The ongoing economic crisis has created deep uncertainty about the future performance, and current value, of many businesses. One technique deal-makers may consider using to bridge disagreements between prospective buyers and sellers of businesses over valuation is the “earn-out.”
With an earn-out, a portion of the purchase price is paid after the closing, contingent in whole or in part upon the target company’s economic performance or achievement of non-economic milestones during the post-closing period. The earn-out may provide for the payment of a fixed amount of compensation upon the target’s satisfaction of a specified performance criterion, or, more typically, a specified percentage of the amount by which the target’s performance exceeds an agreed performance threshold.
Earn-out structures are not new, but the current economic uncertainty makes it likely that they will in the months ahead become more common in negotiated sale transactions, particularly those involving privately held companies for which no dependable market mechanism exists to provide a basis for determining value. Indeed, deal-makers already appear to be increasingly using earn-out structures in acquisition transactions. Available data respecting the acquisition worldwide of private targets, summarized in the chart below, indicate that, while an earn-out remains a relatively uncommon deal element, it was used with significantly greater frequency as the global economy’s prospects darkened during the year ended June 30, 2008 when compared with the immediately preceding year.
There is no “one size fits all” earn-out template. A well-designed structure takes into account the particular facts and circumstances of a target’s business, the deal requirements of the buyer and seller, and post-closing contingencies. Earn-outs bring with them numerous potential pitfalls that should be thoughtfully addressed by the buyer and seller when the deal term sheet and definitive documentation are negotiated. Time spent getting the earn-out provisions right is time well spent, reducing the chances the parties will need to re-open negotiations after the closing in light of unanticipated developments or uncontemplated circumstances.
What performance criterion should be used to measure post-closing performance? Satisfaction of an earn-out may be measured in terms of the achievement of one or more performance milestones, such as the launch of a product, grant of regulatory approval, or the addition of an agreed threshold of new customers. More typically, however, the buyer and seller opt for the precision of a financial metric such as gross revenues, EBITDA, EBIT, or net income to measure post-closing performance. In general, sellers prefer a financial metric that is as close as possible to the revenue line of the financial statement in order to minimize the buyers’ opportunity to depress the calculation of the earn-out by including increased amounts of expense and other adjustments. Buyers, on the other hand, often prefer a financial metric that is as close as possible to the net profits line of the financial statement so as to more accurately reflect the target’s actual performance.
A key goal is to ensure that the criterion is drafted tightly and open to little if any interpretation. Financial metrics should for this reason be calculated in accordance with GAAP or other applicable accounting standards. In addition, sellers should generally insist that the applicable accounting standard be applied “consistent with past practices” to prevent any post-closing decisions of the buyer (although compliant with the agreed-to accounting standard) from distorting the target’s post-closing financial results. Before agreeing to this request, however, the buyer should ascertain that its treatment of all material accounting elements is indeed consistent with the seller’s. A careful review often reveals that the buyer and seller use one or more different accounting practices within a shared accounting standard. If any such difference is likely to be material with respect to the calculation of the earn-out, the transaction documentation should specifically define the accounting practice to be followed.
A host of issues, including those set forth below, should be addressed with respect to applying the agreed-to performance criterion for purposes of determining amounts to be paid under an earn-out.
The five main ones are:
1) Should revenues derived by the target from post-closing sales to the buyer and its affiliates be included for purposes of calculating the earn-out? Buyers sometimes awake to this question only after the closing and object to paying an earn-out with respect to revenue generated by their purchases from the target.
2) Should the earn-out be subject to a cap? The buyer will often argue that the earn-out should be capped at the difference between the value at which the seller would be willing to sell target if 100 percent of the purchase price were to be paid at closing and the amount actually paid at closing. Any amount in excess of this, the buyer will argue, represents a seller windfall. The seller may object to being asked to bear the risk of target underperformance without receiving the possible benefit of overperformance by the target. The seller may point out, if it accepts a cap on the earn-out, that the buyer’s underlying reasoning suggests that the buyer should pay interest on any earn-out from the date of closing through the date of ultimate payment.
3) Does the buyer market goods or services that compete with the target’s products? If so, the seller may wish to consider the dampening effect that sales of the buyer’s competing products might have on the target’s earnings during the earn-out period. In such circumstances, the seller may wish to obligate the buyer to dedicate resources to marketing the target’s goods and services and appropriately incentivizing its sales force to do so. Alternatively, the seller may wish to exclude the competing product lines from the scope of the earn-out and reduce the thresholds of the financial metric accordingly.
4) Should certain expense elements be excluded in calculating the earn-out? For example, buyers, particularly conglomerates, often allocate fixed expenses across business units. Sellers will typically seek to prohibit allocation of such costs to the target. Sellers will also seek to limit the ability of buyers from taking depreciation charges on post-closing investments that have a useful life beyond the earn-out period, as well as to prohibit buyers from deducting expense items related to the transaction itself or the integration of the target’s and buyer’s businesses. In addition, buyers and sellers often agree to exclude extraordinary items of gain or loss for purposes of the earn-out.
5) How will the target be operated after the closing? Whatever performance criterion is used, and however it is applied, amounts earned under the earn-out will depend, even when the seller’s management team remains employed by and in charge of the target after closing, in large measure upon the buyer’s actions and decisions.
The seller will be anxious to ensure that the buyer operates the business after the closing in the ordinary course as the seller had operated it prior to the closing. The seller may therefore insist that during the earn-out period the buyer maintain target as a stand-alone entity and maintain separate books and records for the target in order to enable calculation of the earn-out.
The seller may also seek to obligate the buyer to provide an appropriate level of support to the target’s business, typically not less than the support assumed by the seller’s business plan, so as to maximize chances that the target will succeed in meeting its earn-out threshold. For example, the seller may seek to require that the buyer maintain the target’s working capital at specified minimum levels during the earn-out period, and retain specified key employees and other employees in sufficient numbers and with sufficient experience to maximize the opportunities for success in achieving the earn-out threshold.
The seller will also wish to ensure that post-closing cash and incentive compensation, and other conditions of employment, are sufficiently generous so as to motivate target’s key employees during the earn-out period. If the seller has sufficient leverage in the negotiations, it may insist that the buyer agree to operate the target during the earn-out period in accordance with an agreed-to budget. The seller will also generally seek to restrict the buyer from entering into transactions that would be likely to depress earn-out payments or make the calculation or achievement of the earn-out difficult or impossible. Such transactions include, for example, sale of the target business, discharge of any key employee except for cause, or any transaction that would cause the target to take on any material payment or other obligations outside the ordinary course of business. The seller should also insist that any transactions between the buyer and its affiliates and the target be on an arms-length basis.
For its part, the buyer will assess such seller requests in light of its own goals in acquiring the target, which may include the desire to exploit cost and revenue synergies with its existing businesses, and its operational plans for the target during the earn-out period.
To finesse these sorts of issues, the buyer and seller may agree as part of their negotiation to specify actions of the buyer that are, respectively, required and (absent the consent of seller) prohibited during the earn-out period. To preserve the buyer’s ultimate freedom to deal with the target as it sees fit, notwithstanding such an agreement, it is prudent to include provisions allowing the buyer at any time during the earn-out period to buy down the seller’s earn-out rights.
The length of the earn-out period, typically ranging from one to five years, will relate to the time period considered necessary by the parties to measure the projected value of the target. Details relating to the timing and logistics of earn-out payments should be carefully considered and clearly documented. It is not uncommon for earn-out payments to be paid annually over the earn-out period based upon the target’s performance for the year just ended. The buyer will consider it important to provide a mechanism for netting performance shortfalls by the target in a given year in calculating the earn-out payment for a subsequent year.
The buyer often assumes that it has the right to offset against earn-out payments alleged damages from sellers’s breach, including of representations and warranties as to the target, under the acquisition agreement. The deal documentation should coordinate the buyer’s offset rights, if any, with the buyer’s indemnification rights in general.
The seller will be anxious to ensure that its accountants will have the opportunity to review all target books and records to verify the calculation of the earn-out payment, an exercise that typically is performed by the buyer’s accountants, and, in appropriate circumstances, to dispute the buyer’s calculation of the earn-out before an arbitrator or other independent forum.
The tax treatment of earn-out payments, while beyond the scope of this article, should also inform the structure of any earn-out.
Uncertainty abounds in today’s deal environment, and the earn-out is a potentially useful but deceptively challenging technique to get a deal signed in the face of a disagreement over valuation between a prospective business buyer and seller. Care and thought must be exercised in designing and documenting the earn-out to minimize the risks of disappointed expectations and costly post-closing disputes.
Brendan J. Radigan, Esq. is a partner in the Business Law Department of Edwards Angell Palmer & Dodge LLP. He advises on mergers and acquisitions and other transactions, as well as on corporate and business law issues generally. Reach him at email@example.com. Devin B. Fargnoli, Esq., an associate at Edwards Angell Palmer & Dodge LLP, contributed to the development of the transaction data used in this article.