As a follow-up to his November 26, 2010 installment of The Smith Report (entitled Buying a Company – Great time to deploy Earn-Outs), Ian asked me to take a deeper dive into the legal documentation of earn-out provisions in the M&A context.
The earn-out is, as Ian mentions, a great tool for sellers to receive increased purchase price if the business performs admirably post-closing. Of course, with buyer at the helm of the post-closing ship, how incentivized are you to actually achieve the earn-out targets in the applicable timeframe(s)? That incentive is usually directly related to the language drafted by legal counsel in the acquisition agreement. For example, if the earn-out is based on buyer’s commercialization of a product developed by seller, what resources must buyer allocate to such commercialization? How long will the process take? What kind of marketing strategies must buyer implement? Will buyer be required to dedicate a sales force to promote the product? It is one thing for seller’s counsel to draft the ubiquitous “commercially reasonable efforts” language with which buyer must comply. It is quite another thing, however, to delineate with reasonable specificity what those commercially reasonable efforts entail for buyer to meet its obligations.
To state the obvious, leverage is everything.
Extreme Seller Pain – What Earn-Out?
The firesale. Seller is left with no leverage and most times has to accept what buyer’s giving, regardless of how painful that offering may be. In an earn-out based on achievement of product commercialization, a seller’s earn-out nightmare reads something like this:
Buyer has no express or implied obligation to (i) develop, market or sell, or attempt to develop, market or sell, any products or (ii) otherwise use any efforts or engage in any activities in order to generate any earn-out consideration. Any such efforts or activities may be undertaken, if at all, in its sole discretion. If buyer in its sole discretion elects to develop, market or sell, or attempt to develop, market or sell, any products, it may also in its sole discretion elect to terminate such activities (in whole or in part) at any time or reject or otherwise decline any one or more sales opportunities, in each case for any reason or for no reason and without any liability or responsibility to seller or any other person who might have a direct or indirect interest in any of the earn-out consideration. If buyer in its sole discretion elects to develop, market or sell, or attempt to develop, market or sell, any products, it will do so in pursuit of its own strategies, objectives, policies and procedures, in each case as determined in its sole discretion. There are no assurances that any such efforts, if undertaken, will be successful or generate any earn-out consideration. In addition, buyer will be free to change such strategies, objectives, policies and procedures at any time and from time to time without any obligation to consider the impact thereof on the earn-out consideration.
Ouch! The “non-earn-out earn-out.” If I’m a seller in this situation, I tell my stockholders that they should plan to get what’s coming to them on the closing date and nothing else. In fact, as counsel to this seller, I’m drafting my client’s proxy statement to say exactly that. But don’t worry sellers, it doesn’t always have to be this bad.
Seller Relief – The Merger of Equals
When both parties believe that some earn-out should be achievable post-closing based on future revenue targets of the business or some other measure, buyer may affirmatively agree to run the acquired business in a specified manner. This is seller relief – some parameters around what can be expected as earn-out dates are reached. For example, during the earn-out period buyer may agree to run the acquired business only as contemplated by budgets approved by a board comprised of one or more seller representatives. Seller’s hope is that such director(s) will influence where business dollars are spent to maximize the earn-out. That language may look something like this:
Through the end of the earn-out period, the day-to-day management of the acquired business shall be conducted in accordance with the budgets and business plans approved by the board; provided, however, that the acquired business shall at all times be subject to buyer’s policies and procedures relating to corporate governance, internal financial and disclosure controls, internal audit policies, documentation of contracts, compensation and benefits and regulatory and legal compliance.
Certainly, this scenario is more likely to bring seller comfort. Regardless of leverage, however, parties disagree and, therefore, parties should always carefully consider and negotiate audit procedures and dispute resolution provisions around the earn-out. In an effort to make such audits easier and to reduce related disputes, buyers often maintain the acquired business as a standalone subsidiary or division for the duration of the earn-out period. This is sound business practice.
As Ian mentioned in his November 26, 2010 installment, earn-outs are certainly once again ripe for discussion given future prospects as global economic conditions gradually improve. As you can imagine, the variations of earn-outs are limited only by your imagination. Feel free to contact me at email@example.com or (617) 951-9097 with questions or comments on this or other M&A topics. In the meantime, happy structuring!
Timothy R. Bowers
K&L Gates LLP, Boston
This contribution is for informational purposes only and does not contain or convey legal advice or necessarily express the views of K&L Gates LLP. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting with a lawyer.