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COVID And M&A Earnouts
The COVID-19 virus has ushered in unprecedented and challenging times for our country and our global community. From the deeply personal pain and suffering caused by the virus as a health pandemic to behavioral adjustments in the consumer population at large (“social distancing,” etc.), to our everyday routines, burdens created by business closures and shelter in place orders, the full force and impact of the virus on our society won’t be known for a long time. Apart from these personal and social consequences, of course, the economic downturn is very real and upon us.
And yet businesses move forward, even in a very different and challenging environment. Certainly, the COVID virus is impacting the way M&A transactions are being looked at, papered, and implemented. Pricing has become trickier and buyers are seeking ways to achieve acceptable levels of confidence in the economic prospects of the target business going forward, and/or to ensure an equitable allocation, as between buyer and seller, of the risks that those prospects are not realized. As COVID uncertainty continues to proliferate within the M&A sector, earnout provisions are being looked at increasingly as one tool by which to address the potential effect of that uncertainty on transactions.
At the same time, earnouts bring a level of uncertainty into a transaction - as compared to a “fixed price” paid at closing. M&A professionals sometimes view earnouts warily as simply deferring pricing issues - and potential disputes - until after the closing. Or, as one court observed:
“What an earn-out (and particularly a large one) typically reflects is disagreement over the value of the business that is bridged when the seller trades the certainty of less cash at closing for the prospect of more cash over time. In theory, the earn-out solves the disagreement over value by requiring the buyer to pay more only if the business proves that it is worth more. But since value is frequently debatable and the causes of underperformance equally so, an earn-out often converts today's disagreement over price into tomorrow's litigation over the outcome.” 
This client advisory looks at how earnouts are generally structured in an M&A transaction. A subsequent, follow-up advisory will review how US courts have generally dealt with litigation involving earnout disputes.
In M&A purchase agreements, provisions addressing the purchase price, and how it is to be paid, are, understandably, among the most critical. The price to be paid to acquire the target can take many different forms (e.g., cash, securities of the buyer, other non-cash consideration, and/or a buyer note—whereby the seller finances some or all of the purchase price). Additionally, a portion of the purchase price may consist of contingent payments that are payable after closing, commonly referred to as an “earnout.” The typical earnout provision entitles the seller to further payments if the target, post-closing, meets prescribed (usually, but not always, financial-based) benchmarks.
Common Characteristics of Earnout Provisions
Unlike many aspects of an M&A purchase agreement, which are fairly standardized, earnout provisions are highly fact-specific and often heavily negotiated. As such, there is no “typical” earnout provision. However, there are basic considerations that go into determining and negotiating an appropriate earnout provision:
- Milestones. The milestones which, if reached, trigger payment of an earnout need to be set out in the purchase agreement. Often, these are financial milestones (e.g., EBITDA, or revenue, of $X for fiscal years 2020 or thereafter) but they can also be non-financial, such as procurement of a key government or regulatory approval or contract in the pipeline, or closing of a major strategic partnership. An issue related to achievement of milestones is whether the earnout should accelerate upon a change in control.
- Measurement. Because of the flexibility inherent under most accounting standards (e.g., GAAP) when determining financial terms, the parties should be specific about how the milestones are measured. Additionally, if the benchmark is profit-based, the parties must determine which expenses are included in the profit calculation, particularly to ensure an appropriate allocation of the buyer’s general and administrative expenses to the post-closing target business. This allocation can be tricky and subject to disputes and second-guessing: allocating employee salaries and benefits, rent, marketing expenses, in-house accounting, and administrative costs, etc., to a business unit which is sharing those services with other units or divisions or units within the overall enterprise is an inexact science at best.
- Length. The parties must agree on the length of the earnout period. This includes determining whether there is a single earnout or multiple, staged earnout payments over time. The answers may well depend on the specific industry in question, taking into account seasonality and other aspects of potential volatility.
- Control Over the Earnout Business. The seller wants to maximize its control over decision-making that can impact the earnout. This control can run the spectrum from full business control replicating the seller’s pre-closing operations to providing the buyer input (e.g., into hiring decisions) on specified decisions. The seller also usually asks the buyer for “commitments” to fund the earnout business properly or consistent with past practice, and even to take steps intended to maximize the ability to achieve the earnout benchmarks. The seller’s rationale is that, in most cases, these commitments help align the interests of the seller and the buyer to achieve the benchmarks. Most buyers resist making some or all of these commitments. Although the seller and buyer interests may well be aligned, the buyer, as the new owner of the business, usually wants the freedom to run the business as it sees fit. Further, the buyer may need to make decisions that are not ideal for achieving the earnout but may be best for the buyer’s businesses as a whole. For example, if the buyer’s overall enterprise shifts strategic or financial priorities, whether deliberately or in response to real-world events, the relative place of the acquired business in achieving those goals may similarly change.
- Tax and Accounting Treatment. Depending upon the circumstances, the buyer may need to record the fair value of the earnout as of the closing date under GAAP. In addition, parties often use earnouts to retain selling shareholders as key employees for a time after closing. However, if the payments become linked to employment (e.g., the earnout payments are not made if a seller shareholder ceases to be a target employee on the payment date), the payment may be considered compensation instead of the purchase price, which can have tax impacts for both buyer and seller.
- Setoff Rights. An earnout provision often is connected to the purchase agreement’s indemnity, escrow, and related provisions. For example, the buyer may have a “setoff right.” A setoff right allows the buyer to unilaterally reduce the amount of any earnout payment owed to the seller by the amount of any indemnity claim against the seller under the purchase agreement. A seller may well argue that any such right is, in effect, a “holdback” (albeit contingent) of the purchase price and, therefore, the indemnity escrow should be decreased or eliminated accordingly.
- Disputes. Audit and review rights for a seller can provide oversight and some level of accountability as to the matters impacting an earnout following closing, and the appointment of an independent arbitrator can help streamline the resolution of earnout disputes. The scope and type of any such dispute resolution can be important: do the parties prefer a “mediation” type of process where the third party encourages common ground and compromise, or a more definitive resolution from a technical expert as to the specific matters in dispute (for example, an expert in revenue recognition or accounting integration issues)?
Earnouts are often helpful in bridging a “valuation gap” as between buyer and seller; a problem more likely to occur when the target company is facing economic uncertainty - such as the continued economic impact of COVID. At the same time, earnouts bring a level of uncertainty and may function to kick the can down the road insofar as pricing is concerned. Careful, precise language is critical so that the earnout provision - itself a tool for hedging against uncertainties - functions properly and as the parties intended, without bringing undue risks of disputes into the post-closing business venture.
Public and privately-held international and domestic companies with cross-border and multi-country M&A transactions turn to Dan Avery, a Director, for legal representation. Dan is a member of the ABA’s committee that publishes private company M&A deal point studies and of the M&A Advisory Board for the Bloomberg M&A Law Reporter. Dan has been involved in the acquisitions or dispositions of more than 80 different businesses located throughout the U.S., Europe and Asia for domestic and international corporate buyers and sellers. Dan also represents companies involved in the retail, entertainment, music and sports industries.