|"Earnout Implications: Implied Obligations are Making Buyers Second Guess Performance Based Deals"
May 1, 2010
It's generally understood that in a perfect world, there would be no need for buyers and sellers to structure transactions with an earnout provision. In today's far from ideal M&A market, however, dealmakers are more frequently calling on these provisions to help bridge the gap
between buyer and seller expectations. While both sides probably feel pretty good about the earnout if it helped clear a hurdle otherwise preventing a close, it may not be long before the earnout becomes a source of dispute.
The historic tension between buyers and sellers relying on earnout provisions relates back to the role of the acquirer once the deal is completed and their responsibility regarding the performance of the assets post close. If the benchmarks aren't met, depriving sellers of expected payouts, the sellers will argue that the buyer didn't do enough to ensure the earnout was met. Every few years a new case pops up that provides a precedent for earnout structures.
In 2007, for instance, AmerisourceBergen Corp. was on the losing end of a decision in which the company was blamed for a missed earnout that the courts ruled was owed Bridge Medical's former shareholders. AmerisourceBergen acquired Bridge in 2002 through a $27 million deal that included the possibility of another $55 million payout if Bridge hit certain benchmarks. Bridge failed to reach the specified milestones, but the court ruled that AmerisourceBergen had failed to actively "promote" and "market" Bridge's current line of products and services. While there may be some debate around the definition of active promotion, the contract did stipulate that the buyer had to make an effort on behalf of the target. Two new cases, however, has lawyers taking a second look at earnout provisions because the courts ruled that such a duty can be implied.
When PerkinElmer Inc. acquired Sonoran Scanners in 2001, the buyer paid $3.5 million, and included an earnout that could double the value of the deal should certain performance milestones be met. The buyer even hired the company's founder, and included an incentive laden contract that outlined as much as $6.6 million in bonuses if the company surpassed other specified targets. Sonoran, which manufactured computer-to-plate printers, managed to sell only a single unit under its new owner, and three years after the deal, the business was shuttered. Sonoran's founder, in a subsequent lawsuit, claimed that PerkinElmer had an "implied obligation to exert reasonable efforts to develop and promote" the acquired assets. Since a provision obligating the buyer to put forth reasonable efforts was not included in the original purchase and sale agreement, Sonoran successfully argued that such an obligation is implied. PerkinElmer was granted summary judgment by a Massachusetts district court overseeing the case, but the First Circuit Court of Appeals overturned the decision, citing an earlier precedent set by the Supreme Court of Massachusetts involving intellectual property and licensing agreements. The ruling, according to David Denious, a partner at law firm Dechert LLP, has "the M&A bar buzzing," especially given the popularity of earnouts recently.
Denious says the ruling could make it more difficult for buyers and sellers to negotiate around an earnout, since acquirers are going to be more careful about including disclaimers that make them immune to similar claims.
"Earnouts ultimately come down to control. The seller is linking their payout to a business in which they no longer have a voice," Denious says, adding that now buyers are being forced to document in the agreement that not only will the sellers not have any control, "but now [the buyers] don't even have to try."
The Sonoran case is not the only example. According to a recent client note from law firm Debevoise & Plimpton, a similar ruling unfolded in Ohio. After NA Management Corp. acquired a subsidiary of Eggert Agency, the seller sued the acquirer on claims that job cuts and the elimination of a key office prevented the target business from reaching specified milestones. Moreover, the seller also claimed that the buyer converted the clients to its own technology platform. Again, there were no provisions dictating the buyer's obligations, yet the US District Court for the Southern District of Ohio ruled that they were implied.
Deal pros, however, don't necessarily believe that the rulings will dissuade buyers and sellers from using earnouts. Deborah Hong, a partner in the business practice group of law firm Stradley, Ronon, Stevens & Young, notes that she is currently working on two separate deals that incorporate earnouts and that, by and large, she is still seeing more and more instances in which buyers and sellers use the provisions to close a gap. Still, she cites that generally, these clauses are "one of the sensitive areas of negotiations."
Generally, she says, it is easier to execute when buyers are dealing with a set of assets that will remain independent post close. This eliminates the potential for dispute around attribution and where, specifically, revenue was derived. Moreover, she adds that it helps if existing management stays on with the asset, which precludes some of the fights that tend to erupt over control.
Another area that can lead to disputes relate back to the accounting methods of each party. She says that precision is important in this particular area so both sides are on the same page as it relates to the definition of Ebitda.
This issue also came up in the AmerisourceBergen/Bridge Medical case. Hong says that she will not only specify accounting metrics, but also develop formulas and provide examples to eliminate any confusion over the math.
A new trend Hong is seeing is the use of call options, which can limit buyer risk since it allows them to buyout the earnout ahead of schedule if it looks like the target is going to surge past the set milestones. This can make the accounting easier too, especially if the earnout is extended out multiple years.
From the sellers' perspective, more earnouts are being negotiated with change in control accelerations. If sellers are already worried about control when they choose the acquirer, it's only natural that if the buyer gets sold or decides to unload the asset, they'll seek protection. Hong adds that seller counsel is increasingly thinking about buyers' credit worthiness, and in some cases, attempting to force buyers to put money aside in escrow.
Meanwhile, as the lawyers may fret about the details of an earnout, buyers and sellers will continue to turn to the provisions to help bail them out of an otherwise unbreakable impasse. To a lot of dealmakers, that's worth the risk of litigation that may occur three or four years down the line.
Doug Nakajima, a managing director at consultancy LECG, notes that at the end of the day, buyers aren't going into a deal with designs on side-stepping an earnout. The provisions are used because they offer protection to the buyers, who may be unsure about a sellers' projections. In most cases, the acquirer wants to pay the earnout because it generally means the acquisition met its objectives.
"It can save the deal," Nakajima says. And that's what makes it so valuable in an uncertain market. "It allows both sides to get the value they think they can get," he says.
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