How to Get Deals Done in a Changing Marketplace
If a buyer and seller cannot agree on the valuation of a target company because their respective estimates of its future earning potential differ, an earnout can often bridge the gap by making a portion of the purchase price contingent on the target company’s achievement of defined objectives. If a private equity buyer intends to retain a company’s management stockholders, an earnout will not only help address the valuation gap but will also serve as an additional incentive for the management team to enhance the company’s value post-acquisition. In addition, earnouts reduce the amount of consideration required at closing and thus minimize and may even eliminate the need for third-party financing.
However, not every proposed acquisition with a valuation gap is ripe for an earnout. For example, earnouts are difficult to structure and administer if the buyer intends to integrate the acquired company into an existing business. They are also not very attractive if the buyer intends to introduce new management, revise business strategies, or make operational improvements and does not want to share with the seller the potential value associated with its own efforts.
Even if an earnout makes sense in a particular transaction, both buyer and seller will need to make some sacrifices. The buyer will likely be required to give up some control over the company post-closing because the seller will insist on regulating the operation of the business through restrictive covenants or veto rights to protect its earnout potential. The seller, on the other hand, will need to forgo a portion of what it may deem to be a fair price at closing and settle instead for the opportunity to be compensated later if the business performs well. And both parties will have to endure the added complexity and negotiation that inevitably accompanies an earnout and accept the potential prospect of a protracted post-closing dispute over whether and to what extent earnout payments are due.
If the parties decide to proceed, threshold structuring issues will include the measurement criteria and the time period over which the measurement will take place. Sellers typically prefer top-line metrics (e.g., revenues) because they are less prone to manipulation, while buyers prefer bottom-line measures (e.g., EBITDA) because they more accurately reflect value. The duration of an earnout is typically one to three years.
In any event, sellers will want to ensure that the business is operated to maximize the earnout metric. The buyer, on the other hand, will not want to limit its control, especially if it wants to integrate the target into its other businesses or alter the target’s operations. This is a delicate balance and there are varying outcomes, ranging from narrow covenants or veto rights to extensive governance provisions permitting sellers to be involved in the day-to-day operation of the business.
Buyers considering use of an earnout should note that Delaware law’s implied covenant of good faith and fair dealing may, regardless of whether sellers have any contractual protections, prevent a buyer from taking actions that would limit the earnout metric. In Horizon Holdings LLC v. Genmar Holdings Inc., the court held that this Delaware standard meant the buyer could not take actions in respect of the acquired company that would interfere with the management sellers’ ability to achieve the earnout (e.g., changing product names and marketing, shifting production priority, discontinuing certain products or shutting down manufacturing facilities), even though the agreement did not expressly provide sellers with rights with respect to such actions post-closing.
If the earnout is treated as deferred purchase price, i.e., sales proceeds and not compensation for future employment, the earnout payment (aside from an imputed interest component) will generally be taxed at capital gains rates rather than as ordinary income and would not be deductible by the company. Where management sellers will be working for the buyer post-acquisition, the sellers will try to ensure that the earnout payments are not subject to forfeiture for termination of employment to avoid characterization as employment income. Buyers will usually take the opposite view.
For U.S. federal income tax purposes, the “installment method” generally applies to gain attributable to earnout payments unless a seller elects out of such treatment in the year in which the acquisition closes. Under the installment method, a seller generally would not recognize the deferred portion of the purchase price unless and until it actually receives the earnout payments.
The accounting treatment of earnouts was modified at the end of last year to require a “fair value” of cash earnouts. Under FAS 141R, future earnout payments to be made in cash, other than those treated as employee compensation, must be assigned a fair value at the time of closing and fully recognized as a liability at that time. Subsequently, the value of the earnout must be remeasured at each reporting date, and will effect earnings in that period to the extent of any fluctuations in the estimated value. In contrast, under the old accounting regime, an earnout liability was not recognized until the contingency was resolved, and there were generally not any interim impacts on earnings or liabilities.
Another form of consideration seen more frequently these days is a seller note. A seller note will typically bear interest, payable in cash or in kind, at a rate similar to that of a bridge loan or a high yield security. The note will usually not amortize, but instead will be payable in full at maturity (a so-called “bullet” payment).
Seller paper is often unsecured and deeply subordinated to other indebtedness of the acquired company, including any third-party acquisition financing. Payments on the note will usually be tightly restricted, with debt service permitted only for so long as there is no default under the senior debt. However, in certain circumstances (e.g., if seller paper represents a significant portion of the purchase price), the debt may more closely resemble third-party financing and sellers may have additional rights, such as transferability, restrictive covenants and cross-default or cross-acceleration provisions.
Sellers may tolerate payment limitations for a period of time, especially where there is an attractive interest rate, but they may require the buyer or the acquired company to agree to substitute alternate financing for the seller paper at a specified future date or press for the inclusion of other mandatory redemption rights (e.g., upon a change of control). Sellers may request the right to be prepaid if there is a change of control or initial public offering of the issuer. A buyer may want the right to convert the loan into company stock if it is not able to arrange for substitute financing within a required time period.
Depending on the structure of the transaction and the characteristics of the seller note, this form of consideration may provide a seller with installment method treatment for tax purposes and thus the advantage of deferring gain with respect to the portion of the purchase price represented by the note, subject to certain applicable tax limitations.
The parties may instead prefer to use target company stock (or the stock of an upper level holding company) as part of the deal consideration. For example, this structure could be preferable if the buyer wants to reduce overall target company indebtedness. However, a seller should be aware that the equity interests likely will be subject to significant transfer restrictions.
Rollover equity can take different forms, ranging from common stock with few rights to preferred stock with a special dividend rate and perhaps mandatory redemption provisions. Where a seller’s equity stake in the acquired company is substantial (at least 10-15 percent), a seller may obtain governance rights such as one or more board seats or veto rights with respect to extraordinary transactions.
When rollover equity takes the form of buyer’s stock, tax structuring often becomes crucial. Unless the transaction qualifies for tax-free reorganization treatment, the sellers generally will be subject to tax on the shares they receive even though these shares may be illiquid or subject to transfer restrictions, and taxable gain triggered by the receipt of such consideration would not be eligible for deferral under the installment method. The sellers may insist on a structure that qualifies for tax-free treatment, but this may run counter to the buyer’s tax objectives (e.g., the desire to obtain a step-up in basis).
Although the current market is challenging, there are strategies available to buyers and sellers to help overcome the many hurdles. While it is of course difficult to predict how long present market conditions will prevail, one thing is clear: Creativity in deal making will be at a premium for the foreseeable future.
This article was written by Kevin A. Rinker, partner and Meir D. Katz, associate, Debevoise & Plimpton LLP and appeared in The Deal.
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