points
actions.
Buyershouldincludeanacknowledgmentfromsellerintheacquisition
.
Yarboroughv.
DeVilbiss
Air
Power
Inc.,
321
F.3d
728
(8th
Cir.
2003)
Earnoutpaymentwasbasedonlyonsalestocertainspecifiedcustomers.
Buyerdiscontinueddoingbusinesswithonespecifiedcustomerand
transferredthat
portion
of
its
business
to
another,
non
specified
customer.
Agreementstatedthatbuyerhastheright,initssolediscretion,to
determinethetermsandconditionsofanyandallrelevantsales,including
thedecisiontomakeornotmakeanysuchsales.
8thCircuitfoundbuyerhadexpresslyandunambiguouslycontractedforabsolutepoweroveritsabilitytomakesalesinordertoforeclosesellers
claimofbreachoftheimpliedcovenantofgoodfaith.Thecourtaffirmedthe
grantofsummaryjudgmentforbuyer.
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Sellers Points
AffirmativeCovenants: Sellershouldnegotiateforaffirmativecovenantsrequiringbuyertoactingoodfaith,usereasonableeffortsandtake
everyaction
necessary
to
maximize
the
earnout
payment.
RestrictiveCovenants:Sellershouldalsone otiateforcovenantsexplicitlyrestrictingcertainactions,including,forexample:transferringfixed
coststotheacquiredbusiness,firingorrelocatingkeypersonnelandunder
capitalizingthe
business
or
the
R&D
needed
for
growth.
Control:Sellermayalsowanttocontractforacertainlevelofcontrolovertheoperationsoftheacquiredbusinessduringthelengthoftheearnout
period(e.g.,approvalrightsovercertainmajordecisions,abilitytoelecta
certainnumber
of
directors).
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Sellers Points: The Problem of Damages
SelfExecutingRemedies:
Inearnoutscases,damagescanoftenbehardtoprove.
LaPointv.AmerisourcebergenCorp.,2007Del.Ch.LEXIS131(Del.Ch.2007),
illustratesthis
problem
for
sellers.
TheDelawareChanceryCourtheldthatbuyerbreachedacovenant
requiringittoexclusivelyandactivelypromotetheacquiredbusinesss
products,butitdidnotfindthatsellersatisfieditsburdeninproving
damages. Thus,thecourtawardedonlynominaldamagesonthatcount.
Toavoidthistypeofoutcome,thepartiesshouldspecifyremediesfor
breachesoftheagreement(e.g.,liquidateddamages).
Itisdifficulttoprovethatspecificbenchmarkswouldhavebeenachievedbut
for
breaches
by
buyer.
Breachofcontractualprovisionallowingsellertoretaincontrolofthe
acquiredbusinesssoperationscreatesevenmoreuncertaintyastodamages.
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Sellers Points: The Problem of Damages
PossibleSelfExecutingRemedies:
qu a e amages.
Breachof
any
express
covenant
results
in
damages
of
maximum
or
partial
earnoutpayment.
Canresultinwindfallfortheseller. SeeAvesair,Inc.v.InPhonic,Inc.,
2007NCBC32(N.C.Super.Ct.2007). Inthatcase,theacquisition
agreementprovided
that
regardless
of
whether
the
earnout
threshold
wasme , emax mumearnou wou e ue uyer a e ouse
commerciallyreasonableeffortstosellacquiredbusinessproducts,(ii)
terminatedcertainemployeesor(iii)failedtoprovideoutsideaudited
financialinformationattheendoftheearnoutperiod. Thecourt
concludedthat
because
outside
audited
financial
information
was
not
provided,sellerwasentitledtomaximumearnoutpayment.
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Sellers Points: The Problem of Damages
PossibleSelfExecutin Remedies contd :
Breach
of
any
(i)
express
obligation
of
buyer
to
use
acertain
level
of
efforts
to
maximizetheearnoutor(ii)impliedcovenantorobligationresultsindamages
Specificremedies:Breachofcovenanttomakeexpenditureorotherrequired
actionresultsinanadjustmenttothefinancialmetricusedfortheearnout
calculation.
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Additional Consideration: Accounting
Historically,earnoutconsiderationwasrecognizedinbuyersfinancial
statementsifandwhentheconditionstopaymentoftheearnoutwere
satisfied.
UnderFAS
141(R),
effective
in
2009,
earnouts
are
now
required
to
be
recordedatfairvalueatthedateofclosing. Therecordedfairvalueisthen
subjecttoperiodicadjustmentsbasedonthelikelihoodofpaymentoractual
earnoutpaymentsthathaveoccurred.
Anysuch
adjustment
must
be
recorded
as
gain
or
loss
on
buyers
income
statement.
Resultofthisruleistoacceleratetherecordingofliabilitiesrelatedtothe
earnoutandcouldalsocausefutureearningsvolatility.
Thismay
make
the
use
of
earnouts
less
attractive
to
buyers
or
cause
buyers
to
negotiateforashorterearnoutperiod.
compensationratherthanpurchaseprice.
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Additional Consideration: Earnouts as a
Istherighttoanearnoutasecurity? Anearnoutcanbea
securityundercertaincircumstances. TheSEChasissued
multipleno
action
letters
on
the
subject
and
has
created
a
Istheearnoutrightanintegralpartoftheconsiderationtobereceivedinthe
transaction?
Istheearnoutrightrepresentedbyanyformofcertificateorinstrument?
Dotheholdersoftheearnouthaveanyrightincommonwithshareholders
suchasvotinganddividendrights?
Doesthe
earnout
represent
an
equity
or
ownership
interest
in
the
surviving
entity?
,
28
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