Purchase price is arguably the most important issue for both the buyer and the seller in an acquisition transaction. Without an agreement on price there is no deal. Each party uses different assumptions and adjustments in determining the value of a business. Inevitably, this results in a difference of opinion on pricing. Lately, this disconnect seems to arise from a disagreement on the target's projected earnings. Such disagreements over valuation have become increasingly commonplace after the recent economic downturn where many businesses' earnings were drastically reduced. As a result, buyers and sellers in private transactions are once again turning to earnouts in order to reach a consensus on purchase price.
An earnout is a contingent portion of the purchase price that is paid after closing to the seller upon the target business achieving certain agreed financial or non-financial benchmarks within a specified period of time. Utilizing an earnout limits the buyer's risk that it is overpaying for an underperforming asset, while also providing the seller with what it considers appropriate deal consideration if the target business' projected performance is achieved. A properly crafted earnout has the potential to lead to a win-win situation--the seller realizes a higher purchase price by capturing value from the future growth of the target and the buyer gets what it paid for. Particularly in today's recovering economy, a carefully drafted earnout can serve as an important tool to help consummate a transaction that might otherwise be dead on arrival.
Anecdotal evidence suggests that a major factor influencing the existence and use of earnouts is the health of the M&A and debt financing markets and the economy as a whole. This fact was evident during the "seller's market" from 2005 through 2007. Increasing prices during this time led to increased competition among potential buyers. As a result, many buyers were hesitant to incorporate earnouts as part of the purchase price because there was a meaningful risk that another buyer could win the deal by offering the full amount of the purchase price upfront. Additionally, inexpensive financing was readily available, which provided buyers with both a means and a justification for paying what may in hindsight have been inflated prices.
As most people who are reading this article are well aware, not too long after the peak of the M&A market, the economy took an unprecedented turn for the worse and many companies suffered significantly reduced revenues and earnings as a result. In addition, many buyers (both financial and strategic) stayed on the sidelines as debt financing became sparse, and for a while non-existent. As the general economy and the M&A and debt financing markets began to improve in the last quarter of 2009, the issue of purchase price was front and center in the eyes of both sellers and buyers. The typical argument expressed by sellers for their expected valuation was that the reduced revenue and earnings suffered during the downturn was only temporary and performance would return to normal when the economy recovered. They emphasized that the target's business was fundamentally sound and value should not be discounted because of timing. However, buyers and their debt financing sources were wary of overpaying for a business that might never fully recover. In this valuation tug-of-war, sellers, in an effort to get a price closer to what they believe the target is worth in a better economic climate, and buyers, in an effort to acquire a promising business at a fair price, have each become increasingly amenable to using earnouts. As a result, the use of earnouts has steadily increased in acquisition transactions involving businesses that have suffered during the economic downturn.
Choosing the Benchmark
The benchmark is perhaps the most critical component of the earnout and should be custom tailored to the target's business. Benchmarks can be financial, non-financial, or a combination of the two, and can relate to the entire business or a specific division or product line. Because there is a significant potential for future disputes regarding whether the benchmark was met, it must be easily measurable and as clearly and comprehensively defined as possible.
Financial benchmarks typically relate to gross revenue, EBITDA (earnings before interest, taxes, depreciation, and amortization), and net income. Gross revenue is the easiest benchmark to determine because it is not affected by costs and expenses of the target. However, gross revenue benchmarks are rarely used because businesses are typically valued based on an EBITDA basis. Yet financial benchmarks other than gross revenues are more prone to manipulation because of the many inputs involved.
EBITDA is generally the default benchmark as it is consistent with the valuation methodology used by buyers. EBITDA is preferred over gross revenue by the buyer because it reflects the cost of goods and services, selling expenses, and general and administrative expenses. Although the items that are included in the definition of EBITDA vary from deal to deal, the calculation commonly excludes "extraordinary items" of gain or loss as defined in United States generally accepted accounting principles (GAAP), gains or losses resulting from non-ordinary course sales of assets, management fees and other intercompany charges, and transaction fees arising out of the acquisition itself. Other adjustments are often included, such as to the purchase and sale prices of goods and services in non-arm's length transactions, which are adjusted to reflect amounts realized or paid as if dealing with an independent party in an arm's length transaction. Such adjustments "normalize" EBITDA and arguably make it the most fair financial benchmark for both the buyer and the seller.
Non-financial benchmarks are varied and are typically used in acquisitions of development stage companies and those that operate in heavily regulated industries, such as those in the biotech and pharmaceutical industries. Examples of non-financial benchmarks include obtaining regulatory approvals, expanding sales presence to certain markets and obtaining a specified number of unique visitors to a website. Although the determination of whether a non-financial benchmark has been met may seem binary in nature, it can be just as complicated as that of a financial benchmark. The parties should anticipate the variables that surround such a determination and the impact they may have on the seller's ability to achieve the earnout.
The likelihood that the earnout will be achieved generally depends entirely on the operation of the target business following the closing. The buyer will likely have total control over the business following the closing unless the seller can negotiate contractual protections. Formulating a mutually acceptable set of protections is usually as difficult as formulating a clearly defined benchmark. The parties often have diverging interests during the earnout period. The seller will likely want the target to maximize the short-term performance of the business in order to achieve the earnout. The buyer might take the opposite approach and cause the company to eliminate low margin items or to make significant investments during the earnout period in order to maximize long-term growth.
Sellers typically try to negotiate for negative covenants to provide them with veto protection for major business decisions, such as incurring additional debt, expanding operations, cutting products or product lines, and hiring and firing key employees. Additionally, the seller will usually request a generic covenant that the target's business will be operated in a manner consistent with past practice. Not surprisingly, buyers are generally opposed to any restrictions on their ability to run the business they just paid for. Buyers typically argue that they should have complete discretion to run the company and that the buyer's interests are aligned with those of the seller because each wants the business to succeed. Unfortunately for buyers, some courts have recently implied that absent specific contractual language to the contrary, the covenant of good faith and fair dealing requires the buyer to operate the target's business so as to maximize the likelihood of an earnout payment. (See, e.g.,Airborne Health, Inc. and Weil, Gotshal & Manges LLP v. Squid Soap, LP, C.A. No. 4410-VCL (Del. Ch. Nov. 23, 2009); Sonoran Scanners, Inc. v. Perkinelmer, Inc., No. 09-1089 (1st Cir. Oct. 29, 2009).) Accordingly, buyers might seek to include specific contractual language in the acquisition agreement that negates any obligation of the buyer to operate the target's business in a certain manner, such as an acknowledgement that the buyer has the right to operate the target's business as it sees fit and that it is under no obligation to cause the earnout to be achieved. One potential compromise may be for the buyer to agree to a provision that it will not take any action or omit to take any action with the sole intent of reducing or eliminating the earnout payment. Under this approach, the buyer has the discretion to run its business so long as it is not intentionally taking actions to avoid making earn-out payments to the seller.
In addition to issues relating to post-closing control and determination of the relevant benchmark, there are a host of other considerations that the buyer and the seller should keep in mind while negotiating an earnout. At a minimum, the parties should carefully consider issues relating to: measurement of the target's performance relative to the benchmark; structuring the earnout payment (i.e., whether it should be a linear or an "all or nothing" equation), the method of payment of the earnout (i.e., whether it should consist of cash, equity, debt, or a combination); the appropriate length of the earnout period; whether one or multiple earnout payments should be made; the effect of acquisition financing on the earnout, including subordination of the earnout payment to lenders; the effect of future acquisitions and sales by the buyer, including a sale of the target during the earnout period; and dispute resolution mechanisms, including negotiation of the buyer's right to "buy out" the earnout by paying a specified sum regardless of the target's performance.
In light of the frequent debates between buyers and sellers regarding valuation of businesses that have suffered lackluster performance during the economic downturn, earnouts are playing a more prevalent role in helping parties reach agreement on purchase price in private transactions. Despite the complexity and possibility of future disputes, a carefully thought out and clearly drafted earnout has the potential to create a win-win situation for both buyers and sellers.