ood deals occur where parties are reasonably flexible, understand that no one wins if no deal is made and that everyone needs to walk away feeling they have won. Good deals usually can be done quickly where both parties see a good result being achieved for both parties. A buyer that feels that they have acquired a firm that can provide many times the return on the purchase price, is a deal that can later absorb some problems. A seller who knows they achieved a strategic sale that was worth many times the conventional financial value of the firm can also feel rightly proud of the deal. The key is to make everyone happy with the result.
Whether you are approached with an offer or you stimulate an offer by establishing the relationships as described in this process, you will end up negotiating a deal with many dimensions. Generally in this type of process it is important to meet somewhere on the same page and in the same book. If you are on another planet with respect to price and conditions, the time will be entirely wasted and both parties will end up frustrated.
In most cases, most elements of a deal are negotiable. Whatever constraints you have and whatever constraints they have in negotiating a deal should be uncovered as soon as possible. For example, you might decide that you wish to retire and staying on for any period other than a short handover is not what you want. There may be pressing family or personal reasons for your decision but it may be sufficiently important for you not to wish to compromise that part of the deal. It may be important for you to have some guarantees of further employment for some of the staff. The buyer may wish to have a guarantee that certain key staff stay on for some minimum period. Whatever these issues are, they should be set out before the serious process of negotiation begins because they help to determine whether they can be met.
I like to think of a deal as representing a certain target value to the buyer. That value represents their view of the balance between the risks in the deal and what they are prepared to pay for the opportunities it represents to them. They will have perceptions of risks based on industry and personal experience.
Part of the entrepreneur’s negotiating objective is to show how the risks have been minimized or removed and how they can fully exploit the opportunity. Imagine the target value as a point on a continuum that moves down with higher risk and up with greater opportunity actualization. Their initial task is to move the point up as high as possible by reducing risk and showing greater opportunity realization.
Once the best price that can reasonably be expected is offered, you can start to break that value, the ‘deal value’, up into deal elements. The deal value can then be carved up in any number of ways but, at this point, the pie does not get any bigger. With that approach both parties can start to set out where they want the value to be spent.
The deal value may be achieved by the seller at some period in the future based on certain conditions being met. To the extent that those conditions can be met, the buyer is normally willing to make available the whole deal value. However, to the extent that it cannot be met or is not met, the deal value is reduced by some amount representing the cost of correcting the shortfall or the opportunity cost of not having that advantage.
Some minimum level of performance may not be negotiable. So, for example, if the deal depends on certain key employees staying on after the acquisition, additional incentives may be offered to them to gain such assurance. You should consider this additional incentive as a deduction from the deal value, but perhaps essential to satisfy the buyer. Some period of non-compete may also be required to prevent the key managers and shareholders from joining the competition or setting up a new company in competition. If three years was the desirable period but the sellers want only two, the deal value should be reduced by some amount representing the additional risk faced by the buyer.
This framework can provide a workable method of negotiating elements of the deal. Any reduction in risk moves the final deal value up, although this may appear as an increase in the purchase price to the seller. Any increase in risk or reduction in the ability to exploit the opportunity simply reduces the deal value.
In order to fully achieve the value from the deal, the buyer may wish the seller to complete R&D projects, sign up key customer contracts, cancel or negotiate specific obligations, negotiate redundancies or relocate staff. These could be framed as staged payments, earnout or fixed payments on achievements. In other words, the final acquisition price can be made up of many elements, each of which has a fixed or calculated value, which can be paid out in stages or accumulated to an end point and then paid out in some mixture of shares and cash. The period can be relatively short if it is expected that key objectives can be determined quickly, or it could be over a number of years if it requires a considerable period for the objectives to be achieved.
Elements which may be included in the final deal may include the following:This should represent the minimum that will be paid for the firm. It may be subject to adjustments through a balance sheet audit which will verify valuations and liabilities. It also may be subject to adjustment through warranties and representations for some specified period of time. The base price might be offered in the form of shares in the acquiring corporation, or cash or some combination of both.
Escrow:An escrow sets aside some portion of the purchase price against adjustments and warranty claims. Generally this will be held by an escrow agent and may be claimed against by providing specific evidence of claims. Usually it is limited in time, such as one year. At the end of the escrow period, the remaining shares are returned to the selling shareholders.
Options:Options of selling employees may be converted to ordinary shares prior to the sale being consummated or may be carried over into options of the acquiring corporation. Options carried forward provide incentives for employees to stay with the buyer. Additional options may be offered to key employees to retain them.
Stage Payments:Stage payments are normally aligned to the achievement of objectives. So, for example, they could be aligned to the delivery of certain key R&D milestones, or completion of certain contracts, or the signing of certain key contracts.
Earn Out:An earnout aligns the purchase price with the achievement of specified revenue targets or other milestones. This may be set at specified increases in the purchase price or a percentage of the purchase price based on specified targets. The additional earnout would normally be for a set period and may or may not be capped. The earnout may be for all shareholders or limited to key shareholders who stay with the buyer.
Continued Employment:Continued employment of former owner/managers and/or key employees may be sought by either or both of the parties depending on how important those staff are to achieving future objectives. Specific jobs could be negotiated. Specific management agreements and remuneration and incentives may be included in the deal. Some staff may prefer a short term consulting agreement.
Director Position:The acquirer will not be able to verify everything in the deal. To overcome this limitation, they would normally require the Directors and/or shareholders, or some subset of them, to provide warranties and representations about key elements of the firm. This might be asset valuations, contingent liabilities, incomplete litigation, prior balance sheet and revenue statement assurances and so on. Any claims in this area might be taken against an escrow account if that is set up, adjust the final purchase price if some balance is still to be paid, or might be subject to a recall of value through arbitration or litigation.
Non-Compete:Generally the buyer wants to protect themselves from competition from former key shareholders and executives of the selling firm. This is usually set for a limited period like 2 to 3 years. It would normally exclude the individual from working with a competitor or from undertaking a start up which would compete.
Holding Period:Where publicly listed shares are being taken as part of the purchase price, these may be subject to registration. That process may take some months. During this period the selling shareholders will not be able to sell their shares. There also may be further restrictions on the sale of shares which the buyer requires in order to not flood the market or not to show a lack of faith in the future of the corporation. Shareholders continuing on as key executives may also be subject to non-trading or blackout periods or sale restrictions due to insider trading restrictions.
Specific Liabilities:The selling shareholder may be asked to take over specific liabilities or contingent liabilities. This may happen where key shareholders have personal loans to the firm. The buyer may regard their repayment as an obligation of the sellers and not theirs. They may also decide that the risks inherent in specific contingent liabilities are too difficult to assess and ask that the sellers absorb whatever is the eventual outcome. Since contingent liabilities are often deal killers, this is something which sellers need to give special consideration to. If the alternatives are no deal or a deal with some possible downside, the latter may still be worth doing. At other times the contingent liabilities may be capped on either side or may be handled through the escrow.
Costs:Legal and Accounting professional fees incurred by each party are normally borne by the respective parties. However, these costs may be assigned in some proportion to one or both of the parties depending on the deal structure.
Use of Intellectual Property:Normally full rights to any IP passes to the new owner, but this need not necessarily exclude use by the seller. It may be possible to negotiate the use of IP for personal or non-competing purposes post sale.
In negotiating the deal, both sides have issues which need to be addressed and both sides usually have some flexibility to trade. A higher risk taken by one side should result in a change in the purchase price. If the sellers absorb some contingent liability risk, this should result in some other advantage to them, such as a higher price or more options etc.
Owners of the selling firm often agree an earn-out as a way of securing additional compensation for the business they are selling. This frequently occurs where the price the buyer is willing to offer is seen by the selling shareholders as inadequate compensation for the potential of the business. Circumstances where this might occur are;
• Significant expenses have been incurred in recent research and development which has been written off but has not yet translated into revenue;
• The owners have taken either very low salaries or excessive salaries or benefits which are not able to be easily calculated;
• Large contracts have been secured, or are about to be secured, where the benefits have not flowed back into the accounts;
The selling shareholders argue for a higher valuation on the basis of potential. The acquirer may be reluctant to agree the higher value arguing that the benefits may not be realized. The compromise is often negotiated as an earnout based on the future performance of the acquired firm or the combined entity.
Another reason for an earnout arrangement is a performance based purchase price where other activities or achievements other than revenue or profits may be the basis for such payments. This might include;
• Completion of development milestones
• Acceptance of products by named customers
• Completion of key contracts
• Approval of products by licensing authorities
• Granting of rights under patents, trade marks, or licenses
• Achievement of various quality targets
Earnouts should be used where there is a reasonable level of uncertainty of some future event or future performance which can have a material impact on the value of the acquisition. There should also exist the possibility that none of the earnout will be earned if the anticipated events or targets are not met in a material manner.
Where events are more certain, such as the outcome of a litigation settlement, lease payout, warranty claim and so on, these are better handled through escrow arrangements and under warranties and representations. In these situations, the valuation is set on a positive note where all outstanding items are worth zero. A portion of the purchase price is then set aside, generally in escrow and claims are made against that portion as each item is finalized or settled. These items are generally discrete in nature, often able to be calculated in advance and not overly subject to effort by either party and will normally be limited in time.
The earnout approach is best used when the parties are not able to agree on a purchase price because future events, which could materially affect the value acquired, cannot be determined with any certainty. Alternatively, the buyer is willing to pay more but only if the seller can achieve certain predetermined performance or event objectives.
As a general rule, a good earnout formula is one where the buyer is very willing to pay the earnout if objectives are achieved and the seller has a reasonable degree of influence over the events that contribute to that level of achievement. A good earnout formula is also easily defined, measured and objective and not capable of manipulation by either party at the expense of the other.
Earnouts are however not as common as may be expected.In an article in CFO magazine titled ‘Caution: Earnouts Ahead’, the author Roy Harris notes that contingency terms were found in 4 percent of all announced U.S. M&A deals, with over 10 percent of all deals valued at or below $250 million, encompassing such terms. More than two hundred acquisitions in the U.S. have contained earnout agreements in each of the five years to 2000, with a total value of such transactions peaking at $27.9 billion in the year 2000.
Source:http://www.indiainfoline.com/nevi/earn.html Accessed 9th May 2004There is considerable disagreement among practitioners about the most workable term of an earnout. On the one hand, shorter terms have higher degrees of likely achievement while longer terms allow for too many influencing events to occur. Also longer earnouts reflect lower present day values due to the discounted cash flow impact of distant payments. Thus the further out the potential payout, the less value it has for the sellers and the more likely it is to be disputed or not achieved.
Example:Baltimore-based Sylvan Learning Systems Inc. certainly found it so. The company, a prolific acquirer of educational companies in recent years, started out by setting up one-year earnouts. For the managers Sylvan retained, “the natural response was to go gangbusters in terms of revenues and not spend for future growth,” says senior vice president and CFO Sean Creamer. Sylvan now designs earnouts for three years or more and monitors the deals carefully, sometimes using special audits to make sure the managers aren’t “gaming the system.”
Source: http://www.cfo.com/article/1,5309,7261|0|C|2|,00.html Accessed 9th May 2004To a certain extent, it depends on which party has the greatest influence over the target achievements. The longer the buyer is in effective control, the more influence, positively or negatively, they can impact on performance.
How large should the earnout be?Conventional wisdom suggests that earnouts should be limited to 10-25% of the ultimate purchase price. One of the issues that both parties should be aware of is that earnouts are really only appropriate where there is some degree of uncertainty in achieving defined potential targets. If the events or targets were guaranteed, these can be factored into the base price. Where probable outcomes may in fact not be achieved, both parties need to think through the consequences if the earnout is not achieved or substantially not achieved.
An earnout element based on specific large events may be quite reasonable if the final determination cannot be readily influenced by either party. This could be, for example, FDA approval which is awaiting final determination. This might significantly change the valuation and both parties may agree a significant earnout on the conclusion. However, if the earnout requires active co-operation of all parties and is based on many contingencies, it simply opens the gates to a claim of lack of effort on the part of the buyer.
How should the earnout be calculated?There is no magic formula for earnout calculations especially those that are performance based. Should they be based on a cumulative achievement or on stage targets? The problem is one of uncertainty for both parties. The seller will want to ensure that payments, once achieved, are not subject to clawback while protecting against events outside their influence, while the buyer wants to reach certain long term objectives.
The biggest problem in all earnout calculations is finding an objective formula that is not subject to manipulation or re-interpretation by either party.May be boosted by promotions, discounts, poor contracts, early shipments, false invoicing, manipulated stage payments, etc. Revenue may also be negatively impacted by cutbacks in allowable marketing expenses, promotion of competing products, interference or delays in completing contracts through approval cycles or newly imposed conditions.
expensesCan be reduced by reducing staff, delaying staff replacements, delaying purchases, cutting back on R&D, delaying performance bonuses, buying lower quality stock or components, fighting warranty claims and so on. Additional costs may be imposed for redundancies, implementation of new systems, additional reporting and budgeting requirements and so on.
Net ProfitCalculations can be influenced by changing depreciation methods, how goodwill is expensed, reclassifying expenses as capital items, excluding some payments as extraordinary items and so on.
Even where the manner of calculation has been specified, there can be alternative calculations. The words ‘According to GAAP’ (Generally Accepted Accounting Principles) need not ensure that a particular method is used if the auditors recommend a change due to legislation or a new accounting standard. Even ‘as applied at the time of the agreement’ will not necessarily cater for an event not foreseen. The terms ‘consistently applied’ are often used to overcome changes. Setting out the method of calculation during the earnout discussions may help bring out any differences in treatment. The measurement issues become increasingly complex as operations are merged with those of the buyer or central services are undertaken by the parent which results in disputes over transfer prices between entities.
Where competing products are being offered, the earnout may be calculated on both product lines in order to avoid any issue of deliberate bias.Targets should be kept simple, easily and unambiguously calculated and subject to objective measurement by an independent auditor if necessary. Revenue, for example, is easier to calculate than profits. Specific milestones are easier to determine than profits. Earnouts can be based across a range of events or targets, some financial and others based on specific events.
Example:SAL’s former shareholders and creditors have an earnout that is contingent upon three events in 2002: 1) an earnout note, due in twenty-four months, for $500,000 will be issued if the SAL Model 5 stepper’s performance satisfies stated stepper throughput and mechanical performance criteria by no later than March 31, 2002; 2) a second earnout note, due in twentyfour months, for $500,000 will be issued if the combined Model 5 stepper and JMAR X-ray source demonstrates X-ray lithography exposures which satisfy stated performance criteria by September 30, 2002; and 3) a total of 354,736 JMAR shares and an earnout note, due in twenty-four months, for $1.2 million will be issued if an order from a commercial semiconductor manufacturer is received by December 31, 2002 (with pro rated reduction of the payment to zero if the order is received between December 31, 2002 and March 31, 2003).
Source: http://www.bristoldirect.com/adobe/JMAR_ Research_1-22-02.pdf. Accessed 9th May 2004The parties need to agree how the additional valuation created through the earnout will be paid out. Sometimes this is done in cash, other times in cash and shares, or just in additional shares. When shares are used for the earnout, both parties need to agree a formula for how the number of shares is to be determined. This might be at the same market price as for the base compensation, or it might be the price on the day of the payout. Sometimes it is hard to judge where the sellers might be better off. What would happen, for example, if there was a major change in the share price?
Example:The last round of Nasdaq listings was triggered by the success of Chinadotcom’s listing, which having both ‘China’ and ‘dotcom’ in its name ensured it had a very hot reception. Who could have guessed at the time that it would trade down from a peak value of $73.43 to a 39th of that ($1.86) at its low?
Source: http://www.financeasia.com/Articles/18395183-969A41CD-A63F80D95A44D208.cfm Accessed 9th May 2004This is an area of much dispute between buyer and seller. If the earnout is based on operating the business as a continuing concern to achieve the performance targets, this may not sit comfortably with the buyer. The buyer is exposed to expense blowouts, capital project commitments and agreement obligations. Also the buyer will want the business run so that it reduces risk exposure while putting the business on a good footing for the time it takes over effective control.
This potential conflict in interests often results in the acquired business being subject to numerous reporting requirements, expenditure approvals and restrictions on borrowings, capital commitments and so on. Working out the operating conditions and then recalculating the earnout on the new basis can help. It may be appropriate to work out various critical factors such as headcount, expense budgets, capital expenditure allowance, marketing spend and so on.
Example:Autonomy Corporation plc , a leading provider of infrastructure software for the enterprise, today announced it has entered into a definitive agreement to acquire etalk Corporation, a leading provider of enterprise-class contact centre products, for a purchase price of US$70 million payable in a combination of cash and Autonomy ordinary shares, with an opportunity to earn additional consideration payable in Autonomy ordinary shares upon meeting and exceeding certain future performance-related targets.
Source: http://www.cambridgenetwork.co.uk/pooled/articles/DF_ NEWSART/view.asp?Q=BF_NEWSART_156736 Accessed 18th February 2006
A more serious issue is conflict of interest over where the efforts of the newly acquired business should be directed. With an earnout in place, acquired management will have a focus on maximizing their earnout. At the same time, the reason for the acquisition may be to integrate the businesses or to leverage the assets or capabilities across a wider corporate entity. It is difficult to do both at the same time. The most capable people and those with the most knowledge in the acquired business will want to focus on the earnout. However, it is these same people who need to be involved in assisting the roll-out of the newly acquired assets or capabilities.
The new owners have to decide one way or the other. Either they leave the business alone during the earnout or they compensate the prior owners for the time required to work with the new larger entity. This may ultimately result in the new owners paying out all, or most, of the anticipated earnout in advance.
Earnout or employment compensation?Where the selling shareholders argue that the business being acquired has unrealized potential and they wish to be compensated for that – the earnout is correctly paid out to all shareholders. However, where the new owners wish to motivate the newly employed managers to achieve certain objectives or targets, the additional value should be included within employment agreements as additional bonuses or compensation.
The difficulty here is to separate that which rightly belongs to the shareholders as a group and that which is reasonably held to be personal effort. Shareholders may well object to one of their number being offered an overly generous package where they think the compensation should go to them all for creating the foundation on which the near term benefits are being achieved. Where business deals or significant milestones are clearly in progress, the shareholders could argue that the benefits should accrue to all shareholders even if some additional compensation was paid to an individual to see it through to completion.
As a general rule, the more certain the target is to being achieved, the more the compensation should be directed to the selling shareholders as a group. Alternatively, where significant effort is still required, compensation should be directed to the individuals who can best deliver the results. Whatever is agreed, it is best if all the selling shareholders, or at least the larger non continuing owner/managers, sign off on the deal as this should avoid future litigation.
Example:Billabong International Ltd., Australia’s largest publicly traded surfwear manufacturer, has acquired the Honolua Surf Co. apparel brand and its 19-store retail network. Depending on the eventual payout, the acquisition will cost Billabong between $10 million and $15 million.
The acquisition will be funded by debt and paid in two installments, according to Billabong. The initial payment to Honolua is 75 percent of the agreed purchase price. After three years, Honolua will receive 25 percent of the initial purchase price plus an incentive-based payment calculated on the increase in retail profits over the period. In addition, Honolua’s co-founders, Tom Knapp and Randy Blumer, receive an annual earnout over three years based upon continued employment.
Source: http://www.insider.com.au/inside/html/modules.php?name= News&file=article&sid=1724 Accessed 9th May 2004Not all events can be forecast and there will be occasions when the earnout is frustrated by events outside one or both partys’ influence. Some of these may be anticipated, such as the resale of the acquired firm and an agreement entered into about the resulting impact on the earnout.
What happens, for example, if the prior management is unable to continue due to ill health or if actions of the buyer cause the acquired business to be severely disrupted?
Earnouts are frequently renegotiated as events unfold. This however requires goodwill on both sides.
“In July we indicated that 100% of the Group’s total potential earnout liabilities had been realized, renegotiated or capped. Further progress has been made in renegotiating Parsec’s earnout due to some major changes in that business.
Agreement has therefore been reached with the vendors of Parsec to settle their outstanding earnout (maximum total of £6.8m payable in Anite’s financial year 2005/6) for £873,000, to be paid in guaranteed loan notes, repayable after one year.
This, together with other minor adjustments, has reduced the total future cash earnout liability from £25.4m to £19.5m, whilst bringing forward all remaining 2005/6 financial year liabilities, thus ensuring that all outstanding earnouts will have been paid out by the year ended 30 April 2005, subject to performance.”
Source:http://www.pressi.com/int/release/74044.html Accessed 8th May 2004Brooktrout Inc., a provider of telecommunications hardware and software, tried earnouts in an acquisition in the early 1990s and discovered that a demotivated workforce can destroy all the supposed benefits of the