When Genzyme announced recently it was exploring a new deal structure to help resolve the impasse on price with bidder Sanofi-Aventis, it highlighted a great tool in the M&A world, the earn-out deal. They called the structure a CRV or Contingent Value Right, an earn-out by another name. The seller receives further consideration beyond the amount paid at completion dependent on certain targets being met.
The Philosophy of Earn-Out deals
The concept is quite simple. The buyer’s perception of value is lower than the seller’s aspiration on price. This gap is usually fueled by differing views on the potential growth of the target company.
In Genzyme’s case the gap revolves around the future revenue stream of Campath, a multiple sclerosis drug. Genzyme projects sales will reach $3.5 billion in 2017, buyer believes more like $700m!
There you have it, the future value gap. The earn-out attempts to wrap a formula around that gap (could be profits, gross profits, sales) and pay outs are based on achievement of predictions being achieved.
These techniques were famously used to build up large service groups eg WPP, the world’s largest advertising agency. There is an important negotiation point worth stating. The earn-out amount is in addition to the up front sum paid to gain 100% of the shares. The earn-out doesn’t buy the buyer any more shares. The 100% of shares are bought by the up front sum with a contractual agreement to pay more if key conditions are met. That means if you are an owner of a company, private or public you expect the buyer to show full respect for what the target has achieved to date, within the up front sum. The battle of minds should be around a fair price for today’s achievement and therefore earn-outs should relate to incremental performance beyond today.
Seems obvious but often lost in the emotion of deals.
A worked example is always easier to understand. Private selling company x has produced EBITDA of $10m during the previous financial year and their 3 year forecasts suggest future profits of $12m, $13m and $16m as new products come on stream.
The following structure attempts to produce a win:win. The seller gets full respect for results to date but also some more upside if the business delivers the forecasts. From a buyer’s perspective the deal looks attractive and safe.
- Pay $117m which looks fair at EBITDA of 11.7 but structured as:
- Up-front $80m, EBITA multiple of 8 times historical earnings
- Earnout formula 10 times (average of projections > $10m) eg 10($13.67m-$10m) = $37m
- Total consideration if targets are met $80m plus $37m = $117m but you own a business producing $16m profit
- Initial EBITDA multiple = 8, Exit multiple (when you have stopped paying) 7.3
Rules to document
Because earn-outs are being executed when the buyer has full control of the business it is important that sellers build protections into the Purchase contract:
- Accounting policies to be used
- Management charges from the buyer eg payroll, legal, treasury services
- Intra group pricing to be deployed
- Cost of finance provided by the buyer
- The appointment of auditors
- Rules concerning changes to staff
The key to these rules is to avoid arguments post acquisition. Imagine the post acquisition strategy and legislate for the obvious.
Issues to negotiate
- Earn-outs do not work in every case. if you intend to totally integrate the acquired company from day 1, earn-outs around profits are impossible.
- Remember an earn-out effectively ring fences a target company until the deal is paid out. Gross margin & sales earn-outs do allow some integration post acquisition.
- Salaries can’t be artificially held down by the seller to pump up profits.
- When things go wrong, don’t hang around, post acquisition, move in and fix the problem.
- Long earn-out deals never work. Max time 3 years but probably better with two. The sales earn-out can be longer if the revenue stream can be kept separate.