In uneasy markets and lower valuations, sellers too are proceeding cautiously. Increasingly, sellers (and buyers) are leveraging earnouts. Joel Weinstein, Chairman of Rutter Hobbs & Davidoff's Corporate and Securities practice, shares his legal expertise, offering insight for sellers and their advisors when employing earnouts.
M.A.: Why should a seller enter into an earnout agreement?
J.W.: There are many circumstances in which earnouts are often useful for a seller. These include the following:
a. Where a seller and purchaser disagree over projected earnings or other factors of value for the target. For example, situations arise where the seller has a line of new products for which the valuation of the assets would be based solely upon projections and where the purchaser and seller may have legitimate differences as to volume, pricing and even market acceptance.
b. Another situation is in the case of a turnaround. Historical financial information may lack benefit to the purchaser in evaluating the price for a turnaround acquisition. An earnout that bases a portion of the valuation on actual future performance can enable the seller to bridge the issues that the purchaser has to avoid risks inherent in speculative estimates.
c. Another instance would be where the differences in valuation may also be consequences of different analyses of economic matters, such as general terms of the economy or trends in the seller company's industry. Earnouts can bridge the gap between these different assumptions.
d. Also, earnouts are effective for sellers that focus on software development and for service firms. Here, the earnout is the mechanism for inducing management to make the transition and to maximize profit for the purchaser. In these examples, essentially the earnout is the value existing in the business prior to closing, which management may only realize by meeting performance goals.
e. Finally, earnouts are beneficial for the seller where the seller is committed to a valuation that may seem unrealistic to the purchaser, but benchmarks and targets are set by the purchaser based on the seller's projections, which may appease that seller and close the deal.
M.A.: What provisions in the law provide a seller protection?
J.W.: In the absence of an alternative dispute resolution, the parties may sue to seek an interpretation and enforcement of the earnout. Although there are a limited number of published cases interpreting earnouts, a court has the authority to set the ground rules for the purchaser's conduct of the business post-closing court where the definitive agreement lacks detail as to the parties' conduct of the business post-closing. In the absence of operational details for the target post-closing and, for example, use of general terms such as "the purchaser will operate the business in a commercially reasonable manner to enable the seller to achieve its earnout," a court may attempt to interpret the intent of the parties by looking to past business practices of the seller to decide whether the purchaser breached the parties' intent to integrate the target and enable the seller to realize its bargained for payout.
Structuring protections for the seller must be balanced while not unduly interfering with the flexibility of operation of the target post-closing. If the purchaser is constrained to operate the business through restrictive covenants, the earnout protections are likely to substantially limit the purchaser's ability to modify, expand or contract the target's operations or capital structure. Instead the earnout would be drafted in a form of required accounting treatment of certain items.
M.A.: What are some of the most litigious aspects of earnouts; and what should all parties be on the lookout for?
J.W.: There are several aspects of earnouts that give rise to disputes.
f. Determination of the earnout. The seller would insist that the purchaser maintain separate books and records for the target, division, or other source of the earnout throughout the earnout period. The purchaser would covenant that these financial records will be made available for review upon reasonable notice.
g. Accounting issues. There are several accounting issues that may arise. For financial milestones, the parties should stipulate with as much detail as possible the accounting principles that will be used to calculate whether the thresholds have been met. GAAP embraces a wide range of acceptable accounting practices and is subject to change. The ability to manipulate results of an earnout through adjustment to GAAP is often legitimately of great concern to the seller. Particular care in delineating the calculation principle should be used if the threshold is EBIT or EBITDA. The parties should incorporate into the acquisition agreement a description of the accounting principles to be employed.
h. Consistency of practice and post-closing accounting. A problem may arise in the form of movement of revenue and expenses by the purchaser in control of the target after the closing. The seller would desire that the post-closing accounting should not vary from prior practice. Due diligence into the pre-sale accounting policies of the seller will clarify past practice and reveal any areas of potential dispute. The parties should determine whether changes in GAAP after closing will affect the determination of the earnout.
i. Potential exclusions in calculating the payout and other possible adjustments. In using a net income, EBIT or EBITDA measure, the seller would seek to exclude all transaction-related expenses that are charged against the earnings upon which the earnout is calculated. When net income is used as the performance yardstick, parties almost always adjust for increased depreciation caused by a write-up in assets obtained in the acquisition. When net income, EBIT or EBITDA are used as the performance measures, the seller also should ascertain what administrative or general overhead expenses the purchaser will allocate to the target after closing, and determine how those expenses will impact the post-closing figures. The seller will likely attempt to exclude executive compensation expense allocated to its former company. Typically, the seller would assert that indebtedness resulting from the acquisition allotted to the target after closing should be excluded when calculating the earnout. In addition, the seller should give attention to the exclusion of expenses associated with financings and pre-payment penalties. Intercompany transactions between the target and the purchaser or its affiliates also may require adjustment to reflect the amounts that the target would have realized or paid if dealing with an independent third party on an arms-length basis. Another potential area for variation that should be addressed includes inventory valuation methods, as well as the manner of treating inventory as obsolete, depreciation schedules, accounting for retirement and welfare benefits and reserves for bad debts. One solution is to identify the expense items at issue that may be recognized by the purchaser according to GAAP and provide that the designated expenses, or a percentage thereof, will not be included as expenses in the calculation of the earnout targets. Also, a purchaser may assert that increases in EBITDA or net income are a material result of efforts of the purchaser rather than the seller whether through management or synergies of production and sales costs, etc. Parties should carefully consider whether there are matters of heightened concern or specific to the target's industry. Typically, the purchaser's accountant is charged with initially computing the earnout, and a challenge and arbitration process is established for the seller.
j. Mismanagement during earnout period. Both the purchaser and seller may fear mismanagement during the earnout period that could affect the payout. The seller typically has concerns that the target will not be properly managed after the closing. In situations in which the seller's management team will not be retained post-closing, the seller likely will require that the purchaser operate the target in the ordinary course of business consistent with past practices of the seller and will attempt to reserve, through contractual covenants, some authority regarding major decisions made during the earnout period. The seller will likely demand that the target be operated as a distinct business entity or division so that its results can be verified. The seller may require that the purchaser adequately fund the target during the earnout period, so that it will be able to capitalize on the opportunities presented to it. It is not uncommon for the seller to establish minimum absolute funding levels. Of course, any limitation on the purchaser's rights to run the target as circumstances require likely will be resisted by the purchaser.
k. Unreasonable business practices by management. Less commonly, the seller's management team will continue to operate the target post-closing without involvement by the purchaser. In this situation, the purchaser's risk is that the seller's management team will operate the business so as to unfairly maximize the payout amount.
l. Uncertainty of Operational Procedures. The parties also may wish to include detailed post-closing operational procedures in the acquisition agreement in order to avoid uncertainty. For example, the purchaser might covenant to operate the company consistent with the target's past practice, subject to certain exceptions where the purchaser might require restrictive covenants that prevent the target from taking specified actions during the earnout period. The parties should be explicit in crafting the expectations for the post-closing conduct of the parties in order to avoid a court setting the ground rules for the buyer's conduct of the business post-closing.
m. Multiple decision makers for seller. In situations in which the seller has several shareholders who are retained by the purchaser to manage the target, the parties should consider establishing a single person or committee as the representative to act on behalf of the persons who were shareholders of the seller at the closing. The shareholders' representative would speak for the shareholders on matters related to the earnout and indemnification. The provisions establishing the representative should delineate its powers and how it can act.
n. Saleof target by purchaser. The parties should determine whether the target or a portion thereof may be sold to a third party during the earnout period, and the effect of such a sale should it take place. A similar problem arises when a third party acquires the purchaser during the earnout period. In considering that case, the seller may suggest that the third party purchaser be obligated to payout some or all of the earnout amount at the time of the second sale.
o. Strategic Buyer or Rollup Platform. Strategic buyers often seek acquisitions to realize benefits from the consolidation of sales forces, manufacturing facilities, distribution systems and the like. A natural consequence of this consolidation may be to shift sales from the target to the purchaser, or vice versa. If that is anticipated, the parties must decide how to measure performance and calculate the earnout. A parallel difficulty arises when the purchaser wants to merge the target into similar entities owned by the purchaser. The difficulty of measuring performance in this case may make the purchaser reluctant to fully integrate the acquired business into the rest of the purchaser's business.
p. Target exceeds goals. The parties must decide whether performance well above threshold levels in one part of the earnout period may be applied to supplement a lesser performance during another part of the earnout period.
q. Dispute resolution. Disputes regarding earnouts are commonplace, and the lawyers drafting earnout provisions are advised to consider the appropriate form of dispute resolution under the circumstances. Many earnouts require binding arbitration of disagreements that the parties cannot resolve within a brief period of time. All provisions regarding dispute resolution should be detailed and carefully drafted.
r. Value of the earnout. Once the source and indicator of the earnout are established, it must be determined how the earnout payment will be tied to the indicator. While the ultimate percentage or multiple is purely a business issue, whether the payment is a multiple or percentage does, to some extent, reflect the reasons the earnout was introduced into the transaction. An often difficult part of negotiating an earnout would be whether payments are prorated if the benchmarks or goals are only partially achieved, or instead, the benchmark is a hurdle for payment. This is simply a matter of negotiating leverage. Often the seller and the purchaser will resolve the negotiation by establishing a minimum hurdle before any payment will be made, and allow a sliding scale for proration after that hurdle is achieved.
M.A.: Is there a worst case scenario for employing an earnout?
J.W.: Earnouts typically are not as effective if the seller's management is not going to continue to operate the target business. In those situations, the seller becomes totally reliant upon the purchaser to run the business successfully. This structure has great potential for generating disputes about the earnout payments.
M.A.: How much of an increase in earnouts have you seen post-credit crisis?
J.W.: The economic downturn in 2008 and 2009 has caused more sellers to consider and accept earnouts as part of pricing the sale of their companies. Sellers today may believe that their companies' flat or declining performance will turn around quickly as the economy improves, yet purchasers are unwilling to pay for unproven performance. An earnout can bridge the resulting valuation gap. Also, the lack of senior debt acquisition financing, and the reticence of capital sources such as private equity groups to accept the seller's earnings multiplier necessitates that sellers and their advisors turn to earnouts to potentially achieve the seller's price valuation and support the purchaser to close the transaction while reducing its initial capital payments.
M.A.: Thank you, Joel.
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