M&A deals look a lot different today than they did 10 to 20 years ago. For most of the 1990s, a typical sale of a venture-backed private company involved a small-to-mid cap public company acquirer, in which the merger consideration was the acquirer’s stock and the deal was structured as a tax-free, pooling-of-interests merger.
Fast-forward a decade and the structure has changed dramatically. The typical deal today involves a large public acquirer that is paying cash but is holding back some portion of the payment until after the deal officially closes to account for possible working capital adjustments, earnouts or other unforeseen issues.
Under the pooling accounting rules, there were severe restrictions on contingent purchase price deal structures. No true earnouts or working capital adjustments were permitted, and indemnification escrows generally could not go beyond 10% of the deal price or be held back for more than 12 months.
Even if a buyer wanted to pay cash and didn’t need to comply with the pooling rules, selling companies typically had more exit alternatives available to them; there were more potential buyers, and going public was a more realistic and attractive option.
The seller-friendly pooling accounting rules became market standard as the starting point of most deal negotiations, and greatly lessened the risk to the selling stockholders on the back end of the deal. The post-closing portion of the sale process was simply not as big a concern, as it presented less likelihood of claims with smaller and fewer escrows at risk for shorter periods of time.
Pooling of interest accounting is long gone now, and the post-closing process is now much more complex. According to the 2009 Private Target Mergers & Acquisitions Deal Points Study conducted by the American Bar Association’s Committee on Mergers & Acquisitions, almost 80% of 2008 deals reviewed included terms providing for possible post-closing purchase price adjustments, with 38% of those adjustments based on more than one metric. Deals with post-closing price adjustments had increased by 10% from the 2007 Study, and the 2005 Study did not even find post-closing purchase price adjustments noteworthy.
The use of earnouts as post-closing consideration also has significantly increased over the past years. The 2009 Study found that 29% of the previous year’s deals included earnout provisions, an increase from 19% in the 2007 Study. Hendrik Jordaan, a member of the 2009 Private Target Study Working Group, recently noted the implications of this in The Deal, stating “the amounts [of earnouts] are larger, there’s more at stake, there’s more risk of companies missing the target. And as a consequence, I think there’s going to be more disputes.”
Similarly, the size of escrows and length of escrow periods have both steadily increased. An escrow fund of 10% of the deal size is now towards the lower end of the spectrum for what a seller should expect. Over half of the transactions reviewed in the 2009 Study had escrow periods exceeding 18 months. This is nearly double the percentage for deals from the 2007 Study. Only 24% of the deals reviewed in the 2009 Study had survival periods of 12 months or less.
With the rise in size and length of escrows, it comes as no surprise that there is a corresponding increase in the number of indemnification claims asserted by buyers. JP Morgan’s 2009 M & A Holdback Escrow Report reviewed 445 transactions originated in 2007 through June 2008, and concluded that 40% of the escrows had claims made against them. The report also highlighted a significant increase in claims from 2007 to 2008.
The increased importance of the contingent component of merger consideration translates into a big increase in the amount of time required by selling stockholders on post-closing matters. With the current typical deal structure now being pretty well established, that is unlikely to change anytime soon.
Paul Koenig is a co-founder/managing director of Shareholder Representative Services (www.shareholderrep.com), which serves as a professional shareholder representative following the acquisition of a VC-backed portfolio company.