Structuring Earn-Out Agreements in South Dakota M&A Deals to Bridge Valuation Gaps

Executing an unreviewed earn-out agreement when selling a manufacturing plant in Sioux Falls or a hospitality group in Rapid City can leave a seller empty-handed even while the acquired business thrives. When buyers and sellers in South Dakota mergers and acquisitions cannot agree on what a company is worth today, structuring earn-out agreements in South Dakota M&A deals provides a contingent pricing mechanism that bridges the valuation gap. Instead of walking away from the table, the buyer pays a baseline amount at closing and commits to paying additional purchase consideration if the business hits specific financial or operational milestones after closing.

However, because South Dakota contract law strictly enforces the literal text of commercial agreements under S.D. Codified Laws § 53-1-2 and S.D. Codified Laws § 53-8-2, a vaguely drafted earn-out often turns a valuation disagreement into a delayed courtroom battle. Understanding how financial metrics, accounting definitions, post-closing operational covenants, and tax allocations work together is essential to protecting both sides of the transaction.

Defining Financial Milestones: EBITDA vs. Gross Revenue Metrics

Selecting the financial yardstick that triggers contingent payments is the most heavily negotiated aspect of any South Dakota M&A transaction. Sellers in cities like Aberdeen, Brookings, and Watertown generally prefer top-line gross revenue milestones because revenue is transparent and difficult for a buyer to manipulate through internal overhead allocations. Conversely, buyers typically insist on net income or Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) to ensure the acquired company actually generates sufficient cash flow to fund the contingent payout.

To prevent post-closing accounting disputes, experienced dealmakers often use a hybrid structure or a tiered sliding scale rather than an all-or-nothing cliff target. Below is a comparison of the primary earn-out metrics used in South Dakota corporate acquisitions under S.D. Codified Laws § 47-1A-1102 and S.D. Codified Laws § 47-34A-902:

How South Dakota Courts Interpret Good Faith in Post-Merger Operations

Sellers frequently assume that if a buyer runs the company poorly or shifts business to another subsidiary after closing, a judge will automatically award the earn-out under the implied covenant of good faith and fair dealing. In South Dakota, relying solely on implied good faith is a perilous strategy. While S.D. Codified Laws § 57A-1-304 codifies good faith in Uniform Commercial Code transactions, the common law standard established by the South Dakota Supreme Court, Pierre governs most stock and asset purchase agreements.

In the landmark decision Garrett v. BankWest, Inc., 459 N.W.2d 833 (SD Supreme Court 1990), the court held that every contract in South Dakota contains an implied covenant of good faith and fair dealing that prohibits either party from injuring the other party's right to receive the benefits of the bargain. However, the court emphasized that this implied duty does not create an independent tort and does not require a commercial party to sacrifice its own legitimate business interests. Subsequent rulings reinforced this strict approach to commercial text.

In Farm Credit Servs. of Am. v. Dougan, 704 N.W.2d 24 (SD Supreme Court 2005), the court ruled that the implied covenant of good faith cannot block a party from exercising rights expressly granted in the contract. Similarly, in Nygaard v. Sioux Valley Hosps. & Health Sys., 731 N.W.2d 184 (SD Supreme Court 2007), the court confirmed that good faith cannot be used to supply new terms that sophisticated parties failed to negotiate. Consequently, if a South Dakota purchase agreement gives the buyer sole discretion over post-closing operations, a court generally will not rescue the seller unless the seller proves intentional bad-faith sabotage targeting the earn-out.

Protecting Sellers from Intentional Buyer Mismanagement

Because South Dakota courts refuse to rewrite commercial contracts after the fact, sellers must build explicit operational guardrails directly into the acquisition agreement. Whether the target company is an agricultural equipment dealer in Mitchell or a software firm in Sioux Falls, customized legal covenants prevent a buyer from artificially depressing earnings during the measurement period.

Affirmative Operational Covenants and Budget Floors

Sellers often negotiate an affirmative covenant requiring the buyer to operate the acquired business as a standalone accounting division consistent with past historical practices. Key protections include maintaining minimum working capital levels, prohibiting the diversion of existing customers to the buyer's other affiliates, and setting a floor on annual marketing and sales budgets. If the buyer reduces the sales force or discontinues a profitable product line without the seller's written consent, the agreement can specify a deemed revenue credit toward the earn-out calculation.

Custom Accounting Schedules and Expense Caps

Stating that earn-out EBITDA will be calculated in accordance with Generally Accepted Accounting Principles (GAAP) is rarely sufficient because GAAP permits wide latitude in revenue recognition and expense depreciation. A well-drafted South Dakota earn-out schedule explicitly excludes intercompany management fees, transaction and integration costs, extraordinary legal expenses, and increased depreciation resulting from the buyer's purchase price step-up. Parties typically attach a sample worksheet to the purchase agreement illustrating the exact line items included in the baseline calculation.

Acceleration Clauses Upon Change of Control or Termination

If the buyer resells the business, merges the division into another entity, or terminates the seller's post-closing employment without cause before the earn-out period expires, the seller's ability to achieve the milestones can be destroyed. Including an acceleration clause requires the maximum remaining earn-out balance-or a predetermined buyout amount-to become immediately due and payable upon a secondary sale under S.D. Codified Laws § 47-1A-1202 or a termination without cause.

Step-by-Step Process in South Dakota to Structure an Earn-Out

Whether your transaction is based in Sioux Falls, Rapid City, Pierre, or Yankton, structuring an enforceable earn-out follows a disciplined legal and financial sequence:

Step 1: Isolate the Valuation Gap and Select the Metric

Begin during the Letter of Intent (LOI) phase by identifying the exact dollar difference between the buyer's offer and the seller's asking price. Choose a metric-such as gross revenue, gross margin, or adjusted EBITDA-that directly measures the specific business projection causing the disagreement.

Step 2: Draft Custom Accounting Rules and Calculation Exhibits

Work with transaction attorneys and CPAs to draft a standalone Earn-Out Schedule stipulating that specific historical accounting policies supersede general GAAP wherever a conflict arises. Attach a pro forma calculation exhibit using the target's prior 12 months of financial data so neither party can misinterpret the formula later.

Step 3: Negotiate Post-Closing Operational Covenants

Define the governance rules for the measurement period, usually lasting between 12 and 36 months. Specify the seller's operational authority, cap parent-company overhead allocations, and insert acceleration triggers for early buyouts or subsequent asset sales.

Step 4: Establish Statement Delivery and CPA Dispute Resolution

Require the buyer to deliver certified financial statements and an earn-out calculation statement within 45 to 60 days after each measurement year ends. Grant the seller a 30-to-45-day inspection window to audit the books and refer any unresolved mathematical or accounting objections to an independent CPA firm acting as an expert arbitrator.

Step 5: Execute the Purchase Agreement and File State Merger Records

Incorporate the earn-out provisions into the definitive Asset Purchase Agreement or Stock Purchase Agreement. If the transaction involves a formal statutory merger of a corporation or LLC, file the required merger documentation with the South Dakota Secretary of State, Pierre to legally consummate the reorganization.

Step 6: Enforce Compliance or Litigate Breaches in Circuit Court

If a dispute involves legal contract interpretation or bad-faith operational interference rather than pure accounting math, a party may file a civil action within the 6-year statute of limitations under S.D. Codified Laws § 15-2-13. Commercial M&A lawsuits are typically filed in the Second Judicial Circuit Court, Minnehaha County, Sioux Falls, the Seventh Judicial Circuit Court, Pennington County, Rapid City, or the Sixth Judicial Circuit Court, Hughes County, Pierre accompanied by Form UJS-232, South Dakota, Unified Judicial System, Civil Case Filing Statement, or in federal court at the U.S. District Court for the District of South Dakota, Sioux Falls using Form JS 44, FED, U.S. District Court, Civil Cover Sheet if diversity jurisdiction applies.

Tax Treatment of Earn-Out Payments in South Dakota

One of the major structural advantages of buying or selling a company in South Dakota is that the state imposes a 0% state corporate income tax and a 0% state personal income tax. However, federal tax rules administered by the Internal Revenue Service heavily impact how much net cash a seller retains from an earn-out. How the agreement is worded determines whether contingent payments are taxed at favorable federal long-term capital gains rates or much higher ordinary income rates.

• Installment Sale Capital Gains Treatment: When an earn-out is structured as contingent purchase price for the transferred business equity or goodwill, payments generally qualify for installment sale reporting under 26 U.S.C. § 453. Sellers report these contingent payments as they are received using Form 6252, FED, IRS, Installment Sale Income, while both parties must align their purchase price allocations on Form 8594, FED, IRS, Asset Acquisition Statement Under Section 1060.
• Imputed Interest Rules: Because earn-out payments are made in future tax years, federal tax law under 26 U.S.C. § 483 and 26 U.S.C. § 1274 automatically recharacterizes a portion of each delayed payment as imputed interest based on the Applicable Federal Rate (AFR), which is taxed as ordinary income to the seller and deductible by the buyer.
• Recharacterization as Compensation Risk: If an earn-out is conditioned on the selling founder remaining employed by the buyer after closing-and forfeiting the earn-out if the seller resigns-the IRS may reclassify the entire contingent payout as disguised wages under 26 U.S.C. § 61. This subjects the payments to ordinary federal income tax rates plus federal payroll and self-employment taxes.

How Much Does It Cost in South Dakota?

Drafting, negotiating, and administering an earn-out agreement in South Dakota involves legal, accounting, and state filing expenses that vary based on deal size:

• M&A Attorney Legal Fees: South Dakota corporate and transaction lawyers generally charge between $275 and $550 per hour. Drafting a customized earn-out schedule and negotiating protective covenants as part of a broader purchase agreement typically costs between $3,500 and $12,000.
• Quality of Earnings (QoE) & CPA Modeling: Hiring a transaction CPA to establish baseline EBITDA adjustments and model the earn-out tiers generally costs $4,000 to $15,000.
• State Merger & Entity Filing Fees: If the deal requires filing Articles of Merger with the South Dakota Secretary of State, Pierre, the statutory filing fee is $60 for domestic corporations under S.D. Codified Laws § 47-1A-122 and $60 for domestic LLCs under S.D. Codified Laws § 47-34A-1206.
• Post-Closing Dispute Resolution Costs: Engaging an independent accounting referee to resolve a contested earn-out calculation typically costs $10,000 to $30,000, which the contract usually splits proportionally based on how far each party's calculation deviated from the referee's final determination.
• Circuit Court Filing Fees: If litigation becomes necessary in a South Dakota Circuit Court, the base civil filing fee is $25 under S.D. Codified Laws § 16-2-29(3)(a) (typically totaling $50 to $70 with mandatory court automation and law library surcharges), though complex commercial litigation attorney fees can exceed $50,000.

How Long Does the Process Take?

Timelines for structuring and completing an earn-out span both the pre-closing negotiation phase and the post-closing operational window:

• Negotiating and Drafting the Earn-Out: Reaching consensus on financial metrics, accounting definitions, and operational covenants typically takes 3 to 6 weeks during the definitive agreement stage.
• Earn-Out Measurement Period: Most South Dakota M&A earn-outs run for 12 to 36 months after the closing date. Periods shorter than 1 year rarely smooth out seasonal business cycles, while periods longer than 3 years often restrict the buyer's ability to integrate the business.
• Annual Calculation & Audit Review Window: Following each measurement year, the buyer typically has 45 to 60 days to deliver the calculation statement, and the seller has 30 to 45 days to audit the records or file a formal notice of objection.
• Independent CPA Arbitration: If an accounting objection is submitted to an independent CPA firm, the contract usually mandates a final binding calculation within 30 to 60 days of appointment.

Because small drafting oversights can cost millions of dollars in lost contingent consideration, working with an experienced corporate attorney is invaluable. You can browse our directory of South Dakota M&A and business lawyers to connect with a local professional who can draft and review your transaction documents.

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