By Michael P. Weiner, Pepper Hamilton LLP
The earnout has come back into fashion as a means of bridging the all too frequent gap between a business owner’s sometimes inflated expectation as to the value of its business to a prospective buyer, and the buyer’s financial modeling of a particular acquisition and its access to the capital resources necessary to consummate a transaction. The reality of the mergers and acquisitions marketplace is that although statistics indicate that both financial and strategic buyers have vast amounts of cash available to fund acquisition transactions, the protracted global economic downturn has fostered a selling community that is reluctant to sell at depressed valuations, and a buying community that is reluctant to buy based on historical financial results that may not be duplicated (a turnaround situation) or projected financial results that may be overly optimistic within a stagnant economy (a company focused on new products or services). Assuming an improvement in macroeconomic conditions, the inverse will likely apply: higher valuations may be justifiably demanded by sellers, but buyers will be reluctant to deploy equity and leverage may remain relatively expensive. As a result, earnouts are often employed as a means for a buyer to lessen its risk of overpayment (including possible offsets against the earnout as an element of the seller’s indemnification of the buyer for breaches of representations and warranties), while offering the seller the possibility that it may ultimately receive, and perhaps exceed, the seller’s subjective belief as to the value of the business to be sold. The typical percentage of the aggregate purchase price which may be represented by an earnout may range from 10 percent to 25 percent, limited by “caps” in those circumstances where earnouts may be premised upon the satisfaction of multiple criteria.
Consequently, the formula ultimately agreed upon by the parties is often a “hybrid” formula which seeks to take into account the specific, sometimes unique, characteristics of the particular industry or service segment in question. For example, in a financial services or insurance industry scenario, post-closing commissions and fees generated by acquired assets may require specific allocation among multiple segments of the buyer’s business as opposed to solely the business previously conducted by the seller. This highlights the need to clearly identify the source of the revenues and related expenses upon which the calculation of the earnout will be calculated. Will it be based upon: the totality of the assets or business acquired and operated as a separate division of the buyer; a specific product or service line; or a blending of the seller and the buyer in those circumstances where there is an overlap between the parties’ products or business segments? The last may be particularly challenging to the drafter, as the calculation must seek to provide that revenues are properly allocated to the buyer or the seller. In the case of an early or development stage target, the metrics may be non-financial: the earnout may be tied to a product launch, receipt of regulatory approval or addition of some volume of new customers.
Consequently, buyers are typically unwilling to include contractual covenants that may provide substantial latitude to legacy management to control the operation of the acquired business post closing. Efforts to reach a middle ground may focus on how certain items will be accounted for during the earnout period; for example, capital expenditures in excess of some historical pre-closing level may be excluded from the calculation of net income during the earnout period. Also, buyers are sensitive to the reality that increases in the earnout metrics post closing may be attributable, whether substantially or otherwise, to the buyer’s own management skill or economies arising out of the various synergies underlying the business combination, and understandably reluctant to reward the sellers for value that they may not have created. These categories of revenue enhancers or expense reducers may be especially difficult to calculate, unless the parties can agree on such easily identifiable savings items like overhead or personnel cost reductions, and these can be clearly expressed in the definitive acquisition documentation.
Earnouts represent a classic example of how it is necessary as counsel to seek a resolution that will merge the theoretical legal concepts at play with the realities and practicalities of the transaction which are properly the main focus of the business personnel. For the buyer, it is critical to craft an earnout mechanism that appropriately incentivizes the earnout recipients through short- and long-term targets that are consistent with the buyer’s long-range objectives. Short-term spikes in profitability that cannot be sustained due to insufficient infrastructure may be rewarding to an earnout recipient, but ultimately reduce the overall value of the transaction to the buyer. At the same time, the seller has accepted a certain level of risk by way of accepting a deferral of a portion of the purchase price, and that risk needs to be balanced against a clear expression of how the earnout will be calculated and reported, disputes will be resolved, and a commitment by the buyer to provide the earnout recipients with every reasonable opportunity to recognize the full value of their efforts.
Michael P. Weiner is a partner in the Corporate and Securities Practice Group of Pepper Hamilton LLP, resident in the Princeton office. He concentrates his practice on transactional matters involving clients ranging from sole proprietorships to publicly-held corporations engaged in a variety of business pursuits, often acting as the primary outside counsel for business entities interested in having access to a “gatekeeper” for their diverse legal needs. Mr. Weiner also is a member of the Sustainability, CleanTech and Climate Change Team.
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