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.
In effect, earnout provisions are a form of purchase price adjustment whereby (i) the buyer is able to delay the payment of some portion of the purchase price until such amounts are actually earned (if ever); (ii) the buyer is able to fund a portion of the purchase price out of the post-closing operations of the acquired business; and (iii) the seller has an “upside” opportunity to receive a higher aggregate purchase price. Crafting of earnout provisions to be included in acquisition documents includes both quantitative and operational elements that are central to the buyer’s ability to effectively integrate the acquired business into its existing structure and motivate the seller/earnout recipient to focus on short-term financial milestones that may result in personal reward, while avoiding adverse long-term consequences for the buyer. In this regard, establishment of the metrics by which the earnout is to be calculated is a critical component, and typically involves discussion between the chief financial officers of the buyer and target company. Gross revenue, or sales, is infrequently used for earnout purposes because it carries little or no incentive for the former owners of the seller’s business, who are now managing the business within the buyer’s organization, to control expenses. Further, the initial sale of a particular good or service may not be an accurate indicator of ultimate profitability. For these types of reasons, net income is often preferred by buyers to measure the post-closing success of an acquired business or product line. From the buyer’s point of view, a net income approach permits the buyer to measure profitability in much the same way as it measures profitability on a business-wide internal basis. Sellers may seek to apply an EBITDA calculation in order to take into account potential downward adjustments relating to transaction-related charges, goodwill amortization, asset depreciation and indebtedness related to the acquisition transaction.
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.
The parties must also agree on the form of payment of the earnout, a time frame for the potential payment of the earnout, and address future events which may result in a termination of the earnout in advance of its scheduled expiration. The most straightforward form of payment is cash. To the extent that securities of the buyer are used as a complete or partial form of payment, the parties need to consider federal and state securities law compliance issues, as well as questions of valuation and the ongoing rights of the sellers as stockholders of the buyer, including voting and information rights and anti-dilution protection. The determination of the base time frame is usually a function of (i) how long the buyer wishes to incentivize the former owners/managers of the acquired business; and (ii) how much time is necessary to appropriately measure the value of the acquired assets. A common “base term” for an earnout may range from 12 to 36 months. Termination events typically include (i) a subsequent sale of the acquired business or assets; (ii) a change in control of the buyer; or (iii) a termination of the earnout recipient’s employment (other than for cause). The buyer may also want to consider including a “buy out” of the earnout, based upon a multiple of historical earnout payments or an independent valuation of the underlying assets or business, to provide the buyer with an exit plan in the event that the inclusion of the acquired business post closing produces some unexpected limitations on the buyer’s operating flexibility. In any event, the result of the termination of the earnout in advance of its scheduled expiration is an accelerated payment to the seller, thereby triggering some tax planning issues for the seller which may be addressed in the negotiation of the calculation of the accelerated amount.
Having established the core parameters of amount and time, specific issues relative to the seller and buyer will also need to be addressed. For example, sellers will want to provide that the accounting principles applied by the buyer for purposes of calculating the earnout payments will be consistent with the accounting methodologies applied by the seller pre-closing; here, mere reliance upon GAAP based accounting may not suffice. On this point, a buyer will focus on whether it can reasonably continue the seller’s accounting methodology, and, if not, whether the buyer’s application of accounting methodologies consistent with its overall business approach may artificially increase earnings for purposes of the earnout calculation. Sellers will also seek assurances that the buyer will not apply transaction-related expenses against the operating results of the acquired business in order to negatively impact the earnout calculation. Other issues relating to the earnout calculation will typically include goodwill amortization, asset depreciation, and allocation of corporate overhead. The respective chief financial officers of the parties typically take a leading role in addressing these issues and providing a framework to counsel for inclusion in the definitive acquisition documentation.
Buyers and sellers often have a pronounced disagreement over the issue of the operation of the acquired business post closing. Sellers, on one hand, are concerned that a buyer’s unfettered ability to operate the acquired business may reduce the value of the earnout. Such a devaluation may occur unintentionally or intentionally, possibly through poor management or possibly through a redirection of resources (both human and capital) away from the acquired business to the buyer’s broader business operations. As a result, sellers will frequently seek written assurances from the buyer that during the earn out period it will not, among other things, without the consent of the sellers: eliminate key “carry over employees”; dispose of any of the assets relating to the seller’s core products or services, or discontinue the marketing and sale of those products and services; fail to provide capital to the acquired business at a rate at least equivalent to the rate provided by the sellers; or introduce significant new expenses to be charged to the acquired business, whether by way of new employees, real property leases, capital expenditures, etc. Buyers will have ready responses for all of these concerns, since, as an intuitive matter, buyers begin from the proposition of “we own it, we run it as we see fit.” A strategic buyer will often believe that members of its existing management team are able to operate the acquired business at least as effectively as the sellers. Buyers will want to retain the flexibility to minimize the negative impact of any miscalculation as to the future profitability of an acquired line of goods or services and not be contractually bound to support that business if market conditions change. Similarly, buyers will want to be able to react to new business opportunities that may present themselves during the earnout period and reallocate resources accordingly. This may be of particular importance where the buyer is subject to financing covenants that impose limits on capital expenditures by the buyer, exacerbating the potential disconnect between payment of earnout obligations on completed transactions and the ability to quickly address new opportunities. In this regard, buyers and sellers contemplating inclusion of an earnout arrangement should be clear as to whether, as a legal and as a practical matter, any such restrictive covenants may adversely impact the potential payment by the buyer of the specified earnout amounts.
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.
The end result, at least documentation-wise, of all of these points and counterpoints is more often than not the inclusion of a relatively detailed treatment of the method by which income and expenses will be accounted for purposes of the earnout; a clear presentation as to the actual mechanism for reporting and delivery of the earnout calculation by the buyer, balanced by a challenge and dispute resolution process for the benefit of the seller; and an undertaking by the buyer not to take any action intended to frustrate the likelihood of the seller ultimately receiving the full value of the earnout. Note that the concept here does not prohibit the buyer from taking actions based on reasonable and sound business judgment which may indeed have the effect of lessening the earnout potential of the acquired business; instead, the concept is that the buyer will not take any action that is premised on an intent to deny the sellers the full benefit of the transaction.
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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