With conditions becoming more favorable for a buyer’s market, attorneys and advisors say we may see more earn-outs negotiated in coming months.
Earn-outs let buyers and sellers bridge differences in price by requiring buyers to shell out additional cash or stock should their new acquisition beat performance benchmarks. Of late, with credit abundant and suitors everywhere, sellers have had little problem getting every penny, upfront, of their desired price tag. As a result, earn-outs have been rare.
But depending on how the credit crunch plays out, sellers may start feeling the itch to compromise. Earn-outs often come into play when a seller feels that the buyer’s offer doesn’t fully reflect some positive development—the imminent introduction of a product, say, or the hiring of a sharp new management team. The buyer also may recognize the possibility of a windfall. But it would rather pay upon performance rather than take its chances.
(In trying to re-negotiate an offer with student lender Sallie Mae, buyout shop J.C. Flowers & Co. recently dangled something like an earn-out in front of selling shareholders. The firm sliced its original offer from $60 per share to $50 per share, but it offered warrants that could make up the difference should the company beat forecasts. Sallie Mae responded by filing suit to force the firm to stick to its original offer.)
No two earn-outs are alike, but they tend to fall into two major camps. One type features an annual look-back in which a payment is made at the end of each year should the company’s performance merit it. Often the benchmark is based on a range of EBITDA, with a lower payment made for hitting the bottom of the range, then scaling up to a higher payment for clearing the top of the range. The earn-out often lasts three to five years; the total payout over the period is generally capped. The second type of earn-out features a single look-back and potential payout, often at the end of a three- to five-year period.
Just about every item in earn-outs can be negotiated. Attorneys and other advisors give the following advice for what you should try to achieve, depending on whether you’re buying or selling.
• Both Sellers and Buyers: Define the benchmarks as clearly and objectively as possible, in part to prevent costly disputes down the road. If relying on EBITDA, make sure you define how it will be calculated.
• Seller: Try for annual look-backs with “catch-ups” that, should the acquired company miss its targets in the early years, let you still collect the full earn-out if it hits them in later years. Buyer: Try for single look-backs after as long a period of time as possible. If forced into annual look-backs, try to negotiate claw-backs that let you recover money if the company under-performs in later years of the earn-out.
• Seller: Negotiate covenants that allow for an accelerated payment of the earn-out after certain events, such as the firing of the management team or the sale of a product line. It also may be to your advantage to negotiate a mechanism for dispute resolution. Buyer: Maintain as much control of the business as possible.
• Seller: Negotiate transparency clauses that give you a look at the company’s books at the time the earn-out is determined.
Buyers naturally like earn-outs a lot more than sellers, not least because they tend to have more leverage when disputes arise. That said, sellers can take comfort in at least one recent court decision arising from an earn-out dispute. Back in 2002, Halpern Denny & Co., New Enterprise Associates and other shareholders agreed to sell bar-code company Bridge Medical Inc. to AmerisourceBergen, a publicly traded pharmaceutical services company, for $27 million. The buyer also agreed to pay up to $55 million more if Bridge Medical hit earnings targets in calendar years 2003 and 2004.
AmerisourceBergen later decided that no contingent payments were due. Halpern Denny and NEA filed suit, claiming in part that the company failed to promote and sell Bridge Medical’s products as promised in the earn-out agreement. Last month the Delaware Court of Chancery sided with the private equity firms and their law firm, Kirkland & Ellis. It ordered AmerisourceBergen to pay $21 million, plus $5.9 million in accrued interest. The company said it would appeal the ruling.
For more on earn-outs, contact Frank Melazzo, managing director, Getzler Henrich & Associates, at 312-474-6177; John R. LeClaire, partner, Goodwin Procter LLP, 617-570-1144; and Morton A. Pierce, partner, Dewey & LeBoeuf LLP at 212-259-6640.