Negotiating Earnout Provisions in M&A Deals Structuring Transactions to Minimize Post-Closing Disputes

Transcription

1 presents Negotiating Earnout Provisions in M&A Deals Structuring Transactions to Minimize Post-Closing Disputes A Live 90-Minute Webinar/Audio Conference with Interactive Q&A Today's panel features: David M. Grinberg, Partner, Manatt Phelps & Phillips, Los Angeles Maryann A. Waryjas, Partner, Katten Muchin Rosenman, Chicago Scott P. George, Managing Director, P&M Corporate Finance, Chicago Bernard I. Zaia, Managing Director, Barrington Associates, Los Angeles Tuesday, July 14, 2009 The conference begins at: 1 pm Eastern 12 pm Central 11 am Mountain 10 am Pacific The audio portion of this conference will be accessible by telephone only. Please refer to the dial in instructions ed to registrants to access the audio portion of the conference. CLICK ON EACH FILE IN THE LEFT HAND COLUMN TO SEE INDIVIDUAL PRESENTATIONS. If no column is present: click Bookmarks or Pages on the left side of the window. If no icons are present: Click View, select Navigational Panels, and chose either Bookmarks or Pages. If you need assistance or to register for the audio portion, please call Strafford customer service at ext. 10

2 Structuring and Negotiating Earnouts July 2009

3 Earnouts An earnout is a variable pricing mechanism that makes a portion of the final purchase price contingent upon the actual post-sale performance of the acquired business 2

4 Characteristics of Earnouts Earnouts must be contingent Deferred purchase price not earnout Purchase price adjustments not earnout Defined targets/benchmarks Generally 20-30% of total consideration More common in sale of privately held companies More frequently used in deals with a transaction value below $250 million 3

5 Rationale for Earnouts Used when Buyer and Sellers cannot agree on value of Target Rewards Sellers if Sellers projections are accurate Protects Buyer from overpaying if Sellers projections are overly optimistic Earnouts are particularly useful Volatile Industries Companies with limited operating history, but promising unproven product, technology or contract pipeline Uncertain economic times 4

6 Advantages to Buyer Reduce risk of overpayment Financing mechanism lower up front capital outlay provides a way for acquisition to pay for itself out of future profits Management performance incentive incentive alignment Limited fraud protection Security for indemnity 5

7 Advantage to Seller Potential for greater consideration than in a fixed price transaction 6

8 Primary Disadvantages Negotiation and drafting of effective earnout provisions Potentially conflicting goals between the Buyer and Seller regarding the operation of the business Additional resources needed by Buyer and Seller to calculate the earnout Great potential for future disputes about the contingent payment 7

9 Performance Benchmarks Goal is to have performance metrics that can be audited Financial benchmarks Net revenues, net income, EBIT, EBITDA, earnings per share, or net equity thresholds Non-financial benchmarks for development stage companies Beta site, beta testing, or others Clarity of benchmarks, payment formula and measurement process is key 8

10 Other Payment Decisions One earnout period or multiple earnout periods Per period or cumulative All or none Lump sum or sliding scale Floors and caps Issues with non-cash consideration Contingent events Security for earnout payments Cash or stock (or combination) 9

11 Earnout Payment Formulas Financial benchmarks Flat amount Percentage of amount by which Target s performance exceeds milestone Non-financial milestones Flat amount of cash or shares Payout is often capped Earnout period is often 1-5 years after closing 10

12 Annual Payment Issues Will the target amounts increase annually, and if so, by how much If earnings increase in the early years, but decrease in later years, how will the Buyer recover excess payments Should the annual payments be at a lower payment percentage than is ultimately to be applied, in order to cushion the Buyer s risk of future EBITDA (or other) shortfalls If earnings are deficient in early years, but increase in later years, must the Target make up a prior deficiency before the Sellers receive a payment 11

13 Annual Payment Issues Should Earnout payments be decreased over time to reflect the integration of the Target into the Buyer s businesses and related synergies 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 the finally determined amount at the end of the term 12

14 Earnout Payments of Stock What rights and obligations will the Seller have regarding the shares once 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 13

15 Earnout Payments of Stock As of what date will the stock be valued Closing date of the original transaction Date of Earnout payment determination before or after giving effect to the Target s contribution? Anti-dilution protection How will the stock be valued Average of closing prices over a specified period Other agreed upon methodology 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 Ensure that maximum number of potential shares is reserved for issuance at the closing and stockholder approval obtained 14

16 Earnout Payments of Stock OID rules of the IRS require that some portion of the deferred consideration, if made in stock, must be allocated to interest, reportable as such by the Seller and deductible as such by Buyer Remaining portion of the stock generally is treated as additional purchase price This results in Sellers having to come out-of-pocket to pay taxes in cash on shares that they may not be able or allowed to sell 15

17 Operating Control Issues Source of tension between Buyer and Seller Buyer may take action beneficial for long-term goals at the expense of short-term earnings Difficulty of measuring performance if Target is integrated into Buyer s other businesses Buyer acquires other similar businesses Re-branding National service providers Segregating the Target s financials can preclude the Buyer from achieving economies of scale and other synergies anticipated in the original acquisition 16

18 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 business consistent with past practice (with certain pre-agreed upon differences) Reserve, through covenants, some authority regarding major decisions made during the Earnout period Expansion of the business Hiring or firing of key personnel (high threshold definition of Cause ) Restrictions on dividends Taking on additional debt Combining the Target or its business with another business 17

19 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 Requirement to keep separate books/records Have one or more seats on the Buyer s board of directors Critical to plug any holes in earnout scheme that could result in an end-run around earnout 18

20 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 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 business operations 19

21 Dealing with Subsequent Organic 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 buyer Sale of the Buyer during the Earnout period 20

22 Resolving Conflict Preventative Measures Clarity, consistency, completeness in drafting the Earnout formula Pinpoint 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 Dispute Resolutions Arbitration provisions choosing the forum and procedure used ahead of time 21

23 Earnout Accounting Issues Consult carefully with accounting experts Specify relevant accounting principles in the agreement Including specific line items used A mere reference to GAAP is not enough Consistency of practice 22

24 Common Earnout Accounting Issues to Be Addressed Allocation of overhead Affiliate transactions/pricing Amortization of goodwill Depreciation Capitalization of expenses Research and development expenses Impacts of additional leverage burden, interest costs and restrictive covenants Effects of extraordinary or non-recurring items Force majeure events 23

25 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 of consideration Compensatory (i.e., compensation expense) Charge to expense in the appropriate periods 24

26 Earnout Accounting Issues Potential exclusions in calculating the payout If net income is the test: add back goodwill amortization connected with the transaction adjust for increased interest expense adjust for higher depreciation caused by a write-up in asset value 25

27 Earnout Accounting Issues Potential exclusions in calculating the payout If EBIT or EBITDA is the test: Sellers should identify administrative or general overhead expenses Buyer will allocate to the Target after closing and determine how those expenses will impact post-closing calculations Sellers will argue that acquisition indebtedness and management fees allocated to Target after closing should be excluded 26

28 Earnout Accounting Issues Potential exclusions in calculating the payout Extraordinary gains and losses Payments pursuant to tax-sharing agreements, if Target becomes a member of Buyer s consolidated taxpayer group 27

29 Tax Issues Earnout payments may be characterized as compensation expense rather than additional purchase price EITF 95-8, Accounting for Contingent Consideration Paid to the Shareholders of an Acquired Enterprise in a Purchase Business Combination Factors to consider: Terms of continuing employment Components of the selling shareholder group Reasons for the contingent payment provision Payment formula Other arrangements and issues Matter of judgment and the above list is not all inclusive 28

30 Terms of Continuing Employment Factors involving terms of continuing employment Linkage to continuing employment If contingent payment is automatically forfeited if employment terminates, it is likely to be considered compensation Duration of continuing employment Level of compensation However, the absence of linkage between continued employment and payment does not necessarily imply that the contingent payment is additional purchase price 29

31 Other Factors to Consider Non-compete agreements Consulting contracts Property leases 30

32 Tax Treatment Compensatory Earnout will be taxed to the recipient as ordinary income Buyer will need to withhold Social Security, Medicare and federal and state income tax Generate a current tax deduction for the buyer Non-Compensatory Earnout payment will be taxable to the seller as capital gain 31

33 Indemnification and Earnouts Buyer can collect by offset against earnout Coordinate with Purchase Price Adjustment 32