Good afternoon, everyone, and welcome to this joint presentation by Oaklyn Consulting and Smith, Gambrell & Russell on selling a privately held business during the COVID-19 pandemic: opportunities and risks in using earn-outs.
Our webinar is view-and-listen only. However, at the bottom of your screen, you will find a button to pose any questions, and there will be a Q&A session before we conclude. A recording of this webinar will be posted at the Insights link at sgrlaw.com approximately 24 hours after we conclude. We will conclude by 1:15 PM.
Our commentators are Frank Williamson and Jonathan Minin.
Frank Williamson is the Managing Partner of Oaklyn Consulting, a mergers, acquisitions, and capital-raising consulting firm that serves closely held businesses, mostly with less than $50 million in sales. He has advised on more than 100 transactions worth over $7 billion in enterprise value.
Jonathan Minin is a partner in the Corporate and M&A departments of Smith, Gambrell & Russell. He has over 32 years of experience in a wide range of M&A transactions on both sides of the transaction table, across numerous industry sectors and during a broad spectrum of economic conditions.
Our presentation has been tailored for senior business executives and those who are both owners and executives of their companies and who may be relatively unfamiliar with earn-outs, so our focus will be on practical considerations for the executive rather than technical legal matters.
As one disclosure matter before we begin, this webinar is provided for general information purposes only and does not constitute legal or professional advice. No users should act on the basis of any material contained in the webinar without obtaining proper legal or other professional advice specific to their situation. No attorney-client or professional relationship is created by any person’s viewing of this webinar.
Again, thank you for joining us, and I will now pass this program over to Frank Williamson.
Frank Williamson:
Well, thank you, everybody, for joining, and thank you, Jonathan, especially for having me be part of this webinar, and to Granelli and Lee at Smith, Gambrell & Russell for making all the logistics and materials come together.
It’s a pleasure to talk a little bit about this topic, which is an important one in the kind of year that we’ve been living through, when we went from reasonably stable times to unstable ones quickly.
If, Granelli, you would go to the next slide, we will begin.
So, as Jonathan and I were talking about a topic that might be interesting to people, what came up repeatedly is the idea that in an uncertain time people still try to get deals done, and when it’s hard to tell what the future is, the way to get that done is to share risk.
Obviously, people make deals by bridging their differences and finding ways, sometimes by just pushing decisions into the future, to have agreement on what can be agreed and agree to disagree on what can’t.
If you go to the next slide.
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What we have seen professional investors do in this market, and also strategic acquirers, is try over the course of the spring to say, look, we’re going to see if, where we were talking about a deal price beforehand, we can keep that price the same but change the structure in the deal.
So what do people mean by structure? Well, they mean some way to have some kind of provision that helps us decide final deal terms in the future.
So here are a few examples on the slide on the screen now. You could pay part of the purchase price as clients transition over to the new entity if there’s some risk that some won’t. Otherwise, you could have a seller take back a note. You could have post-transaction compensation that’s relatively big and a sale price that’s relatively small. You could have an earn-out, our topic today. You could have rolled equity.
Other examples, this is not a complete list of what structure would be. All of them create value, and they help people reach agreement about deal terms, but all of them create complication and there is something left undecided that has to be managed in the meantime.
And so on the next slide we frame it up a little bit in the case of an earn-out.
So earn-outs have to do with earnings, and the idea is that rather than all the price being paid on the closing date, some of it will be contingent on something that happens about earnings in the future.
Broadly speaking, this picture of an income statement: simplicity is the seller’s friend, because it will have to be something tracked over time. And the closer you are to sales, the more simple it will be. The more line items on the income statement that have to be kept track of and have to be managed could be potentially manipulated, maybe in good faith, maybe by accident, maybe not in good faith. All those extra layers of complexity make it harder.
And I will at this point turn it over to Jonathan to talk about how do you avoid some of the risks that go with this extra complexity.
Jonathan Minin:
There we go. I needed to let off the mute button.
Frank, thank you very much.
COVID-19, as Frank was saying, presented a unique challenge in valuations. Many businesses are substantially underperforming from levels in past years, and buyers don’t want to pay for historical results that may not return. Sellers, on the other hand, don’t want to sell based on a price calculated on COVID-19-impacted performance. And earn-outs are that bridge, as Frank said.
Used correctly, they provide an opportunity for sellers to get to the other side of the pricing divide and receive more money. But the risk is that they do not work as intended and the bridge is shorter than the distance to be traveled, and then the seller finds itself having sold the business at much less than they desired.
Lee, if you could advance us to the next slide.
Thank you very much.
So what an earn-out really is, at its core, is a risk allocation mechanism. Who is going to bear the risk of the performance of the business after the closing has occurred?
But the goals are often not the same between buyer and seller, because what the buyer wants to do, in general, is they know they’re going to pay at closing, but they’d really rather not have to pay any more if they can help it. On the other hand, the seller takes the opposite view. I’m going to close on the price I get, but I’m really not thrilled about that, and I want the price that’s going to come from the earn-out.
So the goals are often different. But one thing is for certain, and that is that the seller will get paid less at closing in exchange for the expectation, the hope, of being paid more later. So the agreement of purchase and sale must be drafted with great care to protect the seller’s expectations of additional purchase price payments during the earn-out period.
And if you look at a classic bell curve, you’re going to find somewhere around 12 to 24 months is going to be kind of the tall part of that bell curve. But as Vice Chancellor Laster of the Delaware Court of Chancery said a number of years ago in an opinion, an earn-out often converts today’s disagreement over price into tomorrow’s litigation over outcome.
And litigation is a place that nobody in business really wants to be, and it needs to be avoided.
Now, sellers ought to know their business better than anyone, and so they should consider that business broadly and consider all of the various factors that go into an earn-out calculation and those metrics, and be sure and communicate those to your professional advisors so they can draft the agreement carefully.
Because the agreement of purchase and sale, whether it’s going to be an asset transaction, a stock transaction, a merger, whatever it’s going to be, needs to be drafted with great care to protect the seller’s expectation of those additional payments.
And buyers can and do play games to do an end run around the earn-out if the flexibility allows them to do that. It may not be with any animus, although sometimes it is, but people are going to do what they are allowed to do and will act in their own best interests.
Now, sometimes people say, well, we’re going to rely on the implied covenant of good faith and fair dealing to make sure that the buyer does the right thing. However, what most people don’t realize, unless they’ve been in this area before, is that that implied covenant of good faith and fair dealing is not all it’s cracked up to be. It’s not as broad and it’s not so terribly easy to prove. So it’s best not to rely on that to protect the seller’s expectation.
Lee, if you could advance please.
My advice: negotiate it now, because you’re likely not going to be able to negotiate it later.
Now, I represent buyers and I represent sellers, and have for many years now. This presentation is going to primarily be from the perspective of the seller. But if any of you joining us today are from the perspective of the buyer, this will at least give you some insight on what may be going through a seller’s mind.
What I’ve advised sellers in other presentations and webinars and whatnot is your maximum point of negotiating leverage is going to be at the letter of intent stage and typically goes down from there. That’s something Frank and I have talked about before.
And while you don’t have to put the whole agreement in the letter of intent, and obviously you’re not, if you’ve got key important earn-out provisions, at least conceptually think about trying to get them in the letter of intent, because that will give you the ability to have a stronger negotiating point later when your counsel and your advisors are negotiating the definitive purchase agreement.
So now, if you could advance this please.
One of the things to consider when you’re trying to protect that earn-out is just what are going to be the post-sale rules of operation. And here there’s a bit of a catch-22. Earn-out provisions that are drafted generically, without precision and without careful thought, may appear to protect the seller, but in reality they can also provide to the buyer the roadmap on how to evade the earn-out payments. It gives them the roadmap, and it can give them the flexibility if the agreement and provisions for earn-out are not drafted carefully.
Lee, please, next slide.
Now, here are some examples of what can happen.
The buyer accelerates by prepayment various expenses that normally would be paid after the earn-out period is over into the earn-out period and reduces profitability as a result.
Buyer seeks out exceptions to the historical method of depreciation and amortization to front-load those into the earn-out period. This would be relevant if the earn-out is done on an EBT or EBIT basis rather than an EBITDA basis.
Sellers should ask themselves, what really will be the accounting methodologies for purposes of calculating the earn-out, because they don’t have to be the same as accounting for tax. They are two different calculations. So just what are going to be the accounting methodologies?
Now, sometimes people say, well, we’ll just do it in accordance with GAAP, generally accepted accounting principles. However, that in and of itself is probably not sufficient because GAAP itself has some flexibility.
The other thing that happens is that buyers who are unrestrained could throw money at third-party disputes rather than negotiating better deal terms. What could those disputes be? They could be disputes over accounts receivable. They could be product or service liability disputes. They might be employment claims. But the buyer would have an incentive to say, let’s get this resolved during the earn-out period, because if we can throw money at this problem and make it go away during the earn-out period, again, depending on how much flexibility they have on the earn-out provisions, it could be that the seller winds up underwriting that resolution by having these charges go against earnings or other earn-out metrics and therefore defeat the earn-out.
Now, on the next slide, please.
Let’s say that your earn-out is based on gross sales, that the buyer has multiple divisions and reroutes those sales opportunities to another division or cuts your business’s marketing budget. Let’s say they offer a customer a substantial discount during the earn-out period in exchange for full pricing and committed business after the earn-out period.
Ask yourself this question: why is my business being purchased? Is it to grow the business? Is that what the buyer’s intention is? Or is it to remove competition from the market?
There are stories that Microsoft did this a number of times, that if there was an application out there that competed with a Microsoft application and Microsoft viewed that as a threat, they would go and buy that business. They didn’t buy that business to grow that application. They bought that business to kill that application. What would happen is the installed customer base would get a notice that after such and such a date we’re no longer going to support this application, and, oh by the way, it won’t be supported in the next version of Windows, but we just so happen to have a Microsoft application that will suit your needs just fine.
And ask yourself, will the business be starved for support? How do you make sure that doesn’t happen? And will key employees be retained and will they be properly incentivized by the buyer?
Let’s say that the earn-out is calculated after overhead charges are deducted. This could be an EBITDA earn-out or an EBT or an EBIT, and the buyer saddles the acquired business with a large corporate SG&A expense. The sellers can find themselves saying, you know what, we ran our numbers before the closing and if things had gone the way they should, we would have gotten the earn-out, we would have met those metrics, but here comes the buyer who has saddled us with this large corporate SG&A expense and that throws our calculations all out of whack, and in fact we’re not going to get the earn-out at all. How did that happen? And those are the kind of things that do occur.
Lee, please, next slide.
Frank mentioned this: try to keep things simple if you can. And by simplicity, I mean earn-out metrics that are well understood and therefore the drafting can be done and the negotiation can be done to try to defend the integrity of the earn-out.
Consider ways that a buyer could defeat the earn-out and draft language to close off or limit those buyer strategies. For example, who’s going to have control of the business levers that can affect the earn-out, things like the amount of marketing support, incentives and incentivization payments to key employees, the SG&A allocation, as I mentioned earlier. What about intercompany transfer transactions?
Consider this scenario. Let’s say that the seller’s business was selling to the buyer before closing. Those were done on an arm’s-length negotiated basis. Now the seller’s business is part of the buyer’s organization, and those sales are going to be intercompany sales. How do you make sure that the integrity of the pricing remains the same? Or if it’s done at the last price for intercompany purposes, at least for the accounting of the earn-out, the fair market value is used?
How will revenue recognition be handled? What about treatment of follow-on acquisitions and divestiture expenses?
Consider this. The buyer does a lot of deals. He’s bought your company now, they’re going to do another deal. Well, who’s going to be the buyer? Well, maybe they want to push the acquisition into what was your company. So now all of those acquisition expenses get pushed into your company, depresses earnings for the year or the period of the earn-out, and now you find yourself frustrated and not getting your earn-out.
How will accounts receivable aging be handled? I had this come up last year. The buyer tried to negotiate a provision that said after 90 days AR would be valued at zero. Well, it just so happened that in my client’s business it was very normal in that industry that accounts receivable were paid often on 120-day terms. There was nothing wrong with the credit risk of their customers. That’s just the way that business worked.
And so you want to have a situation where you can control and constrain the ability of the buyer, particularly obviously for most companies you’re on an accrual basis, to take a charge against earnings because of writing down accounts receivable.
Make sure that the earn-out provisions in the agreement of purchase and sale are drafted very precisely and comprehensively. The goal, as I said before, is to limit the flexibility of the buyer to defeat that earn-out.
Ask this question: what happens if the business or its assets are sold before the earn-out period has concluded? What happens at that point? If nothing is provided for, you could find that your earn-out is now controlled by a party you don’t know and you didn’t negotiate with.
Consider the possibility to treat it much like a loan with a due-on-sale clause, that if the buyer decides to flip your business and it’s still during the earn-out period, your earn-out gets paid. That would be a situation where you would have the earn-out accelerated. Or if the buyer refuses to accelerate the earn-out, at least try to consider the possibility of asking a parent company to guarantee those earn-out payments if that business is subsequently sold to a third party.
Lee, next slide please.
Other ways that sellers defend the integrity of the earn-out: obviously post-closing covenants are absolutely critical, especially if the seller is going to be ceding operational control.
Now, many of you are probably familiar with a covenant that says that the buyer will conduct the business in the ordinary course and consistent with past practice. But what does that really mean? It’s a common phrase, but what does it really mean?
So let’s say that in my prior hypothetical, the buyer goes and does an M&A transaction and stuffs your business with a lot of transaction expenses, and the seller comes back and says, well, wait a minute, that was outside the ordinary course of business. The buyer comes back and says, what are you talking about? You have a whole history of investing in your business. You do all kinds of things to invest in the growth of your business, and you have for years. That’s why we were interested in it. And by the way, you’ve also done M&A. You did one with us. So how can you complain that our doing an M&A transaction is somehow different?
Now, maybe they’re right. Maybe they’re wrong. But where does that lead? That leads you to what Vice Chancellor said. It leads you to a dispute. It leads you into litigation, and that is guaranteed to be an unhappy place for pretty much everybody.
And provide for a method of verification and remediation so that the seller’s expectation of earn-out payments are more likely to be achieved.
Consider this as part of post-closing: will the seller’s business be kept as a separate operation, or will it be amalgamated with the buyer’s existing business? And if it’s the latter, will pro forma accounting financials be done, and if so, what elements will be included and excluded from the calculation?
Also consider this: is the earn-out going to be based on a cliff effect? Will it be all or done? In other words, if you don’t meet the earn-out metrics in whole, then you don’t get the earn-out at all. That can be pretty risky because it incentivizes the buyer to say, well, let’s run a good business but not quite to the earn-out threshold.
What makes a lot more sense, if you can negotiate it from the seller’s perspective, is a sliding earn-out scale so that if you reach 80 percent of an earn-out metric, you get 80 percent of that earn-out.
What are the consequences of the breach?
Earlier in my career I was a business litigator. There is a difference between showing breach and proving breach, and there is an entirely different thing about proving damages. And even if you can show that the buyer was in breach, the next phase is to prove damages. And what a good buyer’s litigation attorney is going to say and argue is that now wait a minute, okay, you’ve been able to prove breach, but how do you know that the business would have performed well enough to achieve the earn-out? You’re engaging in speculation. There could be all kinds of other reasons that might not have resulted in the earn-out being paid, and therefore your damages are speculative.
And as some of you may know, speculative damages are often not recoverable.
So what’s the alternative strategy? It is to negotiate liquidated damages. If the seller is able to prove, and again if we have the unfortunate situation of litigation, which could be litigation, could be arbitration, if the seller is able to prove that the buyer breached the earn-out provisions, then the consequence of that is the earn-out gets paid. No further proof is necessary.
Now the advantage of doing it that way, of course, is that you don’t have to prove damages, but the other advantage is it provides a very powerful economic disincentive for the buyer to play games with you, because they realize if they get caught with their hand in the cookie jar and the seller is able to prove that they breached the earn-out provisions, they’re going to wind up having to pay that earn-out.
So I hope this has been of some help in bringing up some of the issues.
Frank, some comments from you, and then we can ask if some questions have come in.
Frank Williamson:
Jonathan, I think your advice is really good and around this overall theme of how do you get to agreement leaving as little disagreement about business terms, and obviously also legal terms, as possible at the time that you’re first doing the deal.
It does take boring into more specifics than people often think is necessary, and I think you highlighted such good points about exactly defining what are the measurements.
It’s not common in the negotiation of the business terms to end up with situations in which you say, well, exactly what do we mean by revenue recognition, exactly what are the accounts on the income statement and how do you account for them, exactly how we count my client versus not my client for the purposes of the earn-out. Those things are often taken a little bit for granted, and this is just how we normally do our bookkeeping and our metrics for the business.
And I think that once an earn-out is the solution to bridging differences, people are well served, both on the business terms and the legal terms, by playing out the sometimes even painful levels of detail of what do people mean by the words that they’re using.
Jonathan Minin:
Thanks very much.
As it turns out, I can actually see we did have a question come in.
Frank, I’ll go ahead and pose that to you. During the COVID crisis, are you seeing earn-outs less than 24 months? Have you run into any deals like that, or at least discussions of potential deals like that? And what is your thought on an earn-out less than 24 months?
Frank Williamson:
The answer is I haven’t seen them yet, and I would be surprised at this point if I did see one where someone was pushing for 12 months.
The goal people have tried to do is how do we push the determination of price out in time to the other side of this health event and the economic dislocation. And so maybe in March or April someone would have said, well, 12 months, we’ll be on the other side of it. But I think where we sit now in August, with what we’re seeing around the country and the globe, to say yes, we’ll be able to come to terms in August of 2021 about how the business really performs, that seems unlikely to me.
And that a longer earn-out rather than a shorter one is probably what we need to grapple with, and that just adds complexity versus being a short earn-out period. It is longer that the businesses need to be segregated, longer that management needs to think about two operations, longer that you’re relying on someone else to do the measuring for you if you’re a seller.
And so it is adding complexity when we want to create simplicity. So I would love to see people attempt less than 24 months, but I’d be surprised if that’s in much discussion right now.
Jonathan Minin:
Right. And I would agree with that.
One of the things that we don’t know, and I think we’ve all heard in the news that we’re all waiting for a vaccine, and please, good Lord, we will get a vaccine, but the reality is that that vaccine is not going to be available to everybody immediately. It’s going to take time to get through the economy and for people to resume a hopefully normal life.
And I think that goes to the idea of exactly what you’re saying about it could take some time to get through this.
You know, we’re all having to do these virtual webinars now, but one of the nice things is the ability of participants to come in with good thoughts of their own, and I’ll share one that came in in the Q&A. It’s a really good point. I’m going to share it with the rest of the participants.
The guest here said, do buyer due diligence. If you’re going to be looking at an earn-out, that previous people injured by the high jinks of buyers when they’ve done other deals, those people who’ve been injured will usually be pretty happy to share their experiences.
So perhaps buyers always do seller due diligence, but as this particular participant I think wisely pointed out, if you’re a seller and you’ve got an earn-out, this is probably not a bad time to do some due diligence on the buyer and see what other targets have experienced with the earn-out and have they been standing up about it.
So thank you to the participant who shared that with everybody. I was pleased to share it with the group.
Frank Williamson:
You know, Jonathan, you’ve mentioned often in our conversations the importance of people, even if there is an earn-out, realizing that the price they get at closing really is what they need to be satisfied with in the end.
And I think this good point about buyer diligence does just bring to mind that if people aren’t clear, if people aren’t happy with just the closing price, in unfortunate situations it’s a good time to invest in making sure that you are clear about your no-deal options, because it can be a long way through the negotiation, at the final details, or after, when you discover that your buyer is not what you hoped.
And so a great deal can be done in diligence, but a lot is just living with people effectively over two or three years when you really wanted to go do something different.
Jonathan Minin:
That’s correct.
And toward that point, and I think it kind of comes off this particular participant’s comment, is to realize that obviously we don’t know what the future holds. And if you’re not really comfortable that the buyer is going to have the ability to actually pay the earn-out even if owned, is to consider what type of protection mechanisms need to be done.
For example, an upstream parent guarantee, or in extreme cases maybe even a standby letter of credit if necessary. Because remember, as a seller, when it comes to the earn-out, you are an unsecured creditor.
So that bears keeping in mind, that if things go really badly for the buyer, if they’re actively or through accident, when it comes to that earn-out payment, you’re an unsecured creditor unless you’ve made some arrangements to the contrary.
So I think that looks like we had one more question come in. Let’s see if I can pull that up.
This question was: buyers push back on conditions to earn-outs with the statement that they would not be buying the company if they weren’t intent on its success post-closing. What is the comeback to get the appropriate protections?
Well, that’s a really good question.
Franklin, why don’t you go ahead and answer, and then I’ll chime in as well.
Frank Williamson:
It’s always good to have 50 comebacks to these things, isn’t it?
Good fences make good neighbors is my standard.
Well, that’s right. And I think the issue is to respond very politely and say, yes, we know you’d like to see this business do well, but for a lot of people who are sellers, they have duties to others, other investors in the company. And even if this is a really closely held business, you can say, look, I’ve got responsibilities to my family. In a larger business, you might have other investors, and I have responsibility to them.
And yes, you can tell me now that you want the business to grow, and I accept that that’s your intention now, but what we don’t always know is how the future unfolds. And so my duty as a good steward of this organization is to make sure that the document is negotiated and documented so that there are appropriate protections. That’s the way I would address something like that.
Jonathan Minin:
So I think that’s taking care of our questions. Again, thank you all for coming.
Lee, I’ll pass this back to Cornell to wrap things up.