earnout strategies for m&a deals: the...

Presenting a live 90‐minute webinar with interactive Q&A

Earnout Strategies for M&A Deals: Earnout Strategies for M&A Deals: Bridging the Valuation GapMaximizing Lender Recovery Upon Borrower Default

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, JANUARY 25, 2012

Today s faculty features:

Maryann A. Waryjas, Co-Chair, Corporate Governance Practice, Katten Muchin Rosenman, Chicago

Scott P. George, Managing Director, P&M Corporate Finance, Chicago

John P. O’Connor, Partner, Plante & Moran, Chicago

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Structuring andStructuring and Negotiating Earnouts

January 25, 2012

© M. Waryjas, S. George & J. O’Connor, January 2012

Your Presenters

• Maryann A. WaryjasPartner, Katten Muchin Rosenman, LLP

Ms Waryjas helps private equity funds hedge funds and their portfolioMs. Waryjas helps private equity funds, hedge funds and their portfoliocompanies achieve their strategic business goals and objectives – ontime and within budget. She has been the legal architect for manysuccessful transactions. Over her career, she has represented generaland limited partners in PE funds and hedge funds and other financingand limited partners in PE funds and hedge funds, and other financingsources, in forming investment vehicles, control transactions, equityinvestments, senior and junior debt financings, public bond issuances,PIPE transactions, and restructurings.

M b t t d t M W j @k tt lMaryann can be contacted at [email protected] or(312) 902-5461.

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Your Presenters

• Scott P. GeorgeManaging Director, P&M Corporate Finance, LLC

M G h 30 f i t t b ki i dMr. George has over 30 years of investment banking experience andhas advised on more than 250 transactions involving mergers,acquisitions, divestitures, fairness opinions, going private transactions,and various types of public and private financing transactions. He alsoh t i i ith IPO i l di th i l i S i lhas extensive experience with IPOs including those involving SpecialPurpose Acquisition Companies (SPACs). Mr. George hasconsiderable experience in the Business Services, Consumer andIndustrial sectors. Mr. George graduated from Northwestern Universitywith a BA degree in Economics and earned his MBA from Thewith a BA degree in Economics and earned his MBA from TheUniversity of Chicago Booth School of Business.

Scott can be contacted at [email protected] or (312) 602-3613.

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Your Presenters

• John P. O’ConnorPartner, Plante & Moran, PLLC

M O’C i P t i th S i I d t t Pl t &Mr. O’Connor is a Partner in the Service Industry group at Plante &Moran, PLLC. He has more than 23 years of experience servingprivately held companies including due diligence, consultation on M&Astructuring and purchase price valuation and allocation. Mr. O’Connori d t f D P l U i it d d MBA f th K llis a graduate of DePaul University and earned an MBA from the KelloggSchool of Management at Northwestern University.

John can be reached at [email protected] or(312) 602-3516.( )

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Copyright © M. Waryjas, S. George & J. O’Connor, January 2012.

All i ht dAll rights are reserved.

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Introduction to Earnouts

• An earnout is a deal pricing mechanism that causes a portion of thepurchase price to be contingent upon the post-sale results of the Target

– Most commonly used in deals valued <$250 million– Calculation relies upon defined targets/benchmarks– Benchmarks are usually one or more of revenues, NI or EBITDA– Earnout period is typically anywhere from one to three years– Generally represent ~20-30% of total deal consideration

• Recently become more popular due to larger than normal gap betweenB ’ d S ll ’ ti f lBuyers’ and Sellers’ perception of value

– Included in 38% of deals in 2010 vs. 29% in 2008 and 19% in 2006

10Source: American Bar Association 2011 Private Target M&A Deal Points Study

Primary Rationale

• Used when Buyer and Seller cannot agree on deal value– Rewards Seller if Seller’s projections prove accurate– Protects Buyers from overpaying if Seller’s projections are overlyProtects Buyers from overpaying if Seller s projections are overly

optimistic

• Earnouts can be particularly useful in the following situations:– Volatile industries and/or uncertain economic times– Companies with limited operating history that have a promising but

unproven product, technology or contract pipelineA t li ht b i h B i bl t bt i f ll t f– Asset-light businesses where Buyer is unable to obtain full amount offinancing at closing

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Advantages to Buyer

• Reduces risk of overpayment• Serves as partial financing mechanism

– Reduces required upfront capital outlayReduces required upfront capital outlay– Allows Buyer to pay for acquisition out of future profits

• Lays foundation for management performance incentives (aligns interests)• Mitigates risk of management fraudg g• Provides security for indemnity enforcement

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Advantage to Seller

• Increases probability of closing a fully valued transaction• Provides potential for greater consideration than could be realized in a

fixed price transaction• Allows for exit today without forfeiting ability to share in future growth of

the company

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Primary Disadvantages

• Incremental time and resources required to negotiate and draft effectiveearnout provisions, and to calculate the earnout

• Potentially conflicting goals between the Buyer and Seller regarding theoperation of the business

• Great potential for future disputes about the contingent payment• Necessity of maintaining ongoing relationship between parties

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Performance Benchmarks

• Goal is to have performance metrics that can be easily “audited”• Typical financial benchmarks include:

– Net revenues, NI, EBIT, EBITDA, EPS or net equity thresholdsNet revenues, NI, EBIT, EBITDA, EPS or net equity thresholds• In 2010, more than 74% of earnouts tracked financial metrics:

– 37% tracked Revenue– 32% tracked Earnings/EBITDAg– 5% tracked a combination of above metrics

• During the same year, 26% tracked other, often non-financial, benchmarks:– Beta site or beta testing thresholds (for early stage companies)g ( y g p )

• Clarity of benchmarks, payment formula and measurement process is key


Other Payment Decisions

• One earnout period or multiple earnout periods• Per period or cumulative• All or noneAll or none• Lump sum or sliding scale• Floors and caps• Contingent eventsg• Security for earnout payments• Form of consideration (cash, stock, other)

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Earnout Payment Formulas

• Financial benchmarks– Flat amount– % of amount by which Target’s performance exceeds milestone% o a ou t by c a get s pe o a ce e ceeds esto e

• Non-financial milestones– Flat amount of cash or shares

• Limitation on paymentsp y• Earnout periods are typically one to five years, with transactions closed

in 2010 having earnout periods of the following lengths:– Up to 1 yr.: 27% – 2 to 3 yrs.: 33%– 1 to 2 yrs.: 30% – Over 3 yrs.: 12% Note: Percentages do not add to 100% due to rounding.


Annual Payment Issues

• Will the “target” amounts increase annually, and if so, by how much?• If performance is strong in the early years, but weak in later years, how

will the Buyer recover excess payments?• If performance is weak in the early years, but strong in later years, must

the Target “make up” a prior deficiency before the Sellers receive apayment?

• Should the annual payments be at a lower payment percentage than is• Should the annual payments be at a lower payment percentage than isultimately to be applied, in order to cushion the Buyer’s risk of futureEBITDA (or other) shortfalls?

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Annual Payment Issues

• Should earnout payments be decreased over time to reflect theintegration of the Target into the Buyer’s businesses and relatedsynergies?

– For example:• 5 times excess earnings in the first year;• 4 times excess earnings in the second year, etc.

• Should there be a “true up” at the end of the annual payments and thefinally determined amount at the end of the term?

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Earnout Payments of Stock

• What rights and obligations will the Seller have regarding the sharesonce received?

– Securities Act of 1933 restrictions– Other restrictions on transfer– Registered shares or registration rights– Holdback periods– Drag along requirements– Repurchase rights in favor of the Buyer– Tag along rights– Voting requirements

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• As of what date will the stock be valued?– Closing date of the original transaction– Payment calculation dateay e t ca cu at o date

• How will the stock be valued?– Average of closing prices over a specified period– Other agreed upon methodologyg p gy

• Consider anti-dilution protection• If Buyer is a private company and a closing stock price cannot be

determined, then by whom will the stock be valued?– Buyer’s board of directors “in good faith”– Independent valuation (accounting firm, investment banker, etc.)

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• Ensure that maximum number of potential shares is reserved forissuance at the closing and stockholder approval is obtained

• OID rules of the IRS require that some portion of the deferredconsideration, if made in stock, must be allocated to interest, reportableas such by the Seller and deductible as such by Buyer

• Remaining portion of the stock generally is treated as additionalpurchase pricepu c ase p ce

• Results in Sellers having to come out-of-pocket to pay taxes on sharesthat they may not be able or allowed to sell

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Operating Control Issues

• Can create source of tension between Buyer and Seller• Buyer could be motivated to take action beneficial for long-term goals at

the expense of short-term earnings• Difficult to measure contributed performance if Target is integrated into

Buyer’s other businesses• Also challenging if Buyer acquires other similar businesses (e.g., re-

branding issues possible use of national service providers)branding issues, possible use of national service providers)• Segregating the Target’s financials can preclude the Buyer from

achieving economies of scale and other synergies anticipated in theoriginal acquisition

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Operating Control – Seller’s Considerations• If Buyer controls and manages the business after closing, Seller may want to:

– Require Buyer to operate the Target “in the ordinary course of businessconsistent with past practice” (with certain pre-agreed upon differences)

• Based on transactions that closed in 2010, 27% of earnoutsincluded such a covenant, whereas 8% included a covenant to runthe business to maximize the earnout

Reserve through covenants some authority regarding major decisions– Reserve, through covenants, some authority regarding major decisionsmade during the earnout period

• Expansion of the business• Hiring or firing of key personnel (including definition of “Cause”)g g y p ( g )• Restrictions on dividends• Combining the Target or its business with another business• Taking on additional debt

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g

Source: American Bar Association 2011 Private Target M&A Deal Points Study

Operating Control – Seller’s Considerations• If Buyer controls and manages the business after closing, Seller may

want to:– Require Buyer to adequately fund Target during the earnout period,

so it will be able to capitalize on opportunities presented to it– Require Buyer to keep separate books/records– Have one or more seats on the Buyer’s board of directors– Critical to plug any “holes” in the earnout scheme that could result

in an end-run around the earnout

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Operating Control – Buyer’s Considerations• Retain as much flexibility as possible to operate business as Buyer sees fit• Be cognizant of good faith and fair dealing principles• If Target’s management/shareholders will continue to manage theIf Target s management/shareholders will continue to manage the

business after closing, the Buyer risks that:– Management will operate the business to inflate the earnout

payments– Management may be more focused on remaining “separate” to

support the earnout, than to integrating with Buyer’s overall businessoperations

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Dealing with Subsequent Unexpected Change Events• Sale of the Acquired Company or a portion of the Acquired Company

during the earnout period– Lump sum payment? How much?– Does new buyer assume the earnout obligation? Any related

restrictive covenants?– Allocation of tax benefits can result in new buyer owing $ to first

buyerbuyer• Sale of the Buyer during the earnout period

– Based on transactions that closed in 2010 and included an earnout,35% of purchase agreements included a clause that accelerates thep gearnout upon a change in control


Resolving Conflict

• Preventative Measures– Clarity, consistency, completeness in drafting the earnout formula– Pinpoint problems and insist that parties agree in advance on how thesePinpoint problems and insist that parties agree in advance on how these

should be treated• Accounting Mechanisms

– Buyer prepares statement following period end, Seller reviews,objections resolved through independent accounting firm

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Resolving Conflict

• Dispute Resolutions– Arbitration provisions – choosing forum and procedure use ahead of time

• IndemnityIndemnity– Can structure so Buyers can offset indemnity payments against earnout– Based on transactions that closed in 2010 and included an earnout, 62%

contained express offset rights, 24% were silent on the issue and 5%prohibited offsets (offset rights could not be determined for the remaining8%)

Note: Percentages do not add to 100% due to rounding.


Earnout Accounting Issues

• Consult carefully with accounting experts• Specify relevant accounting principles in the agreement

– Include specific line items usedInclude specific line items used– Mere reference to GAAP is not enough

• Consistency of practice

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Common Earnout Accounting Issues to be Addressed• Allocation of overhead• Affiliate transactions/pricing• Amortization of intangible assets and goodwill chargesAmortization of intangible assets and goodwill charges• Depreciation• Capitalization of expenses• Research and development expensesp p• Impacts of additional leverage – burden, interest costs and restrictive

covenants• Effects of extraordinary or non-recurring items• Force majeure events

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When Does Buyer Record an Earnout?

• Non-compensatory (i.e., purchase price adjustment)– FAS 141R requires a buyer to recognize the fair value of earnouts

in the initial accounting as of the acquisition date• Subsequently, earnouts must be re-measured at each

reporting date– Under prior accounting practice, contingent consideration was

recognized upon the resolution of the contingency and payment ofrecognized upon the resolution of the contingency and payment ofconsideration

• Compensatory (i.e., compensation expense)– Charge to expense in the appropriate periodsg p pp p p

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• Potential exclusions in calculating the payout– If net income is the test:

• Add back goodwill amortization connected with the transactionAdd back goodwill amortization connected with the transaction• Adjust for increased interest expense• Adjust for higher depreciation caused by a write-up in asset value

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• Potential exclusions in calculating the payout– If EBIT or EBITDA is the test:

• Sellers should identify administrative or general overheadSellers should identify administrative or general overheadexpenses Buyer will allocate to the Target after closing anddetermine how those expenses will impact post-closingcalculations

Sellers will argue that acquisition indebtedness and management– Sellers will argue that acquisition indebtedness and managementfees allocated to Target after closing should be excluded

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• Potential exclusions in calculating the payout– Extraordinary gains and losses– Payments pursuant to tax-sharing agreements, if TargetPayments pursuant to tax sharing agreements, if Target

becomes a member of Buyer’s consolidated taxpayer group

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Tax Issues

• Earnout payments may be characterized as compensation expenserather than additional purchase price

– EITF 95-8, Accounting for Contingent Consideration Paid to theShareholders of an Acquired Enterprise in a Purchase BusinessCombination

– Factors to consider:• Terms of continuing employment• Terms of continuing employment• Components of the selling shareholder group• Reasons for the contingent payment provision• Payment formula• Payment formula• Other arrangements and issues

– Matter of judgment and the above list is not all inclusive

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Terms of Continuing Employment

• Factors involving terms of continuing employment– Linkage to continuing employment

• If contingent payment is automatically forfeited if employmentIf contingent payment is automatically forfeited if employmentterminates, it is likely to be considered compensation

– Duration of continuing employment– Level of compensation

• However, the absence of linkage between continued employment andpayment does not necessarily imply that the contingent payment isadditional purchase price

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Other Factors to Consider

• Non-compete agreements• Consulting contracts• Property leasesProperty leases

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Tax Treatment

• Compensatory– Earnout will be taxed to the recipient as ordinary income– Buyer will need to withhold Social Security, Medicare and federalBuyer will need to withhold Social Security, Medicare and federal

and state income tax– Generate a current tax deduction for Buyer

• Non-Compensatory– Earnout payment will be taxable to Seller as capital gain

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