M&A Earnout Thoughts
Updated: May 13, 2019
Earn-out arrangements are often crucial in bridging price expectations between buyer and seller and getting a deal to closing. Unfortunately, earn-out provisions are also a common source of post-closing disputes.
This memo discusses an issue on the edge of quantifying the earn-out metric that can easily be overlooked – the exchange of trade secrets or other confidential business information between the target company and its new parent company. When it happens, the financial impact on the earn-out metric of recognizing the shared confidential information can be large and unexpected.
BACKGROUND, IMPLEMENTATION AND COMMON DISPUTES
At its core, the value of a business comes from its ability to generate future earnings. Those future earnings can be stable or uncertain. When uncertain, an earn-out can be a valuable tool to bridge the seller’s expectations and the buyer’s view. Earn-outs allow the parties to keep part of the purchase price flexible by making it contingent on future events. That can be useful in many different situations, for instance:
1. The target company manufactures and sells medical devices. It has several mature products as well as a new product nearing the end of development. The company’s ability to generate future earnings depends, in part, on it obtaining FDA approval for the new device. The earn-out payment can be defined as a lump-sum payable if the target company achieves FDA approval for the new product by a certain date.
2. A financial buyer is purchasing a business with stable margins that has grown significantly over the course of the last few years. The owner-operator expects the sales growth to continue, while the buyer is skeptical. The parties can agree to an earn-out based on the target company’s revenue growth exceeding a target.
3. A strategic buyer seeks to acquire a company that complements its existing business. It expects the acquisition to allow it to penetrate new geographic and functional markets and complement its existing product mix. The smaller seller believes it can profitably expand the business on its own and wants the purchase price to reflect that. The parties can agree to a staged earn-out structure based on the target company’s adjusted EBITDA over a period of time.
As can be seen, earn-outs can are tailored to the specific facts of the deal to facilitate parties’ needs. Despite customization, earn-out provisions generally have in common that they define an earn-out performance metric and its measurement (whether financial or milestones) as well as the rights and obligations of the parties toward achieving that performance post-closing.
Earn-out disputes generally fall into two categories. First, many disputes relate to the measurement of the financial or operational performance of the target company and are effectively accounting questions. For instance, a dispute can center on how revenue from a project should be recognized over time in accordance with GAAP. Second, if the earn-out targets are not met, the parties may disagree on the cause of the failure and accuse the counterparty of not meeting its obligations or acting in bad faith. The seller may accuse the buyer of failing to provide the agreed upon back-end infrastructure which caused the company’s performance to fall short of the earn-out target.
Precise drafting of the earn-out provisions in the purchase agreement is a good way to minimize earn-out disputes, but skillfully negotiating the rights and obligations of each party when it comes to calculating the earn-out targets and making the earn-out payments is critical, especially when it relates to the transfer of trade secrets and other intellectual property.
SEPARATE ACCOUNTING OF THE TARGET COMPANY POST-CLOSING TO FACILITATE EARN-OUT CALCULATION
In addition to establishing targets and metrics, earn-out arrangements typically provide for a variety of other elements to set the stage for the earn-out and future performance. Those elements can also be customized to fit the situation. The medical device/FDA approval earn-out could be accompanied by an obligation of the new parent company to make funds available for animal testing and cover other development expenses. It may also come with an obligation on the parent company to bring the product to market in accordance with an existing business plan.
An important consideration in building an earn-out is to what degree the acquired company will remain separate from its new parent/corporate group during the earn-out. The seller generally wants to guard against losing the earn-out payments in the mix, while the buyer wants to start receiving the benefit of the acquisition synergies as soon as possible. Historically, it was not uncommon to have the acquired company operate as a standalone business during the earn-out period. In the context of strategic acquisitions, however, that may undesirably limit the buyer’s ability to realize the strategic synergies it seeks from the transaction and for which it paid a significant amount of money. Such arrangements have become less common in recent years.
If the target business is not operated using past businesses practices post-closing, its activities generally at least have to be separately accounted for to calculate the earn-out payments based financial targets like the company’s adjusted EBITDA. The agreement may provide for the adjusted EBITDA to be determined based on a separate accounting for the company post-closing performed in accordance with U.S. GAAP as historically applied by the company.
To enable truly separate accounting, that approach may be supported by a provision in the agreement that any intercompany transactions and transfers between the new corporate group and the target company are to be accounted for at arm’s length terms. Without a strict continuance of the business in accordance with past business practices, such a provision can prevent financial leaks from the target company to the parent which could result in the failure to meet the earn-out target.
The contract language can be refined with a variety of customizations. For example, if the target company is a supplier of the buyer, a pricing table or formula may be attached to the agreement for products or services. The earn-out provision can also be refined by addressing transactions and transfers that would be in the equity sphere, like agreed upon capital contributions or dividends, or that should be accounted for other than at arm’s length terms, like cost allocation for shared corporate services and overhead expenses. The provision can also have an acceleration of the earn-out upon the any number of acceleration events, like a transfer of assets out of the target company that exceeds a defined threshold or a material breach by the purchaser of any of the earn-out covenants in the agreement.
A provision requiring separate accounting may be unexpectedly difficult to implement for the parent corporate group as it may take more out of the group’s processes and procedures than generally required in its regular course of business. External financial reporting often largely takes place on a consolidated group basis. Intercompany transactions may otherwise receive limited attention. Of course, the parent corporate group may already be set up to carefully account for all intercompany transactions at market-conform transfer prices in order to, for example, comply with tax obligations.
“AT ARM’S LENGTH” AS THE CONTRACTUAL ANCHOR
At arm’s length accounting for transactions and transfers between the target company and its new corporate group, with some customized exceptions, can appear uncontroversial as it can be perceived to naturally go hand-in-hand with the separate accounting provision in the agreement. In practice, that uncontroversial appearance can drive significant earn-out payments and disputes based on the flow of confidential information between the target company and its new corporate group.
As the target company gets adopted into the new corporate group, there are many potential occasions for the disclosure of otherwise confidential information between the target company and its new corporate group, for example:
1. The target company may give its new owners an extensive, in-depth tour of it most modern plant. Perhaps, the corporate group adopts some of the company’s best practices in its plants.
2. The target company may present its business plan and budget to group management. Perhaps, the corporate group adopts part of the sales approach or otherwise uses the included commercial information in its broader business.
3. After closing, the target company integrates its systems with those of its new corporate group. With that integration, the corporate group obtains access to the target company’s contact management data, account information and other financial data.
4. A key member of the target company’s sales management team gets promoted to a sales position at the corporate group level during the earn-out period. Outside of the group relationship, the change in positions would have been in violation of the team member’s non-compete agreement.
The information flow can go both ways. The target company may directly benefit from being able to plug into the knowledge base of its new corporate group. In any event, without contractual language to the contrary, the at arm’s length pricing of the sharing of confidential information can have a significant impact on the earn-out metric.
Because of the nature and complexity of earn outs, there is no easy conclusion. The lesson here is that the terms of the earn out and what could go wrong depending on the timing, duration and metrics being used need to be thoroughly reviewed and vetted. Even after thorough review, the language has to be crystal clear. Even then, problems may come up which can best be handled by customized dispute resolution provisions associated with the earn out provision.