Larkspur Analytics Earn-Out: Fix the Metric Before the Buyer Controls the Costs

1) Document Review Memo — Draft Earn-Out Weaknesses and How They Can Cut the Payout

To: Priya Nandakumar and Tom Ellery Re: Larkspur Analytics earn-out provision in Meridian draft purchase agreement Bottom line: As drafted, the earn-out should be treated as highly uncertain and potentially worth little. The metric is controlled by Meridian after closing, the formula does not pay meaningful amounts at Larkspur’s plan, and Meridian’s ordinary integration practices can eliminate the payout without any need for bad faith.

A. The biggest issue: the earn-out is tied to EBITDA after Meridian controls the costs

The draft provides:

> “Target EBITDA shall be determined in accordance with Buyer’s accounting policies consistently applied.” > “Buyer shall operate the Target in its sole discretion.”

Meridian has already told us it intends to:

• merge Larkspur’s sales team into Meridian’s;
• move Larkspur onto Meridian shared services;
• allocate corporate overhead; and
• expense integration costs where incurred.

Meridian’s allocation policy allows corporate overhead allocations of 6% to 9% of revenue and integration costs to be expensed into the business unit. At Larkspur’s Year 1 plan revenue of $16.8M, a 7.5% overhead allocation is $1.26M. The illustrative materials show:

| Year 1 at Plan | $M | |---|---:| | Larkspur standalone plan EBITDA | 3.90 | | Less: Meridian overhead allocation at 7.5% of revenue | (1.26) | | Less: integration costs expensed to unit | (0.40) | | EBITDA after Meridian allocations | 2.24 | | Year 1 EBITDA threshold | 3.40 | | Earn-out under draft | 0.00 |

So Larkspur can hit its revenue and gross profit plan and still generate zero earn-out.

That is not a theoretical concern. It is exactly the kind of issue that caused a prior Meridian dispute: in the 2021 acquisition, sales teams were merged, shared costs were allocated, the EBITDA earn-out missed by approximately 1.5%, and the founders received nothing after two years of litigation.

B. The formula itself makes the $12M headline earn-out largely illusory

The draft says the earn-out equals 100% of the amount by which EBITDA exceeds the threshold, capped at $6M per year.

That means:

• Year 1 threshold: $3.4M
• Year 1 cap reached only if EBITDA is $9.4M
• Year 1 plan EBITDA: $3.9M
• Year 1 payout at plan before allocations: $0.5M

And:

• Year 2 threshold: $4.1M
• Year 2 cap reached only if EBITDA is $10.1M
• Year 2 plan EBITDA: $4.9M
• Year 2 payout at plan before allocations: $0.8M

So even before Meridian allocations, Larkspur hitting its plan would produce only:

| | Year 1 | Year 2 | Total | |---|---:|---:|---:| | Plan EBITDA | 3.9 | 4.9 | 8.8 | | Threshold | 3.4 | 4.1 | 7.5 | | Draft payout at plan | 0.5 | 0.8 | 1.3 |

The headline says “up to $12M,” but the business would need EBITDA of $9.4M in Year 1 and $10.1M in Year 2 to earn the full amount. That is more than double the current plan and not a realistic earn-out construct for this business.

C. “Buyer’s accounting policies consistently applied” gives Meridian too much control

This provision lets Meridian determine EBITDA using its policies, not Larkspur’s historical accounting practices. That creates risk around:

• revenue recognition;
• capitalization versus expensing of implementation work;
• reserves and write-offs;
• bonus accruals;
• stock compensation;
• intercompany charges;
• software, data, and cloud cost classification;
• sales commission treatment;
• bad debt reserves;
• purchase accounting effects;
• integration and restructuring costs.

Even if Meridian applies the same policies it applies elsewhere, those policies may be inappropriate for measuring Larkspur’s seller earn-out.

D. “Sole discretion” eliminates practical operating protections

The draft says Meridian may operate the Target in its sole discretion. That allows Meridian to make ordinary post-closing decisions that reduce EBITDA, including:

• combining the sales team;
• assigning Larkspur personnel to Meridian accounts;
• changing sales incentives;
• moving customers to Meridian contracts;
• changing pricing or bundling;
• delaying hiring;
• reducing marketing spend;
• changing project staffing;
• shifting low-margin work to Larkspur;
• moving high-margin opportunities elsewhere;
• allocating shared costs.

A buyer does not need to act maliciously for these decisions to reduce EBITDA. Integration decisions that are rational for Meridian as a whole can still destroy a seller earn-out.

E. Sales force integration creates revenue and cost attribution problems

Meridian plans to merge the sales teams within six months. The draft does not say how revenue will be attributed after that happens.

Questions not answered:

• If a Meridian salesperson sells Larkspur analytics services, does that revenue count?
• If Priya or Tom help sell Meridian services, does that revenue count?
• If Larkspur’s legacy customers buy bundled Meridian/Larkspur services, how is revenue allocated?
• If a customer contract is papered through Meridian rather than Larkspur, does it count?
• If shared sales employees cover both companies, how are costs allocated?

Meridian’s policy allocates shared sales staff costs by “headcount of accounts served,” which can be arbitrary and may not track actual effort, revenue contribution, or gross profit.

F. Corporate overhead allocation can erase the earn-out

Meridian’s historical overhead allocation is 6% to 9% of revenue. On Year 1 plan revenue of $16.8M, that is:

| Overhead Rate | Allocation | |---:|---:| | 6.0% | $1.01M | | 7.5% | $1.26M | | 9.0% | $1.51M |

Year 1 plan EBITDA is only $3.9M against a $3.4M threshold. So even a modest corporate allocation can eliminate most or all of the earn-out.

This is the central problem: EBITDA is the wrong metric where the buyer controls post-closing cost structure.

G. Integration costs are not excluded

Meridian’s policy says integration costs are expensed where incurred. That means the costs of Meridian’s own integration plan can reduce Larkspur EBITDA.

Examples:

• systems migration;
• finance/HR/IT conversion;
• severance or duplicate personnel;
• consultant fees;
• rebranding;
• contract migration;
• retention bonuses;
• new reporting systems;
• office consolidation.

Those are buyer-driven transaction/integration costs and should not reduce the seller earn-out.

H. Annual calculation creates cliff and timing risk

The earn-out is measured separately for Year 1 and Year 2. There is no cumulative true-up.

That creates timing risk:

• a delayed customer signing can move revenue from Year 1 to Year 2;
• a large annual software/data expense can fall in the wrong period;
• integration costs can be front-loaded;
• project timing can shift gross profit between periods.

There should be a cumulative two-year measurement or at least a carry-forward/catch-up mechanism.

I. No audit rights, dispute process, or access to records

The draft says payment is due within 120 days after year-end, subject to Buyer’s calculation. It does not provide sufficient seller protections, including:

• delivery of detailed calculation schedules;
• access to books and records;
• supporting workpapers;
• right to object;
• independent accountant dispute resolution;
• payment of undisputed amounts;
• interest on late payments.

Without those rights, the founders may not be able to effectively verify the calculation.

J. Prior Meridian acquisition is a diligence red flag

The 2021 Meridian acquisition is highly relevant. It shows that Meridian’s preferred structure — EBITDA earn-out, merged sales teams, shared cost allocations, buyer discretion — has already produced a dispute where founders received nothing after a near miss.

This does not prove bad faith by Meridian. It does prove the drafting risk is real and foreseeable.

K. Items I would specifically diligence before signing

As a diligence lead, I would request and review:

1. Meridian’s detailed allocation methodology by business unit for the last three years.
2. Actual overhead allocated to acquired businesses post-closing.
3. The full earn-out language and dispute materials from the 2021 acquisition.
4. Pro forma Larkspur P&L under Meridian policies for Years 1 and 2.
5. Revenue attribution rules after sales integration.
6. Treatment of bundled contracts and cross-sell revenue.
7. Integration budget and who bears those costs.
8. Planned headcount changes.
9. Shared services implementation timeline.
10. Any changes to pricing, commission plans, or customer contracting.

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2) Proposed Replacement Metric and Earn-Out Structure

Recommendation

Replace EBITDA with an Earn-Out Gross Profit metric, measured before buyer-controlled overhead, integration costs, corporate allocations, shared services charges, and purchase accounting effects.

For a data services firm like Larkspur, gross profit is a better earn-out metric because it captures the economics Larkspur can influence — revenue generation, project delivery, utilization, and direct delivery cost — while excluding post-closing costs Meridian controls.

Proposed Metric: “Earn-Out Gross Profit”

Earn-Out Gross Profit means:

> Earn-Out Revenue minus Direct Delivery Costs, calculated consistently with Larkspur’s historical accounting practices as applied in the twelve months prior to closing, and excluding all corporate overhead, shared service charges, integration costs, transaction expenses, purchase accounting adjustments, management fees, allocated sales costs, and other costs not directly incurred in delivering Larkspur services.

Earn-Out Revenue should include

Revenue from:

1. Larkspur legacy customers;
2. Larkspur pipeline existing as of closing;
3. renewals, expansions, and follow-on work from Larkspur customers;
4. new customers for Larkspur analytics/data services;
5. Meridian-referred customers purchasing Larkspur services;
6. bundled Meridian/Larkspur contracts, with reasonable allocation to Larkspur services;
7. revenue moved to a Meridian affiliate that would have been Larkspur revenue absent integration.

Direct Delivery Costs should include only

1. salaries, wages, payroll taxes, and benefits of Larkspur delivery personnel to the extent directly performing Larkspur services;
2. third-party contractors directly used for Larkspur client delivery;
3. project-specific software, data, cloud, hosting, and tools consumed in delivery;
4. client-specific reimbursable travel or project expenses, to the extent historically treated as cost of revenue;
5. customer credits, refunds, and write-offs directly related to Larkspur services.

Proposed annual structure

Maximum earn-out remains $12M over two years, but payout should be tied to gross profit achievement rather than EBITDA.

Use annual targets based on Larkspur’s plan:

| | Year 1 | Year 2 | |---|---:|---:| | Plan revenue | $16.8M | $19.6M | | Plan gross profit | $10.1M | $11.9M | | Earn-Out Gross Profit target | $10.1M | $11.9M | | Floor at 85% of target | $8.585M | $10.115M | | Annual maximum payout | $6.0M | $6.0M |

Formula

For each year:

> Annual Earn-Out Payment = $6.0M × [(Earn-Out Gross Profit – Floor) / (Target – Floor)]

Subject to:

• zero payment if Earn-Out Gross Profit is below the floor;
• cap of $6.0M per year;
• linear interpolation between floor and target;
• full annual payment if target is achieved or exceeded;
• final cumulative true-up after Year 2.

Cumulative true-up

To reduce timing manipulation, include a two-year cumulative true-up.

Cumulative two-year numbers:

| | Amount | |---|---:| | Two-year gross profit target | $22.0M | | 85% cumulative floor | $18.7M | | Maximum cumulative earn-out | $12.0M |

At the end of Year 2, calculate:

> Cumulative Earn-Out = $12.0M × [(Cumulative Earn-Out Gross Profit – $18.7M) / ($22.0M – $18.7M)]

Less amounts already paid, subject to a cumulative cap of $12.0M.

This avoids a bad Year 1 / strong Year 2 mismatch and makes the earn-out measure business performance over the full two-year period.

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Worked Numerical Example for Exhibit

Example A — Larkspur hits plan

| | Year 1 | Year 2 | Total | |---|---:|---:|---:| | Earn-Out Revenue | $16.8M | $19.6M | $36.4M | | Earn-Out Gross Profit | $10.1M | $11.9M | $22.0M | | Gross Profit Target | $10.1M | $11.9M | $22.0M | | Annual Payout | $6.0M | $6.0M | $12.0M |

Result: If Larkspur hits the agreed operating plan, the founders receive the full $12M.

Example B — Larkspur achieves 95% of plan gross profit

| | Year 1 | Year 2 | Total | |---|---:|---:|---:| | Earn-Out Gross Profit at 95% of target | $9.595M | $11.305M | $20.900M | | Floor | $8.585M | $10.115M | $18.700M | | Target less floor | $1.515M | $1.785M | $3.300M | | Achievement between floor and target | 66.7% | 66.7% | 66.7% | | Payout | $4.0M | $4.0M | $8.0M |

Result: A near-plan performance produces a meaningful but discounted earn-out rather than a cliff loss.

Example C — Same Year 1 operating performance as plan, but Meridian allocates overhead

Under current draft:

| Year 1 Draft EBITDA Calculation | $M | |---|---:| | Larkspur standalone plan EBITDA | 3.90 | | Less: Meridian overhead allocation | (1.26) | | Less: integration costs | (0.40) | | EBITDA after allocations | 2.24 | | EBITDA threshold | 3.40 | | Draft earn-out | 0.00 |

Under proposed gross profit structure:

| Year 1 Proposed Calculation | $M | |---|---:| | Earn-Out Revenue | 16.80 | | Earn-Out Gross Profit | 10.10 | | Gross Profit Target | 10.10 | | Annual earn-out | 6.00 |

Result: Meridian’s overhead allocation and integration costs do not erase the earn-out if Larkspur achieves the agreed revenue/gross profit performance.

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3) Permitted and Prohibited Cost Allocations; Business Model Change Clause

A. Permitted cost deductions for Earn-Out Gross Profit

Only the following should reduce Earn-Out Gross Profit:

1. Direct delivery employee costs

Actual salary, wages, payroll taxes, benefits, and approved bonuses for employees directly delivering Larkspur services.

2. Direct contractor costs

Third-party contractors directly assigned to Larkspur client projects.

3. Project-specific technology costs

Cloud, hosting, data, software, and tools consumed directly in delivering Larkspur services to customers.

4. Client-specific reimbursable project expenses

Travel, materials, and similar expenses historically included in cost of revenue.

5. Customer credits and refunds

Only to the extent directly related to Larkspur services and not caused by Meridian integration or bundling decisions.

6. Bad debt/write-offs

Only for revenue included in Earn-Out Revenue and calculated consistently with Larkspur historical practice, not through buyer-wide reserve changes.

B. Prohibited cost deductions or allocations

The following should not reduce Earn-Out Gross Profit:

1. Meridian corporate overhead;
2. IT, HR, finance, legal, executive, insurance, facilities, and administrative allocations;
3. management fees;
4. shared services charges;
5. integration costs;
6. systems migration costs;
7. transaction expenses;
8. acquisition accounting or purchase accounting adjustments;
9. amortization of acquired intangibles;
10. restructuring charges;
11. severance caused by Meridian integration;
12. retention bonuses imposed by Meridian;
13. rebranding costs;
14. litigation or dispute costs;
15. costs from changing Larkspur onto Meridian systems;
16. costs of duplicate personnel during integration;
17. allocated shared sales team costs;
18. Meridian executive time;
19. intercompany charges or markups;
20. corporate software licenses not used solely for Larkspur delivery;
21. costs from Meridian-mandated changes in business model, pricing, contracting, or delivery methods;
22. costs exceeding an agreed budget unless approved in writing by the seller representative;
23. any cost not historically included in Larkspur cost of revenue.

C. If EBITDA is retained, required add-backs

If Meridian refuses to move entirely away from EBITDA, the agreement should at minimum require add-backs for:

• corporate overhead allocations;
• shared service charges;
• integration costs;
• transaction expenses;
• purchase accounting adjustments;
• changes in accounting policies from Larkspur historical practice;
• costs from sales force integration;
• costs from business model changes;
• extraordinary, non-recurring, or buyer-directed charges;
• intercompany charges above actual cost and without markup;
• any expense not included in Larkspur’s board-approved standalone plan.

But my recommendation is not to use EBITDA at all unless these protections are very strong.

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D. Proposed business model change clause

Below is business-oriented drafting language. Counsel should tailor it to the purchase agreement.

> Operation of the Business During Earn-Out Period. During the Earn-Out Period, Buyer shall not, and shall cause its affiliates not to, take any action or omit to take any action that would reasonably be expected to reduce, defer, divert, or otherwise adversely affect the Earn-Out Payments, except with the prior written consent of the Seller Representative or with an equitable adjustment to the Earn-Out calculation that neutralizes the effect of such action or omission. > > Separate Measurement. Buyer shall maintain books, records, and supporting schedules sufficient to calculate Earn-Out Revenue, Direct Delivery Costs, and Earn-Out Gross Profit on a basis consistent with Larkspur’s historical accounting practices and the methodology set forth in Exhibit [●], regardless of whether Buyer integrates Larkspur into Buyer’s systems, sales force, contracting structure, reporting units, or shared service platform. > > Revenue Attribution. Earn-Out Revenue shall include all revenue from Larkspur services, products, customers, renewals, expansions, pipeline opportunities, and substantially similar data analytics services, whether contracted through Larkspur, Buyer, or any Buyer affiliate. Buyer shall not avoid inclusion of revenue by transferring customers, contracts, personnel, opportunities, or service delivery to another Buyer business unit or affiliate. > > Bundled Offerings. If Larkspur services are sold as part of a bundled or combined offering, Buyer shall allocate revenue to Earn-Out Revenue based on the relative standalone selling price of the Larkspur services or, if not determinable, a commercially reasonable allocation consistent with historical pricing and margin practices. > > Business Model Changes. If Buyer changes the business model, pricing, sales channel, contracting entity, delivery model, product/service mix, commission plan, accounting treatment, cost structure, or customer assignment practices in a manner that affects the earn-out calculation, the Earn-Out Payments shall be calculated as if such change had not occurred, or shall be equitably adjusted to place Sellers in the economic position they would have been in absent such change. > > No Corporate Allocations. No corporate overhead, shared services charge, integration cost, transaction expense, management fee, intercompany charge, purchase accounting adjustment, or other allocated cost shall reduce Earn-Out Gross Profit except as expressly permitted in Exhibit [●]. > > Access and Dispute Rights. Within 60 days after each Earn-Out Period, Buyer shall deliver a detailed earn-out statement with supporting schedules. Sellers shall have reasonable access to books, records, personnel, and workpapers necessary to verify the calculation. Any disputed amounts shall be resolved by an independent nationally recognized accounting firm, whose determination shall be final and binding. Buyer shall promptly pay all undisputed amounts when due, with interest on late payments.

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4) Short Note to the Founders

Priya and Tom,

I would not accept the earn-out as drafted.

The current structure gives Meridian control over the very costs that determine the payout. Meridian can merge the sales teams, allocate corporate overhead, expense integration costs, and apply its accounting policies. Based on the numbers provided, Larkspur can hit its Year 1 revenue and gross profit plan and still receive zero earn-out because EBITDA after allocations falls below the threshold.

There is a second problem: even on Larkspur’s standalone plan, the draft formula would pay only about $1.3M total over two years before allocations, not anywhere close to the stated $12M maximum. To earn the full amount, Larkspur would need EBITDA levels far above the plan.

My recommendation:

1. Negotiate the earn-out hard.

Replace EBITDA with gross profit or revenue/gross profit, exclude Meridian-controlled costs, add cumulative true-up, require revenue attribution rules, and include audit/dispute rights.

2. If Meridian insists on EBITDA, require strong add-backs and operating covenants.

At minimum, exclude corporate overhead, integration costs, shared services, purchase accounting, sales integration costs, and buyer-directed business model changes.

3. If Meridian will not materially revise the earn-out, trade part of it for more upfront cash.

For Priya, who wants certainty, the current earn-out should be valued at a steep discount. Trust in Meridian’s leadership is not a substitute for drafting protections. For Tom, staying two years does not solve the problem because post-closing economics will be controlled by Meridian.

Practically, I would rather see a lower headline price with more cash at closing than a $31M headline where $12M is tied to buyer-controlled EBITDA. If Meridian wants credit for the full $31M value, the earn-out has to be measurable, achievable, and insulated from Meridian’s post-closing cost allocations.

TRANSACTION ADVISORY MEMORANDUM

TO: Priya Nandakumar & Tom Ellery, Co-Founders, Larkspur Analytics FROM: Senior Transaction Advisory & M&A Diligence Practice DATE: October 24, 2024 SUBJECT: Comprehensive Analysis, Restructuring, and Negotiation Strategy for Meridian Systems Group Earn-Out Structure ($12.0M at Risk)

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EXECUTIVE SUMMARY & STRATEGIC ASSESSMENT

Meridian’s proposed earn-out structure is fundamentally broken. As currently drafted, you will receive $0 of the $12.0M earn-out even if you hit 100% of your management plan revenue and gross margin targets.

This is not necessarily an indicator of active malice; rather, it is the predictable mechanical result of pairing an unadjusted, bottom-line EBITDA target with broad corporate discretion over post-closing operational integration, cost allocations, and sales force re-alignment. In fact, Meridian ran this exact playbook in their 2021 acquisition of a $28M software services firm, where a post-close sales reorganization and shared-cost pushdown triggered a 100% earn-out forfeiture and two years of fruitless litigation.

To protect deal value, we must either:

1. Move the metric up the P&L to Revenue or Gross Profit (Revenue less direct delivery labor/costs), eliminating corporate allocation risk entirely; or
2. Strictly define a "Standalone Operating EBITDA" backed by negative operational covenants, an exhaustive list of prohibited allocations, and an affirmative covenant to operate Larkspur in a manner designed to maximize the earn-out.

Simultaneously, because Priya requires certainty and Tom is willing to run the business under clear parameters, our primary recommendation is to barter down the earn-out size in exchange for guaranteed cash at closing (e.g., $24.0M cash + $7.0M restructured earn-out), realigning risk to what you can realistically control.

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DELIVERABLE 1: DOCUMENT REVIEW MEMO Specific Weaknesses in the Draft Clause & Mechanics of Value Destruction

``` DRAFT P&L COLLAPSE (YEAR 1)

Management Plan Base EBITDA $3.90M (-) Corporate Overhead Allocation (7.5% of $16.8M Rev) ($1.26M) (-) Expensed Meridian Integration Costs ($0.40M) ----------------------------------------------------------------------- EBITDA as Calculated by Buyer under Draft Clause $2.24M

Contractual Year 1 Threshold $3.40M ----------------------------------------------------------------------- SHORTFALL TO THRESHOLD (PAYOUT = $0.00) ($1.16M) ```

The draft earn-out clause contains five fatal structural vulnerabilities. Below is the operational and financial analysis of how each flaw operates to eliminate the earn-out.

1. The Denominator Traps: Uncapped Corporate Overhead Allocations

• The Clause: Target EBITDA calculated *"in accordance with Buyer’s accounting policies consistently applied"* and subject to Buyer’s policy that corporate overhead is allocated on a basis Buyer determines is *"reasonable, historically 6% to 9% of revenue."*
• How It Erases Payout: Meridian allocates corporate IT, HR, legal, C-suite salaries, and real estate across subsidiaries. On Larkspur’s Year 1 plan revenue of $16.8M, a mid-point allocation of 7.5% burdens Larkspur’s P&L with $1.26M of non-operational corporate overhead. Larkspur has historically operated without these central costs. This charge alone reduces Year 1 plan EBITDA from $3.90M to $2.64M, driving it $760,000 below the $3.40M threshold before any operational issues occur.

2. Integration and Conversion Cost Offloading

• The Clause: Integration costs are expensed *"in the unit where incurred,"* combined with Buyer’s accounting discretion.
• How It Erases Payout: Migrating Larkspur to Meridian’s enterprise ERP (e.g., SAP/NetSuite), converting data structures, branding integration, re-papering vendor contracts, and legal/severance costs associated with redundant administrative staff will be pushed to Larkspur’s income statement. The modeled $400,000 in integration expenses drives post-allocation EBITDA down to $2.24M, leaving the business $1.16M below the threshold (a 34% deficit).

3. Sales Force Consolidation and Discretionary Revenue/Cost Recognition

• The Clause: Meridian plans to *"merge Larkspur's sales team with its own within six months,"* while allocating shared sales staff *"by headcount of accounts served."*
• How It Erases Payout:
• Top-line leakage: When sales reps sell a bundled solution (Larkspur data analytics + Meridian enterprise software), Meridian’s sales management decides how contract value is allocated across products. If a client receives a bundle discount, Meridian can allocate the margin discount disproportionately to Larkspur’s services to preserve core software margins.
• Headcount cost burden: Meridian’s enterprise sales team likely carries higher base salaries, commissions, and travel expenses than Larkspur’s legacy Raleigh team. If costs are allocated based on "headcount of accounts served," Larkspur will bear sales expenses for Meridian reps who fail to close Larkspur data business.

4. Sole Discretion Standard and Elimination of the Implied Covenant

• The Clause: *"Buyer shall operate the Target in its sole discretion."*
• How It Erases Payout: In corporate litigation (specifically under Delaware or North Carolina law), courts enforce express contractual provisions granting absolute discretion. A "sole discretion" clause heavily diminishes or displaces the implied contractual covenant of good faith and fair dealing. In the 2021 precedent transaction, Meridian successfully argued that reassigning sales personnel, delaying capital expenditures, and altering hiring cadences were legitimate exercises of their contractually bargained-for "sole discretion," insulating them from liability despite gutting the founders' earn-out.

5. Mathematical Impossibility of Achieving the Maximum Payout ($6.0M/Year)

• The Clause: *"Earn-out payments equal 100% of the amount by which Target EBITDA... exceeds the Threshold, up to $6.0M per year."*
• The Flaw:
• Year 1 Threshold: $3.4M. To achieve the $6.0M cap, Larkspur must generate $9.4M in EBITDA.
• On projected revenue of $16.8M, generating $9.4M in EBITDA implies an EBITDA margin of 56.0%. Larkspur’s trailing margin is 21.8%, and management’s aggressive growth plan projects 23.2%.
• Even under a zero-cost-allocation scenario, at 100% of plan ($3.9M EBITDA), Larkspur would only earn $500,000 ($3.9M - $3.4M). The headline $12.0M earn-out is mathematically unachievable under management's base plan and requires an impossible tripling of profitability.

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DELIVERABLE 2: PROPOSED REPLACEMENT METRIC & STRUCTURE

Strategic Recommendation: Move to Adjusted Gross Profit We strongly advise abandoning bottom-line EBITDA. Given Meridian’s operational plans (centralized IT, consolidated sales, shared delivery centers), auditing overhead and sales attribution across an integrated firm will result in protracted conflict.

Instead, we propose Adjusted Gross Profit (AGP), defined as: $$\text{Adjusted Gross Profit} = \text{Total Revenue Attributable to Larkspur Solutions} - \text{Direct Cost of Services}$$

Where Direct Cost of Services includes *only* direct project-level labor, direct contractor costs, and client-dedicated software licenses.

Why This Works for Both Parties:

• For Founders: Eliminates Meridian corporate overhead, integration costs, shared SG&A, and general corporate allocations.
• For Buyer: Protects Meridian from "bad revenue" (unprofitable contracts or low-margin revenue chasing) while incentivizing delivery efficiency.

Alternative / Tiered Structural Design If Meridian insists on a two-tier structure, we can introduce a blended model:

• Metric A (70% Weight / $4.2M/yr): Attributable Revenue Target.
• Metric B (30% Weight / $1.8M/yr): Gross Margin Floor (maintaining gross margins $\ge 58\%$).

Exhibit: Worked Numerical Example (Adjusted Gross Profit Model)

To eliminate the "cliff" effect and fix the mathematical impossibility of the draft agreement, we establish:

1. A Base Floor Threshold set at 90% of Plan ($9.09M in Y1; $10.71M in Y2).
2. A Target Performance Level set at 100% of Plan ($10.10M in Y1; $11.90M in Y2), paying out a target earn-out ($4.0M).
3. An Outperformance Cap set at 115% of Plan ($11.62M in Y1; $13.69M in Y2), unlocking the full $6.0M maximum annual earn-out via linear interpolation.

Proposed Schedule:

• Below 90% of Plan AGP: $0 payout
• Between 90% and 100% of Plan: Pays $0 to $4.0M linearly ($3.96M per $1.0M of incremental AGP)
• Between 100% and 115% of Plan: Pays $4.0M to $6.0M linearly ($1.32M per $1.0M of incremental AGP)

``` YEAR 1 PAYOUT INTERPOLATION CURVE

Earn-Out ($M) $6.0M +---------------------------------------------------------* (Max Cap: $11.62M AGP) | / $4.0M +---------------------------------------* (Target: $10.1M AGP) | / | / $0.0M +-----------------* (Floor: $9.09M AGP) +-----------------+---------------------+-----------------+ $0 $9.09M $10.10M $11.62M Adjusted Gross Profit ($M) ```

Financial Modeling of Three Operational Scenarios:

| Performance Metric ($M) | Scenario A: Underperformance (92% Plan) | Scenario B: Target Performance (100% Plan) | Scenario C: High Growth (115% Plan) | | :--- | :---: | :---: | :---: | | Total Attributable Revenue | $15.46M | $16.80M | $19.32M | | *Direct Cost of Delivery Labor* | ($5.72M) | ($6.10M) | ($6.85M) | | *Direct Client Software/Data Costs* | ($0.45M) | ($0.60M) | ($0.85M) | | Adjusted Gross Profit (AGP) | $9.29M | $10.10M | $11.62M | | *AGP Margin %* | *60.1%* | *60.1%* | *60.1%* | | AGP Threshold (Floor - 90%) | $9.09M | $9.09M | $9.09M | | AGP Target (100% of Plan) | $10.10M | $10.10M | $10.10M | | AGP Stretch Cap (115% of Plan) | $11.62M | $11.62M | $11.62M | | Year 1 Earn-Out Calculation | | | | | *Base Payout (Tier 1: $9.09M to $10.10M)* | $0.79M | $4.00M | $4.00M | | *Stretch Payout (Tier 2: $10.10M to $11.62M)* | $0.00M | $0.00M | $2.00M | | Total Year 1 Earn-Out Earned | $0.79M | $4.00M | $6.00M | | *Payout Under Meridian's Draft Metric* | *$0.00M* | *$0.00M* | *~$0.60M* |

*Key Takeaway:* Under the revised structure, hitting target yields $4.0M, compared to $0.0M under the draft contract.

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DELIVERABLE 3: ALLOCATION FRAMEWORK & COVENANTS

If the transaction requires retaining an operational EBITDA or Gross Profit metric, the definitive agreement must contain strict schedules governing permissible expenses and operational behavior.

1. Categorization of Expenses (Exhibit to Purchase Agreement)

``` +----------------------------------------------------------------------------------------------------+ | PERMITTED VS. PROHIBITED EXPENSES | +--------------------------------------------------+-------------------------------------------------+ | PERMITTED CHARGES (Included in Metric) | PROHIBITED CHARGES (Excluded from Metric) | +--------------------------------------------------+-------------------------------------------------+ | 1. Direct Raleigh delivery personnel payroll, | 1. Corporate Overhead: Corporate executive | | bonuses, and benefits. | salaries, legal, central HR, central finance.| | 2. Direct project contractors & dedicated third- | 2. Integration Costs: Systems migration, | | party data/cloud vendor costs. | severance, branding, consulting, integration | | 3. Legacy sales reps dedicated 100% to | legal fees. | | Larkspur pipeline (base + direct commission). | 3. Shared Sales Allocation: General Meridian | | 4. Direct facilities/rent for Larkspur Raleigh | sales management or enterprise team costs | | office (unless Meridian forces relocation). | not directly generating Larkspur revenue. | | 5. Depreciation of pre-existing Larkspur capital | 4. Transfer Pricing / Software Markups: Inter- | | assets (under legacy depreciation schedule). | company charges for Meridian software tools. | | | 5. Acquisition Accounting Adjustments: Purchase | | | price amortization, transaction expenses. | +--------------------------------------------------+-------------------------------------------------+ ```

2. Contractual Operating Covenant: Business Model & Governance Protections

We will strike *"Buyer shall operate the Target in its sole discretion"* and replace it with the following model covenants:

> Section 2.X: Covenants Regarding Operation of the Business During the Earn-Out Period. > > (a) Standard of Operation. During the Earn-Out Period, Buyer shall: (i) operate the Target as a distinct, standalone operational division or reporting unit; (ii) maintain separate books, accounts, and financial records for the Target adequate to calculate the Earn-Out Consideration; (iii) use commercially reasonable efforts to preserve intact the Target’s business operations, customer relationships, and employee base; and (iv) act in good faith and not take, or omit to take, any action the primary intent or reasonably foreseeable effect of which is to avoid, delay, or minimize the Earn-Out Consideration. > > (b) Negative Covenants. Without the prior written consent of the Stockholder Representatives (Nandakumar and Ellery), Buyer shall not, directly or indirectly: > * (i) Discontinue, deprioritize, or materially alter any core product, service line, or go-to-market strategy of the Target; > * (ii) Divert, reassign, or steer any existing clients, pipeline opportunities, or prospective leads of the Target to Meridian or any of its other affiliates; > * (iii) Reassign, relocate, terminate without cause, or alter the reporting lines of key personnel (including Tom Ellery and technical practice leads) or the dedicated sales force; > * (iv) Terminate or accelerate the surrender of Target’s Raleigh facility, or force relocation into Buyer facilities; > * (v) Impose any intercompany management fees, shared service allocations, or corporate overhead costs on Target’s financial statements other than Permitted Direct Charges set forth in Schedule X; or > * (vi) Merge or integrate Target's dedicated sales personnel into Buyer's centralized sales pool without a formalized, written commission and revenue-attribution schedule agreed upon by the Stockholder Representatives. > > (c) Bundled Sales and Cross-Selling Protocol. In the event Buyer sells Target products or services in combination or bundled with Buyer’s products or services: > * (i) Target services shall be priced at no less than their standalone fair market value and past standalone realized rates; > * (ii) No bundled discount or fee concession shall be allocated disproportionately to Target products/services (discounts must be allocated pro-rata based on standalone list prices); and > * (iii) All revenue derived from customers introduced through Buyer’s enterprise channel that utilize Target's data capabilities shall be credited 100% to Target Attributable Revenue. > > (d) Acceleration Clause. Any material breach of this Section 2.X by Buyer that is uncured within thirty (30) days of written notice shall cause the Maximum Undistributed Earn-Out Amount ($12.0M, or remaining balance) to become immediately due and payable in cash as liquidated damages.

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DELIVERABLE 4: CLIENT STRATEGIC ADVISORY NOTE

TO: Priya Nandakumar & Tom Ellery FROM: Financial & Deal Advisory Lead DATE: October 24, 2024 SUBJECT: Transaction Strategy: Evaluating Your Risk Profile vs. Deal Realities

Priya, Tom:

We need to address the reality of this deal before any further drafts are exchanged.

Right now, you are walking into an asymmetric trap. Meridian has structured this deal so that the $12.0M earn-out represents nearly 39% of your total headline value ($31.0M), yet they hold 100% of the operational control over whether that money is ever paid.

1. The Core Problem: Good Intentions vs. Legal Realities You both mentioned that you *"trust Meridian’s leadership."* In M&A, personal trust between executives does not survive integration:

• Once the deal closes, corporate controllers, integration managers, and auditors execute corporate policy, not promises made over dinner.
• Meridian’s 2021 acquisition proves that when corporate metrics miss targets, their legal counsel relies strictly on the contract's "sole discretion" language. In that deal, founders who generated healthy growth were cut off from a $9M earn-out because corporate overhead was pushed down onto their P&L. They litigated for two years and lost. We will not let you repeat that mistake.

2. Alignment with Your Personal Objectives Your individual priorities actually dictate our negotiation strategy:

• Priya wants certainty: An unadjusted EBITDA earn-out provides zero certainty. Even if operations thrive, accounting entries can wipe out your payout.
• Tom wants to run the business for 2 years: Under the draft agreement, Meridian can reassign your sales team in Month 5 and strip you of operational authority in Month 6 under the "sole discretion" clause. You will have the responsibility of hitting targets without the authority to manage the team.

3. The Recommended Action Plan: A Three-Pronged Strategy

Do not accept the earn-out as currently drafted. We recommend the following three-step posture:

``` NEGOTIATION COMPROMISE MATRIX

[CURRENT DRAFT] [TARGET REALIGNMENT] [RESTRUCTURED TRADEOFF] Cash: $19.0M (61%) Cash: $23.0M - $25.0M Cash: $24.0M (77%) Earn-Out: $12.0M (39%) ===> Earn-Out: $6.0M - $8.0M ===> Earn-Out: $7.0M (23%) Risk: Extreme/Fatal Risk: High Cash Certainty Metric: Gross Profit (Capped) ```

Step 1: Re-trade the Purchase Price Mix (Trade Earn-Out for Cash) We will leverage Meridian’s planned integration against them. We will tell Meridian: > *"If you intend to integrate our sales team and operational infrastructure into your enterprise within 6 months, you are buying operational control. An earn-out predicated on standalone bottom-line metrics is structurally incompatible with your integration thesis."*

We will propose shifting the consideration:

• Counter-Offer: $24.0M Cash at Closing + $7.0M Earn-Out ($3.5M/yr for 2 years).
• The Strategic Benefit:
• Priya locks in certainty: Larkspur’s upfront valuation increases from 6.1x trailing EBITDA ($19M / $3.1M) to 7.7x trailing EBITDA guaranteed cash.
• You bank an incremental $5.0M guaranteed, while retaining an achievable $7.0M upside.

Step 2: Replace EBITDA with Adjusted Gross Profit For the remaining earn-out balance, we will reject EBITDA and implement the Adjusted Gross Profit (AGP) framework detailed in Deliverable 2:

• It directly reflects the commercial health of Larkspur’s delivery team.
• It completely excludes Meridian's 6–9% corporate overhead, ERP integration bills, and home-office legal fees.
• It sets the hurdle at an attainable floor (90% of plan) rather than requiring an impossible 56% operating margin.

Step 3: Implement Tom’s Operational Autonomy Package If Tom is staying on to drive this earn-out, we must insert protective governance covenants into the agreement:

• Tom must retain primary operational oversight over the Raleigh delivery team.
• Meridian cannot reallocate sales staff or re-route inbound analytics leads without mutual consent.
• Any unconsented restructuring triggers an immediate acceleration of the remaining earn-out balance to protect Tom from being sidelined.

Summary Recommendation Do not sign the current term sheet or purchase agreement draft. Authorize our advisory team to counter with: $24M Cash + $7M Gross-Profit-Linked Earn-Out + Mandatory Operating Covenants. This delivers cash certainty to Priya, gives Tom a fair, controllable framework to earn the upside, and eliminates the fatal allocation traps embedded in Meridian's draft.

Larkspur Analytics / Meridian Systems Group: Earn-Out Review

Prepared for: Priya Nandakumar and Tom Ellery (Sellers) Scope: Draft earn-out clause, Larkspur financials, Meridian allocation policy, notes on Meridian's 2021 acquisition Status: Draft for discussion with deal counsel and tax adviser. This is not a legal opinion. Clause language below is a drafting starting point for counsel.

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Executive Summary: Three Things to Know First

1. The $12M earn-out is not reachable even if Meridian acts in perfect good faith. The formula pays 100% of EBITDA above the threshold, capped at $6M per year. Hitting the cap in Year 1 requires $9.4M of EBITDA, about 2.4x Larkspur's own plan of $3.9M. If Larkspur hits plan exactly and is measured on its own standalone costs, the draft pays $0.5M in Year 1 and $0.8M in Year 2, or $1.3M in total.

2. Under Meridian's stated allocation policy, the earn-out pays zero at plan in both years. This is true across the whole 6%–9% overhead range, before any dispute and without any bad faith.

3. The deal as drafted is economically a ~$19–20M deal presented as a $31M deal. The negotiation should be framed that way with Meridian. Either the earn-out is rebuilt so that plan performance earns most of it, or a meaningful part of it is converted into closing cash.

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Deliverable 1: Document Review Memo — Weaknesses in the Draft Clause

1.1 The core problem: thresholds set on one basis, measured on another

The thresholds look generous: 87% of Year 1 plan EBITDA and 84% of Year 2. That cushion is an illusion. The plan EBITDA figures ($3.9M / $4.9M) are Larkspur standalone numbers. They already carry Larkspur's own G&A, IT, HR and finance costs. The draft then measures EBITDA under Meridian's policies, which add overhead allocations and integration costs on top.

| $M | Year 1 | Year 2 | |---|---|---| | Plan EBITDA (standalone) | 3.90 | 4.90 | | Threshold | 3.40 | 4.10 | | Cushion | 0.50 | 0.80 | | Overhead at 6% of plan revenue (low end of Meridian's range) | 1.01 | 1.18 | | Overhead at 7.5% | 1.26 | 1.47 | | Overhead at 9% | 1.51 | 1.76 |

Even the lowest historical allocation is roughly double the Year 1 cushion. Integration costs come on top.

1.2 What the draft pays under realistic cases

| Case (at plan revenue) | Y1 measured EBITDA | Y1 payout | Y2 measured EBITDA | Y2 payout | Total | |---|---|---|---|---|---| | Standalone, no allocations | 3.90 | 0.50 | 4.90 | 0.80 | 1.30 | | 6% overhead + $0.4M integration (Y1) | 2.49 | 0 | 3.72 | 0 | 0 | | 7.5% overhead + $0.4M integration (Y1) | 2.24 | 0 | 3.43 | 0 | 0 | | 9% overhead + $0.4M integration (Y1) | 1.99 | 0 | 3.14 | 0 | 0 |

The Year 2 figures assume no further integration costs. Any additional cost only deepens the shortfall.

What it takes to earn anything in Year 1 at the 7.5% allocation:

• Pre-allocation EBITDA must exceed $5.06M ($3.40M threshold + $1.26M overhead + $0.40M integration). That is about 30% above plan.
• Earning the full $6M would require about $10.7M of pre-allocation EBITDA.

1.3 Clause-by-clause weaknesses

For each weakness, the third column shows how ordinary corporate behaviour, with no bad faith required, reduces the payout.

| # | Draft language / gap | Weakness | How it erodes the payout through normal behaviour | |---|---|---|---| | 1 | "100% of the amount by which… exceeds the Threshold, up to $6.0M per year" | The payout slope bears no relation to the cap. The cap needs 2–2.4x plan EBITDA. | Nothing needs to happen. The structure itself delivers about 11% of the headline at plan. The 100% sharing ratio also means every $1 of cost charged to Larkspur above the threshold removes $1 of earn-out. That is a perfectly aligned incentive for Meridian's finance team to allocate fully, even passively. | | 2 | "EBITDA" undefined | No definition, no add-backs, no exclusions, no reference to GAAP or to Larkspur's historical practice. | Meridian's controller applies the standard segment P&L, which naturally includes everything Meridian charges business units. | | 3 | "In accordance with Buyer's accounting policies consistently applied" | Uses the Buyer's policies, not Larkspur's. "Consistently applied" has no anchor: consistent with what, and from when? Meridian can change policies group-wide. | Meridian applies its revenue recognition, capitalisation thresholds, bad-debt reserves, bonus accrual and commission policies. Each can shift EBITDA between years or reduce it. A group-wide policy change is "consistently applied" across Meridian. | | 4 | Silent on corporate overhead | Allocation policy is "a basis Meridian determines is reasonable," historically 6–9% of revenue. | Applying the midpoint (7.5%) by itself eliminates the earn-out. The range alone is a $0.5M swing in Year 1, equal to the entire cushion. | | 5 | Silent on duplicate costs | When Meridian's shared services replace Larkspur's own IT/HR/finance, Larkspur's costs may not fall immediately (contracts, notice periods, transition). | Larkspur bears both its legacy cost and the allocated charge during transition. Plan EBITDA already includes Larkspur's own G&A, so any allocation that is not offset by an eliminated Larkspur cost is double counting. | | 6 | Silent on integration costs | Meridian policy: integration costs are "expensed in the unit where incurred." | Migration onto Meridian systems, rebranding, re-papering customer contracts, severance and retention bonuses all land in Larkspur's P&L. That is $0.4M in Year 1 on Meridian's own illustration, and possibly more. | | 7 | Silent on sales team merger and revenue attribution | Sales teams merge within 6 months. After that, who books Larkspur revenue? | Larkspur customers are moved onto Meridian master agreements. Larkspur services are bundled into Meridian deals with the discount allocated to the Larkspur line. Cross-sell revenue is booked to Meridian units. Each is an ordinary commercial decision, and each reduces measured Larkspur revenue. | | 8 | Silent on shared sales cost allocation | Meridian allocates shared sales cost "by headcount of accounts served," a count of accounts rather than revenue. | Illustration (hypothetical, to test in diligence): if Larkspur's customers are 30% of the merged team's account count but 15% of its revenue, Larkspur absorbs 30% of sales cost. A firm with many smaller accounts is structurally overcharged. | | 9 | "Buyer shall operate the Target in its sole discretion" | No operating covenants. It arguably displaces the implied covenant of good faith. | Hiring freezes, pricing changes, redeploying Larkspur delivery staff to Meridian projects, slowing investment, or reprioritising the merged sales team toward Meridian's higher-margin products. All are rational, and all reduce Larkspur EBITDA. In 2021, Meridian's lawyers ran exactly this argument. Under Delaware law, which is likely to govern (confirm), courts have generally required sellers to show the buyer acted with the specific intent of avoiding the earn-out (e.g., *Lazard Technology Partners v. QinetiQ*, Del. 2015). That is a very high bar when the contract grants sole discretion. | | 10 | "Subject to Buyer's calculation" | No earn-out statement requirements, no seller access to books, no objection period, no independent accountant, no deemed acceptance. | Meridian's number is final unless the Sellers sue. Litigation is the only remedy, which is what happened in 2021, lasting two years. | | 11 | "Within 120 days after year-end" | Long, with no interest, no undisputed-amount payment, and no definition of "year-end." | If Meridian's fiscal year differs from the closing date, a stub period may be created or one "year" may be partial. Any dispute pushes payment out indefinitely. | | 12 | No catch-up / cumulative test | Year 1 and Year 2 stand alone. | Integration disruption concentrates in Year 1 (sales merger in month ~6). A Year 1 miss caused by integration is permanently lost even if Year 2 recovers strongly. | | 13 | No acceleration events | Nothing happens if Meridian sells Larkspur, is itself acquired, merges Larkspur so it can't be measured, or breaches. | Meridian restructures Larkspur into another unit, so separate EBITDA ceases to exist. The earn-out becomes unmeasurable, and the Sellers must litigate. | | 14 | Purchase accounting and deal-related charges not excluded | Possible items: deferred revenue fair-value adjustment (much reduced under ASU 2021-08, but confirm treatment), earn-out liability remeasurement, stock comp on Meridian equity granted to Larkspur staff, transaction costs. | Any of these can sit "above the EBITDA line" in a buyer's segment reporting unless excluded. | | 15 | Set-off (check elsewhere in the SPA) | Most buyer drafts let the buyer withhold earn-out against indemnity claims, often merely asserted ones. | An asserted, unresolved indemnity claim freezes the payment. Need to see the indemnity and escrow sections. | | 16 | Credit and transfer risk | No escrow, no parent guarantee, no assignment restriction. | If the earning entity is sold or is a thin subsidiary, the payment obligation may sit with an entity that cannot or will not pay. | | 17 | Employment linkage (check the employment agreement) | If payments are forfeited when a founder leaves, the earn-out can be treated as compensation. That means ordinary income rather than capital gain, and post-combination expense under ASC 805. | Priya does not appear to be staying for two years. Any "must be employed" condition would be a significant tax and value problem for her. The earn-out must be pure purchase price. |

1.4 What the 2021 deal tells us

The 2021 pattern is the template for this deal: sales merger in month 5, shared costs allocated, a 1.5% miss, zero payout, two years of litigation, and a "sole discretion" defence. The same buyer is proposing the same integration plan with similar drafting. Assume the same finance team and the same allocation mechanics will apply.

Diligence asks:

• Pull the court filings from the 2021 dispute (pleadings are usually public). They will show Meridian's actual allocation methodology and the specific arguments its lawyers ran.
• Ask Meridian for:
• the overhead rate actually charged to each acquired unit over the last three years;
• the integration costs charged to the 2021 target;
• its fiscal year-end;
• a written description of how shared sales cost will be allocated to Larkspur, including the expected account-count share.
• Confirm governing law and forum.

1.5 A note on "trust"

The founders' trust in Meridian's leadership may be well placed. It is not a protection.

• The earn-out will be calculated 13–24 months from now, by a controller who was not in the negotiation, applying a group policy manual.
• If leadership changes, or if Meridian's own numbers are under pressure, the contract is all that remains.
• The 2021 founders very likely trusted Meridian too.

Nothing in this memo requires Meridian to act badly. The draft fails under entirely ordinary behaviour.

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Deliverable 2: Replacement Metric and Structure

2.1 Choice of metric: Earn-Out Gross Profit

Recommendation: Replace EBITDA with Earn-Out Gross Profit (Larkspur revenue less direct cost of delivery), measured under Larkspur's historical accounting policies. Add a cumulative catch-up and a linear payout schedule calibrated to plan.

Why gross profit rather than revenue or EBITDA:

• Gross profit sits where the founders still have control. After the sales merger and the move to shared services, Meridian controls sales cost and overhead. The founders still control delivery, pricing discipline and customer retention. Gross profit is the line that corresponds to that.
• It answers Meridian's main objection to a revenue earn-out. A pure revenue metric invites "buying revenue" through discounting. Gross profit penalises that.
• It removes the allocation problem almost entirely. Overhead and sales cost sit below gross profit. The remaining risk is reclassification of costs into cost of delivery, which is handled by a locked definition and the allocation list in Deliverable 3.
• It can be reconciled to existing numbers. Trailing gross profit is $8.5M on $14.2M revenue (59.9% margin). Plan is $10.1M (60.1%) and $11.9M (60.7%). The definition can be tied to a schedule reconciling the trailing year, so there is no ambiguity about policy.

Fallback if Meridian insists on an EBITDA-type metric: "Earn-Out Contribution."

• Calculation: Earn-Out Gross Profit, less Larkspur-controlled operating expenses, less a fixed corporate services charge.
• The fixed charge is a stated dollar amount equal to the cost of Larkspur functions actually replaced by Meridian services. It is capped at Larkspur's trailing cost for those functions, not a percentage of revenue.
• Thresholds must be rebased to the same definition.

This is the second-best option. It still requires policing operating expenses.

2.2 Key definitions (exhibit language, summarised)

Larkspur Revenue means revenue from:

• (a) all Larkspur Offerings (Schedule A, including enhancements, successors and rebranded versions), regardless of which Meridian entity sells, contracts or invoices; and
• (b) all Larkspur Customers (Schedule B) for data services of the type provided by Larkspur at closing.

It is recognised under Larkspur's revenue recognition policies as applied in the Reference Financials. The following rules apply:

• Bundles: revenue in bundled Meridian contracts is allocated by relative standalone selling price. Bundle discounts are not loaded onto the Larkspur component.
• Intercompany use: Larkspur services used by Meridian are credited at Larkspur list price less its customary discount.

Direct Cost of Delivery means only:

• compensation and benefits of personnel performing delivery on Larkspur engagements, pro rata to time;
• third-party data, licence and hosting costs directly consumed by Larkspur engagements, at actual cost with no intercompany markup;
• other costs classified as cost of revenue in the Reference Financials.

No reclassification of operating expenses into cost of delivery is permitted.

Earn-Out Gross Profit = Larkspur Revenue − Direct Cost of Delivery.

Reference Financials means Larkspur's trailing-year financials (Revenue $14.2M, Gross Profit $8.5M). These are attached with a line-by-line policy schedule. Where Meridian policy and Reference Financials policy differ, the Reference Financials control.

Operating-expense guardrail (offered to Meridian): If Larkspur-controlled operating spend directed by the Seller Representative or Larkspur management exceeds the agreed budget by more than 10%, the excess is deducted from Earn-Out Gross Profit. This addresses the "founders could overspend to grow GP" objection without handing Meridian an allocation lever.

2.3 Payout schedule

The $12M maximum is retained:

• Up to $6.0M per year;
• $0 at 85% of plan GP, rising linearly to 80% of the annual maximum ($4.8M) at plan, and to 100% ($6.0M) at 110% of plan.
• Linear interpolation throughout, with no cliffs. The 2021 founders lost $9M on a 1.5% miss.

| $M | Floor (0%) | Target (80% = $4.8M) | Stretch (100% = $6.0M) | Slope floor→target | Slope target→stretch | |---|---|---|---|---|---| | Year 1 GP | 8.6 | 10.1 | 11.1 | $3.20 per $1 GP | $1.20 per $1 GP | | Year 2 GP | 10.1 | 11.9 | 13.1 | $2.67 per $1 GP | $1.00 per $1 GP | | Cumulative 2-yr GP (scale to $12.0M) | 18.7 | 22.0 ($9.6M) | 24.2 ($12.0M) | $2.91 per $1 GP | $1.09 per $1 GP |

Cumulative catch-up: At the end of Year 2, the cumulative two-year GP is run through the cumulative scale. If the result exceeds the annual payments already made, the difference is paid. There is no clawback of annual payments.

Payment mechanics:

• Meridian delivers an Earn-Out Statement within 60 days of each period end.
• The Sellers get 45 days to review, with full access to books, records and personnel.
• Undisputed amounts are paid within 10 business days.
• Disputed items go to an independent accounting firm acting as expert, not arbitrator, limited to the disputed items and bound by the definitions.
• Late payments carry interest.
• Meridian parent guarantees the obligation.
• No set-off except against finally determined indemnity claims.

2.4 Worked example (exhibit-ready)

Scenario A: Larkspur hits plan exactly

| | Year 1 | Year 2 | |---|---|---| | Earn-Out GP | 10.1 | 11.9 | | Annual payout | 4.80 | 4.80 | | Cumulative GP: 22.0 → cumulative entitlement 9.60 | | Catch-up 0 | | Total earn-out | | $9.60M | | *Draft clause, same performance* | *$0 (Meridian accounting) / $1.30M (standalone)* | |

Scenario B: Year 1 disrupted by the sales merger, Year 2 recovers

| | Year 1 | Year 2 | |---|---|---| | Earn-Out GP | 9.2 (91% of plan) | 12.4 (104% of plan) | | Annual payout | 3.20 × (9.2 − 8.6) = 1.92 | 4.80 + 1.00 × (12.4 − 11.9) = 5.30 | | Sum of annual payments | | 7.22 | | Cumulative GP 21.6 → 2.909 × (21.6 − 18.7) = | | 8.44 | | Catch-up paid | | 1.22 | | Total earn-out | | $8.44M |

This is the scenario the 2021 founders lived through. Here, the integration dip costs some value but does not erase the payout.

Scenario C: Genuine underperformance

| | Year 1 | Year 2 | |---|---|---| | Earn-Out GP | 8.4 (83%) | 9.9 (83%) | | Annual payout | 0 | 0 | | Cumulative GP 18.3 < 18.7 floor | | 0 | | Total earn-out | | $0 |

This scenario matters for the negotiation. It shows Meridian the structure is not a disguised fixed payment. Sustained underperformance still pays nothing.

Scenario D: Outperformance

| | Year 1 | Year 2 | |---|---|---| | Earn-Out GP | 10.6 | 13.5 | | Annual payout | 4.80 + 1.20 × 0.5 = 5.40 | capped at 6.00 | | Sum of annual payments | | 11.40 | | Cumulative GP 24.1 → 9.60 + 1.091 × 2.1 = | | 11.89 | | Catch-up paid | | 0.49 | | Total earn-out | | $11.89M |

Expected negotiation pushback: Meridian will argue that 80% at plan is too rich. Acceptable fallback positions, in order:

• Target at 70% of the annual maximum ($4.2M).
• Floor raised to 88% of plan.

Do not concede the following:

• the metric definition;
• the cumulative catch-up;
• the absence of cliffs.

These matter more than the slope.

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Deliverable 3: Cost Allocations and Business Model Clause

These lists apply directly to Direct Cost of Delivery under the gross profit metric. They apply in full to the fallback Contribution metric.

3.1 Permitted charges

| Item | Condition | |---|---| | Compensation and benefits of Larkspur delivery personnel | Pro rata to time on Larkspur engagements, at actual cost | | Third-party data, licences, hosting directly consumed

MEMORANDUM

TO: Priya Nandakumar and Tom Ellery, Founders, Larkspur Analytics FROM: [Your Name/Title], M&A Advisory Lead DATE: October 24, 2023 SUBJECT: Deal Diligence & Earn-Out Restructuring – Meridian Systems Group

Priya, Tom: Below is my review of the draft earn-out terms from Meridian. I will be blunt: as currently drafted, this is an illusory $12M earn-out. You are being set up to fail, not necessarily through malice, but through the mechanical realities of post-close integration. Meridian's draft allows them to charge you for the cost of buying you, while legally binding you to a standard they know you cannot meet.

Here is my breakdown of the specific traps in the draft, how we will fix them, and my strategic recommendation for our next counter-offer.

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1. Document Review: Weaknesses in the Draft Clause A less experienced reader might assume Meridian will measure the business exactly as you run it today. As a seasoned buyer, Meridian knows that once they take control, "EBITDA" ceases to be a measure of your operational success and becomes a measure of their corporate accounting.

A. The "Sole Discretion" Clause (The 2021 Lawsuit Trap)

• *Draft Language:* "Buyer shall operate the Target in its sole discretion."
• *The Risk:* In M&A case law, "sole discretion" expressly overrides the implied covenant of good faith and fair dealing. This is the exact clause Meridian used to defend themselves in their 2021 litigation. It legally permits them to merge your sales team, fire your top producers, re-route your inbound leads to their legacy teams, or slash your pricing to bundle your services with their software—all of which would decimate your EBITDA.

B. The Accounting Policy Trap (Integration & Overhead Allocations)

• *Draft Language:* "determined in accordance with Buyer's accounting policies..."
• *The Risk:* Meridian’s policy allocates 6–9% of revenue for corporate overhead (services you don't currently need) and expenses integration costs at the unit level. At your Year 1 plan ($16.8M revenue), a 7.5% overhead allocation ($1.26M) plus $400k in integration costs reduces your $3.9M plan EBITDA to $2.24M. This falls completely below the $3.4M threshold. You could hit every revenue and gross margin target perfectly, and Meridian would legally owe you $0.

C. The Mathematical Trap (The Illusory Curve)

• *Draft Language:* "100% of the amount by which Target EBITDA... exceeds the Threshold, up to $6.0M per year."
• *The Risk:* The math here is highly deceptive. Your Year 1 Threshold is $3.4M. Your Year 1 *Plan* EBITDA is $3.9M. If you perfectly hit your plan (and miraculously avoid their overhead charges), 100% of the excess is only $500k. To earn the maximum $6.0M payout in Year 1, you would need an EBITDA of $9.4M—which is roughly 240% of your current plan. The $31M "headline price" is a fiction. At plan, this is a ~$20.3M deal ($19M cash + $0.5M Y1 + $0.8M Y2).

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2. Proposed Replacement Metric & Structure Since Meridian intends to merge your sales teams in Month 6, you will lose control over OPEX. We must move the earn-out metric up the P&L to Gross Profit, or at a minimum, rigidly define Adjusted Earn-Out EBITDA with a fixed scaling multiplier so that hitting your plan actually results in a meaningful payout.

Because Meridian will likely demand an EBITDA metric to ensure you don't chase unprofitable revenue, we will concede to EBITDA but redefine it as a strictly ring-fenced metric, and we will apply a 3x multiplier to the excess to correct the mathematical trap.

Exhibit A: Worked Numerical Example (Adjusted Earn-Out EBITDA)

*Drafting Logic: We strip out Meridian's overhead and integration costs, and apply a multiplier so that hitting plan yields a reasonable, proportionate payout.*

| Metric ($M) | At Y1 Plan (Meridian Draft) | At Y1 Plan (Our Counter) | | :--- | :--- | :--- | | Revenue | $16.80 | $16.80 | | *Less:* Baseline OPEX | ($12.90) | ($12.90) | | *Less:* Integration Costs | ($0.40) | *Excluded* | | *Less:* Meridian Corp Overhead | ($1.26) | *Excluded* | | EBITDA for Earn-Out | $2.24 | $3.90 | | Threshold | $3.40 | $3.40 | | Excess above Threshold | $0.00 | $0.50 | | Earn-Out Multiplier | 100% | 300% | | Year 1 Earn-Out Payout | $0.00 | $1.50 |

*Note: With a 300% multiplier, reaching $5.4M Adjusted EBITDA yields the full $6.0M max payout, making the upside actually achievable for Tom, while protecting Priya from accounting games.*

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3. Permitted/Prohibited Allocations & Operational Covenants We will strike the "Sole Discretion" clause and insert a "Commercially Reasonable Efforts" standard, supported by the following strict schedule.

Prohibited Allocations (Must be added back to EBITDA):

• Any management fees, corporate overhead, or shared services allocations from Meridian (e.g., IT, HR, executive time, rent for Meridian facilities).
• Any integration, rebranding, or transition expenses.
• Any legal, accounting, or audit fees related to the acquisition.
• Any increased sales commissions resulting from transitioning Larkspur staff to Meridian compensation plans.

Permitted Deductions (If using EBITDA):

• Direct, variable costs historically borne by Larkspur.
• Compensation for dedicated Larkspur headcount only.
• Capital expenditures explicitly requested and approved in writing by Tom Ellery.

Required Operational Covenant (Protection against Business Model Changes): > *"Buyer agrees that during the Earn-Out Period, it shall operate the Target using commercially reasonable efforts to maximize the Earn-Out Payments. Without limiting the foregoing, Buyer shall not, without the Seller Representative's prior written consent: (i) divert inbound leads or existing customers of the Target to other divisions of Buyer; (ii) bundle Target's services with Buyer's products in a manner that artificially reduces Target’s recognized, standalone revenue; or (iii) fundamentally alter the commission structure or primary duties of the Target’s legacy sales personnel prior to the conclusion of the Earn-Out Period."*

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4. Strategic Note to the Founders

Priya and Tom:

I know you both respect Meridian’s leadership. However, the executives you like today are not the ones who will be calculating your earn-out in 18 months—that will be a back-office controller whose bonus is tied to minimizing Meridian's post-close liabilities. The 2021 litigation is a glaring red flag; they have weaponized this exact contract language against founders before.

My Recommendation: Do not accept this earn-out as drafted.

Priya, you want certainty. Tom, you want to bet on yourself, but if they take away your sales team in Month 6, you are betting on *their* team's performance, not yours.

The Play: Let's trade some of the "headline" fluff for guaranteed cash. I recommend we counter with a demand for $24M cash at closing, and an $8M earn-out (capped at $4M per year), tied strictly to Gross Profit, not EBITDA.

If they balk and insist on EBITDA, we give them the Adjusted EBITDA structure in Exhibit A (with the multiplier and strict add-backs). If they refuse our add-backs for overhead and integration costs, they are quietly telling us they plan to use those charges to erase your payout. If that happens, we walk, or we demand the full $31M in cash.

Let's discuss this afternoon how aggressively you'd like me to deliver this counter to their counsel.

Larkspur Analytics: Earn-Out Review and Recommended Restructuring

Prepared for: Priya Nandakumar and Tom Ellery Re: Draft purchase agreement with Meridian Systems Group

Bottom line

The $12M earn-out is not worth anything close to $12M as drafted. At Larkspur's own plan, before any Meridian costs, the clause pays $1.3M over two years: $0.5M in Year 1 and $0.8M in Year 2. After the allocations and integration costs Meridian has told us to expect, it pays $0.

| | Y1 | Y2 | Multiple of trailing EBITDA ($3.1M) | |---|---|---|---| | Plan EBITDA | $3.9M | $4.9M | | | Threshold | $3.4M | $4.1M | | | Payout at plan, before allocations | $0.5M | $0.8M | | | Payout at plan, after Meridian's expected allocations | $0 | $0 | | | Cash at closing ($19M) | | | 6.1x | | Headline ($31M) | | | 10.0x | | Realistic price as drafted ($19M to $20.3M) | | | 6.1x to 6.5x |

Reaching the $6M annual cap needs EBITDA of $9.4M in Year 1 and $10.1M in Year 2. Those are 2.4x and 2.1x plan. The "up to $12M" is a marketing number.

I recommend you do not accept this clause as drafted. Negotiate the metric first. If Meridian won't move on the metric, trade the Year 2 tranche for upfront cash (Section 4).

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1. Document review memo: weaknesses in the draft clause

The central problem

The earn-out pays 100% of every EBITDA dollar above the threshold, and Meridian controls the costs that sit in the EBITDA. Plan cushion over the Year 1 threshold is only $0.5M. Meridian's allocation policy, applied to Year 1 at plan, produces the following:

| Item | Amount | |---|---| | Plan EBITDA | $3.90M | | Overhead at 7.5% of revenue (midpoint of the 6% to 9% range) | ($1.26M) | | Integration costs expensed in the unit | ($0.40M) | | EBITDA after allocations | $2.24M | | Shortfall against the $3.4M

Document Review Memo

Weaknesses in the Draft Clause:

1. EBITDA Metric Tied Solely to Operations:

• Risk: The buyer has control over both revenue recognition and cost allocations, which could depress EBITDA after integration.
• Use Against Sellers: Even without malintent, Meridian's decisions regarding cost allocations and revenue recognition could result in EBITDA figures that are below thresholds, leading to zero earn-out.

2. Accounting Policies 'Consistently Applied':

• Risk: Meridian’s policies can lead to variations in EBITDA calculations.
• Use Against Sellers: Differences in accounting practices between Meridian and Larkspur can understate earnings specifically when integrating financial systems.

3. Sole Discretion in Operations:

• Risk: Meridian has complete control over operational decisions that could impact financial performance.
• Use Against Sellers: Strategic decisions like higher-than-anticipated cost allocations or shifted revenue recognition can ensure thresholds aren't met.

4. Thresholds Close to Plan:

• Risk: The threshold is set close to Larkspur's projected EBITDA, leaving little room for variance.
• Use Against Sellers: This setup requires almost flawless execution to meet the earn-out, heightening risk.

Proposed Replacement Metric and Structure

Metric: Revenue-Based Earn-Out:

Change the earn-out structure to depend on revenue targets rather than EBITDA to reduce exposure to Meridian's cost allocations.

Structure Details:

• Earn-Out Payment: 100% of the excess of actual revenue over Revenue Target, capped at $6M per year.
• Year 1 Revenue Threshold: $15.5M
• Year 2 Revenue Threshold: $18M

Numerical Example:

• Year 1 Revenue: $16.8M
• Threshold: $15.5M
• Excess Revenue: $1.3M
• Earn-Out Payment: If revenue exceeds $15.5M by $1.3M, earn-out payment = $1.3M (subject to cap).

List of Permitted and Prohibited Cost Allocations

Permitted Costs:

• Allocated at no more than 5% of Larkspur's revenue for shared services.
• Integration costs incurred directly related to enhancing Larkspur operations.

Prohibited Costs:

• Costs related to new unrelated ventures within Meridian.
• Excessive executive time allocations unrelated to Larkspur.

Clause on Business Model Changes:

"Buyer shall not materially alter Larkspur’s existing business model nor diminish its operational capacity relative to historical performance during the earn-out period, except for strategic sales integration."

Note to Founders

Recommendation:

Negotiate the earn-out. Current terms expose you to excessive risks, potentially missing pay-outs despite achieving operational goals. Consider trading part for more upfront cash if terms remain unfavorable. Revenue-based earn-outs reduce your exposure to uncontrollable cost allocations.

Priya and Tom:

• Priya: This structure offers more certainty by focusing on revenue rather than bottom-line figures influenced by external costs.
• Tom: Staying involved can help influence operational decisions and ensure alignment with revenue goals.

Proceed with caution and ensure terms better align exposures with potential rewards.