06-22-11 CorpSec Webinar Earnouts

8/2/2019 06-22-11 CorpSec Webinar Earnouts

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arnou s n ransac ons

June22,2011KeyStructuresandRecentDevelopmentsPaulCrimmins13127017068 JessieWaller13127018761BenGray13127018644

MayerBrownisagloballegalservicesorganizationcomprisinglegalpracticesthatareseparateentities("MayerBrownPractices").TheMayerBrownPracticesare:MayerBrownLLP,alimitedliabilitypartnershipestablishedintheUnitedStates;

MayerBrown

International

LLP,

alimited

liability

partnership

incorporated

in

England

and

Wales;

and

JSM,

aHong

Kong

partnership,

and

its

associated

entities

in

Asia.

The

Mayer

Brown

Practices

are

known

as

Mayer

Brown

JSM

in

Asia.

InBrazilMayerBrownisinassociationwithTauil&ChequerAdvogados,aBrazilianpartnership.

[email protected] [email protected]@mayerbrown.com


2/28

What is an Earnout?

as c e n t on: AnearnoutisariskallocationmechanismusedinanM&A

transaction

whereby

aportion

of

the

purchase

price

is

deferred

and

is

calculatedbasedontheperformanceoftheacquiredbusinessovera

spec e meper o o ow ng ec os ng.

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Reasons for Use of Earnouts

ValuationGap:Earnoutscanbridgethebusinessvaluationgapbetweenanoptimisticsellerandaskepticalbuyer.

Allows

asset

to

prove

its

worth.

Financing:Useofanearnoutinstructuringanacquisitionprovidesbuyerwith

anadditionaloptiontofinancetheacquisition(i.e.,buyermaybeabletopayfor

theacquisitionwithfutureprofitsofthetargetbusiness).

Thisattribute

is

particularly

important

in

economic

climates

where

third

party

financingcanbedifficulttoobtainonfavorableterms.

IncentiveBasedCompensation:Earnoutscanalsobeusedasaformofincentivebasedcompensationtosellerswhoarecontinuingasemployeesofthe

acquiredcompany.

Startups: Earnoutsareoftenusedforcompanieswithlittleoperatinghistorybut

.

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Key Structural Considerations

Principalconsiderationswhennegotiatinganddraftingan

(1)thedefinitionandscopeofthetargetbusiness;

(2)theselectionoftheperformancemetric;

(3)theselectionofappropriateaccountingmeasurementstandards;

(4)the

determination

of

the

payout

structure

and

establishment

of

the

earnou per o ;

(5)postclosingoperation(i.e.,theallocationofcontrolbetweenbuyerand

sellerandthelevelofsupport,ifany,thatbuyerwillcommittoassistthe

arge

us ness

nac ev ng

searnou

o ec ves ;

an

(6)disputesandresolution.

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5/28

Key Structural Considerations (contd)

1)DefiningtheTargetBusiness

escopeo e arge us nesss ou ec ear y e ne s nce s e

performanceof

this

business

that

will

determine

whether

earnout

requirementsaresatisfied.

e a ve yeasyw enacqu re us nessw eopera e asan

independentsubsidiaryordivision,butmoredifficultwhenthetargetis

tobeintegratedintobuyersexistingbusiness. Insuchsituations,the

performanceofthebusinessmaybemoredifficulttotrackandspecialaccountingallocationsmayberequired.

Segregatedfinancialstomeasureperformanceoftheacquired

businessshouldbeestablished.

Particularmatterstobeaddressedinclude:(i)thedefinedlineof

business,(ii)whetherexpansionofthebusinessbeyondthedefinedline

willcounttowardtheearnoutand(iii)salestocommoncustomers.

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2)PerformanceMetric

FinancialMetrics:Themostcommonfinancialmetricsare(i)revenue,(ii)net

income,(iii)EBITDAand(iv)earningspershare. Sellersoftenpreferrevenue

andbuyersoftenprefernetincome.

Sellerspreferrevenuebecauseitislesseasilymanipulatedbybuyer(and

easiertoachieve). Usingrevenueasthemetricmayincentivizesellers

managementtograntunprofitabledealstocustomers.

Buyersprefernetincomebecauseitprovidesamorecompletepictureof

performanceandincentivizessellersmanagementtocontrolcosts.

PartiesoftencompromiseonEBITDA(whichfactorsinoperationalcosts

butexcludescertainnonoperationalcosts).

,

appropriatebecausethereisnohistoricalinformationtouseasabasisfor

financialprojections. Inthesecases,productdevelopmentmilestones,

numberofcustomers,numberofproductssoldorlaunchofanewproduct

maybeusedasthemetric. Ingeneral,nonfinancialmetricscanleadtofewer

disputes

regarding

calculations

of

benchmarks.

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7/28


3)AccountingPrinciples

Itisimportanttoestablishappropriateaccountingprinciplesformeasuring

theperformancemetric.

ReferencetoGAAPinandofitselfisusuallynotsufficient.

, ,

consistentwitheitherbuyersorsellershistoricpractices.

Parties

should

also

consider

stipulating

aspecific

set

of

accounting

.

Somespecificaccountingmatterstobeconsideredare(i)useofcashor

accrualrevenuebasis,(ii)revenueandexpenseallocation,(iii)timingof

, ,

othernonrecurringitems,(vi)treatmentofintercompanytransactionsand(vii)treatmentofuncollectedreceivables.

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8/28


4)PayoutStructureandEarnoutPeriod

Installmentsvs.

lump

sum

Percentageofearnoutpaymentuponpartialsatisfactionofbenchmarks

vs.allornothingapproach

Earnoutconditionedonparticipationbysellerinacquiredbusiness

Offsetofindemnificationclaims

Adjustmentswithrespecttopaymentsmade(ormissed)inprevious

installmentsbased

on

subsequent

performance

(e.g.,

carry

back/carry

forwardofEBITDAfromonemeasurementperiodtoother

measurementperiods)

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9/28


Earnoutperiod:

Anearnoutperiodthatistooshortrisksperformancedistortionby

shorttermfactorsorthatsellerswillsacrificethelongterminterestsof

thebusiness.

Sellers

may

seek

ashorter

period

in

order

to

receive

full

paymentsoonerandmitigaterisk.

Alongerearnoutperiodwillallowtimetoensurethattheacquired

businessprovestobeaworthylongterminvestment.

Partiesshouldconsiderincludingaccelerationrights,whichresultinanimmediatepaymentandterminationoftheearnoutarrangement.

Sellermayhaveaccelerationrightuponcertaineventsthat

negativelyimpactsellersabilitytosatisfyearnouttargets(e.g.,

buyerssubsequent

sale

of

acquired

business,

bankruptcy

or

changeofcontrol).

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10/28


5)PostClosingOperationofAcquiredBusiness

Twoimportantquestionsthatmustbeaddressedare(i)howwillpost

acquisitioncontrolbeallocatedbetweenbuyerandsellerand(ii)whatlevelof

support(if

any)

will

buyer

be

obligated

to

provide

the

acquired

business?

(i)AllocationofControloverOperations

Sellerwillsometimesretainalevelofcontrolovertheoperationsofthe

acquiredbusiness(e.g.,approvalrightsovermajordecisions).

,

howtheacquiredbusinessmaybeoperatedtopreventbuyerfrom

makingsignificantchangesthatreducetheearnoutamount,suchas(a)

discontinuingproducts,(b)reducingsalesforceor(c)shiftingsalesand

costs.

Buyermayberequiredtooperatethebusinessconsistentlywith

howitwasoperatedpriortoclosing.

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Thepartiesshouldaddressthetreatmentofbuyersexistingcompeting

businessesandafteracquiredbusinesses.

(ii)LevelofSupport

Affirmativerequirementsforbuyerinsupportingthetargetbusiness(e.g.,

marketing,salesforceincreases,adequatecapitalization).

Requirementthatbuyeruseaspecifiedlevelofeffortstomaximizethe

earnout.

businessinitssolediscretionandnotbeobligatedtoachievetheearnout.

Buyershouldincludelanguageintheacquisitionagreementthat(i)

ives bu er absolute discretion over o eration and ii ne ates an

obligation(express

or

implied)

toward

supporting

the

acquired

businessorachievingtheearnout.

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12/28


6)DisputesandResolution

Financial

statements

and

earnout

calculations

are

typically

prepared

bybuyeranditsaccountants.

statementsandearnoutcalculation.

Arbitrationprocedures

should

be

established

in

advance

to

resolve

futuredisagreementsconcerningtheearnoutcalculationinafairand

expeditiousmanner.

Oftenaninde endentaccountantservesasthearbitrator.

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Earnouts Case Law

TheEarnout:ADisputePostponed?

Dueto

the

complexities

of

structuring

an

earnout,

earnouts

often

lead

to

futuredisagreementsandlitigation.

s ce ance or as ers a e n erecen r orne ea ec s on, ...anearnoutoftenconvertstodaysdisagreementoverpriceintotomorrows

litigationoveroutcome.

o a y,cour s ave eenw ng ouse e mp e covenan o goo a o

imposeobligationsorrestrictionsonbuyerwithrespecttoitspostclosing

operationoftheacquiredbusinessintheabsenceofexpresscontractual

terms.

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Implied Covenant of Good Faith

OToolv.GenmarHoldin s Inc. 387F.3d1188 10thCir.2004

The10th

Circuit,

applying

Delaware

law,

upheld

ajury

verdict

in

favor

of

sellersofaboatmanufacturingbusiness. Theopinionwassignificantinthatit

was not based on a breach of ex ress rovisions in the urchase a reement

butontheimplieddutyofgoodfaithandfairdealing.

The

implied

covenant

of

good

faith

and

fair

dealing

inheres

in

every

contract.

The im lied covenant rotects the s irit of an a reement when without

violatingtheexpresstermsoftheagreement,onesideusesoppressiveor

underhandedtacticstodenytheothersidethefruitsofthepartiesbargain.

Theimpliedcovenant,however,cannotcontravenethepartiesexpress

agreemen

an

canno

e

use

o

orge

a

new

agreemen

eyon

e

scope

o

thewrittencontract.

14


15/28

Implied Covenant of Good Faith (contd) OToolv.GenmarHoldings,Inc.,387F.3d1188(10thCir.2004)

(contd)

Specifically,thecourtheldthatthebuyerbreachedtheimpliedcovenantof

goodfaith

by

(i)

immediately

changing

known

product

names,

(ii)

requiring

theacquiredbusinesstoprioritizesalesofproductsnotsubjecttothe

,

facilities,(iv)forcingtheacquiredbusinesstobearthedesignandproduction

costsofanotherlineofbuyersbusinessand(v)failingtogivethesellersthe

necessaryoperational

control

over

the

acquired

business.

The

court

reasone t at espitet e ac o expressprovisionsrestrictingt e uyer s

actions,theobviousspiritofthecontractwastogivethesellersafair

opportunitytooperatethe[acquiredbusiness]insuchafashionasto

maximizetheearnout andu heldthe ur sfindin thatsuchan

opportunityhad

not

been

given.

Asignificantfactorinthisdecisionwasthefactthatthecourtstrongly

su estedthebu erhadanulteriormotiveandthatthebu ersstrate was

nottogrowthebusinessbuttoeliminateacompetitorandgainaproduction

facility

for

its

other

brands.

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Implied Covenant of Good Faith (contd)

AirborneHealth,Inc.v.SquidSoap,LP,984A.2d126(Del.Ch.

2009)

TheDelawareChanceryCourtrecentlyreachedadifferentresultinAirborne.

BuyerpurchasedsellersSquidSoapbusinessfor$1millionplusupto$26.5

millioninearnout a ments.

Importantly,theacquisitionagreementhadaprovisionrequiringbuyerto

returnthesoldassetsifcertainbusinesstargets,suchasadvertisingspending

andsales werenotachieved.

Shortlyaftertheacquisition,buyersufferedfromcripplinglitigationand

negativepublicitywithregardtoanunrelatedproduct,andtheearnout

tar etswerenotachieved.

Sellerallegedthatbuyerbreachedtheimpliedcovenantofgoodfaithandfair

dealingbynotspendingonmarketingoftheSquidSoapproduct.

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AirborneHealth,Inc.v.SquidSoap,LP,984A.2d126(Del.Ch.

2009)(contd)

Theagreementcontainednorequirementforbuyertospendfundson

marketingso

there

was

no

express

breach

of

contract.

In

addition,

the

agreementcontemplatedthattheassetswouldbereturnedifbuyerfailedto

.

Thecourtagreedthatbuyercouldnotarbitrarilyorinbadfaithrefuseto

expend

resources

and

thereby

deprive

seller

of

the

earnout.

However,

the

[buyer]failedtoexpendfundstomakethebusinessasuccessarbitrarily,in

badfaith,orfornoreason. Tothecontrary,thecourtrecognizedthatbuyer

hadsufferedacorporatecrisisandwasundoubtedlyrestrainedbythelegal

an

inancia

ur ens

o

t e

sett ement

an

systemic

mar et

amage.

T e

courtnotedthatsellerspositionwasalsoundercutbytheeasewithwhichit

couldhavecontractedforanexpenditureofresources.

Buyer smotion orsummary ju gmentwasgrante .

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.

,

.,

. .

Dist.LEXIS91236(D.Mass.2009).

InFireman,sellerssoldtheirmarketingbusinesstodefendantfor$2.8millionincashplusthepossibilityofadditionalearnoutpaymentsoverfiveyears.

Whenthe

acquired

business

did

not

meet

the

maximum

earnout

targets,

sellersallegedbuyerbreachedtheimpliedcovenantbyrebrandingthe

,

refusingtouseitssalesforcetopromotetheproductattradeshows.

ApplyingNew

York

law,

the

court

held

that

the

merit

of

[sellers]

claim

business]tolosemoney. Thecourtfoundthatbuyersactionswere

legitimatebusinessdecisions,andthatplaintiffsallegationsamountedto

nothingmorethandisputesconcerningstrategybetweensophisticated

businesspeople.

Therefore,

the

court

held

that

there

was

no

dispute

of

materialfactastowhetherdefendantbuyerbreachedtheimpliedcovenant

ofgoodfaith,andgrantedbuyersmotionforsummaryjudgment.

Takeaway: Ifsellerwantsbuyertotakecertainactionswhenoperatingthe

business,itshouldnegotiateforsuchprovisionsinthecontract.

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Implied Obligation to use Reasonable

SonoranScanners,Inc.v.PerkinElmer,Inc.,585F.3d535(1stCir.

2009

The1st

Circuit,

applying

Massachusetts

law,

did

not

find

abreach

of

the

implied

covenantofgoodfaith. Nevertheless,itreversedthelowercourtsgrantof

summar ud menttobu erb holdin thatbu erhadanim liedobli ationto

usereasonableeffortstodevelopandpromotesellerstechnology.

Thecourtreliedonaseriesofcasesdealingwithexclusivelicenses.

Thefollowingfactorswereimportantinfindingthatanobligationofreasonable

effortsapplied:(i)theearnoutwassubstantialinrelationtotheupfrontpayment

($3.5millionupfrontand$3.5millioninpotentialearnouts);(ii)thatmostofthe

u front a mentwenttocreditors iii thatthe urchasea reement

contemplatedacampaign

to

market

sellers

technology

and

(iv)

that

[t]here

was

nolanguageintheagreementnegatinganobligation...tousereasonableefforts

orconferringabsolutediscretionon[buyer]astotheoperationofthebusiness.

Remandedtodistrictcourttodetermineifbuyerbreachedthisobligation.

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Implied Obligation to use Reasonable

SonoranScannersseemstobeanoutlier.

Little

other

case

law

implies

a

reasonable

efforts

obligation

in

thecontextofearnouts.

Delawarecourtshavesuggestedthereisnoimpliedobligationtouse

reasonableefforts. Airborne: SquidSoapspositionisalsoundercutbythe

ease

with

which

Squid

Soap

could

have

insisted

on

specific

contractual

,

formofeffortsobligationforAirborne.

Itremainstobeseen,however,ifothercourtswillfollowtheleadofthe1st

.

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Buyers Points: Disclaimers

Inlightofthecaselaw,buyersshouldfocusonincluding

disclaimerprovisionsinanyearnoutscontract.

Buyershouldaddcontractuallanguagethatnegatesanyimpliedcovenantofgoodfaith

andanyimpliedobligationofreasonableefforts.

manner.

Implied

obligation

of

good

faith

can

only

be

disclaimed

if

done

specifically.

Includespecificcontractuallanguageacknowledgingthat,withtheexception

ofanyspecificallynegotiatedrestrictivecovenantsintheagreement,buyer

hasnoexpressorimpliedobligationsinregardstotheearnout.

Include

provisions

waiving

asellers

right

to

sue

under

an

implied

covenant

or

impliedobligation.

Buyershouldalsoincludenorelianceprovisionsandintegrationclauses.

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22/28

Buyers Points

actions.

Buyershouldincludeanacknowledgmentfromsellerintheacquisition

.

Yarboroughv.

DeVilbiss

Air

Power

Inc.,

321

F.3d

728

(8th

Cir.

2003)

Earnoutpaymentwasbasedonlyonsalestocertainspecifiedcustomers.

Buyerdiscontinueddoingbusinesswithonespecifiedcustomerand

transferredthat

portion

of

its

business

to

another,

non

specified

customer.

Agreementstatedthatbuyerhastheright,initssolediscretion,to

determinethetermsandconditionsofanyandallrelevantsales,including

thedecisiontomakeornotmakeanysuchsales.

8thCircuitfoundbuyerhadexpresslyandunambiguouslycontractedforabsolutepoweroveritsabilitytomakesalesinordertoforeclosesellers

claimofbreachoftheimpliedcovenantofgoodfaith.Thecourtaffirmedthe

grantofsummaryjudgmentforbuyer.

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Sellers Points

AffirmativeCovenants: Sellershouldnegotiateforaffirmativecovenantsrequiringbuyertoactingoodfaith,usereasonableeffortsandtake

everyaction

necessary

to

maximize

the

earnout

payment.

RestrictiveCovenants:Sellershouldalsone otiateforcovenantsexplicitlyrestrictingcertainactions,including,forexample:transferringfixed

coststotheacquiredbusiness,firingorrelocatingkeypersonnelandunder

capitalizingthe

business

or

the

R&D

needed

for

growth.

Control:Sellermayalsowanttocontractforacertainlevelofcontrolovertheoperationsoftheacquiredbusinessduringthelengthoftheearnout

period(e.g.,approvalrightsovercertainmajordecisions,abilitytoelecta

certainnumber

of

directors).

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Sellers Points: The Problem of Damages

SelfExecutingRemedies:

Inearnoutscases,damagescanoftenbehardtoprove.

LaPointv.AmerisourcebergenCorp.,2007Del.Ch.LEXIS131(Del.Ch.2007),

illustratesthis

problem

for

sellers.

TheDelawareChanceryCourtheldthatbuyerbreachedacovenant

requiringittoexclusivelyandactivelypromotetheacquiredbusinesss

products,butitdidnotfindthatsellersatisfieditsburdeninproving

damages. Thus,thecourtawardedonlynominaldamagesonthatcount.

Toavoidthistypeofoutcome,thepartiesshouldspecifyremediesfor

breachesoftheagreement(e.g.,liquidateddamages).

Itisdifficulttoprovethatspecificbenchmarkswouldhavebeenachievedbut

for

breaches

by

buyer.

Breachofcontractualprovisionallowingsellertoretaincontrolofthe

acquiredbusinesssoperationscreatesevenmoreuncertaintyastodamages.

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PossibleSelfExecutingRemedies:

qu a e amages.

Breachof

any

express

covenant

results

in

damages

of

maximum

or

partial

earnoutpayment.

Canresultinwindfallfortheseller. SeeAvesair,Inc.v.InPhonic,Inc.,

2007NCBC32(N.C.Super.Ct.2007). Inthatcase,theacquisition

agreementprovided

that

regardless

of

whether

the

earnout

threshold

wasme , emax mumearnou wou e ue uyer a e ouse

commerciallyreasonableeffortstosellacquiredbusinessproducts,(ii)

terminatedcertainemployeesor(iii)failedtoprovideoutsideaudited

financialinformationattheendoftheearnoutperiod. Thecourt

concludedthat

because

outside

audited

financial

information

was

not

provided,sellerwasentitledtomaximumearnoutpayment.

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PossibleSelfExecutin Remedies contd :

Breach

of

any

(i)

express

obligation

of

buyer

to

use

acertain

level

of

efforts

to

maximizetheearnoutor(ii)impliedcovenantorobligationresultsindamages

Specificremedies:Breachofcovenanttomakeexpenditureorotherrequired

actionresultsinanadjustmenttothefinancialmetricusedfortheearnout

calculation.

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Additional Consideration: Accounting

Historically,earnoutconsiderationwasrecognizedinbuyersfinancial

statementsifandwhentheconditionstopaymentoftheearnoutwere

satisfied.

UnderFAS

141(R),

effective

in

2009,

earnouts

are

now

required

to

be

recordedatfairvalueatthedateofclosing. Therecordedfairvalueisthen

subjecttoperiodicadjustmentsbasedonthelikelihoodofpaymentoractual

earnoutpaymentsthathaveoccurred.

Anysuch

adjustment

must

be

recorded

as

gain

or

loss

on

buyers

income

statement.

Resultofthisruleistoacceleratetherecordingofliabilitiesrelatedtothe

earnoutandcouldalsocausefutureearningsvolatility.

Thismay

make

the

use

of

earnouts

less

attractive

to

buyers

or

cause

buyers

to

negotiateforashorterearnoutperiod.

compensationratherthanpurchaseprice.

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28/28

Additional Consideration: Earnouts as a

Istherighttoanearnoutasecurity? Anearnoutcanbea

securityundercertaincircumstances. TheSEChasissued

multipleno

action

letters

on

the

subject

and

has

created

a

Istheearnoutrightanintegralpartoftheconsiderationtobereceivedinthe

transaction?

Istheearnoutrightrepresentedbyanyformofcertificateorinstrument?

Dotheholdersoftheearnouthaveanyrightincommonwithshareholders

suchasvotinganddividendrights?

Doesthe

earnout

represent

an

equity

or

ownership

interest

in

the

surviving

entity?

,

28

Documents

06-22-11 CorpSec Webinar Earnouts