IntroductionThe structuring of acquisitions in New Zealand has come under more scrutiny in recent times as Vendors and Purchasers take a more cautious approach to buying and selling businesses where there is uncertainty of future profitability. A new mechanism that we have found is gaining in popularity is the use of an "earnout" or "contingency price deal".
The earnout mechanism is a useful and versatile tool to bridge the differing expectations of price between what a Vendor thinks their business is worth and what a Purchaser is willing to pay. However, as always, the devil is in the detail, and it is important that an earnout mechanism is well thought out and carefully structured.
What is an earnout?An earnout is a mechanism in which part of the purchase price is contingent upon future performance of the target business. A typical earnout might include payments to the Vendor every year for three to five years based on a percentage of the revenue or the profit of the target business.
Why are earnouts used?Earnouts can bridge the gap when the Purchaser and Vendor cannot agree on price and terms. The parties often have different views about the degree of certainty of achieving future objectives and the value of the target business. Earnouts allow the Vendor to receive full compensation for creating value, especially if much of the value has yet to be realised and the Purchaser is unwilling to pay the total amount up-front. It also reduces the risk to the Purchaser in that the Purchaser only pays the earnout if performance objectives are met.
The earnout mechanism is useful because even where the profits and revenues of a business may be minimal or non-existent. Vendors will often have high expectations of their businesses worth. An earnout is a way for Vendors to obtain a higher purchase price by proving the market value of their business to the Purchaser post completion of the acquisition. It
also indicates to the Purchaser that the Vendor believes in the future profitability of the business. In short, it shows they are prepared to put their money where their mouth is.
Even if parties don't end up agreeing on an earnout mechanism, discussions around an earnout can be fruitful. Exploring a possible earnout will flesh out many issues in more depth than might otherwise not be discussed. These discussions may bring the parties closer together on price.
When should an earnout be used?Earnouts are most often used when at least one of the following is true:
The Purchaser and Vendor can not agree on the purchase price; The Purchaser has not done due diligence or is not satisfied with the results of due diligence; The Vendor plans to continue working for the business post completion and the earnout mechanism is a useful motivating tool; The performance of the business is linked to retaining certain key customers or suppliers and the Purchaser does not want to take the risk that a change in ownership of the target business would lead to the termination of those contractual relationships; The Vendor is about to introduce a new product line, or enter a new market and the success of the new product is uncertain; The parties are expecting major new contracts to be entered into by the business but there is still an element of risk that these might fall over; The business has been recently losing money contrary to past historical performance. Pitfalls/ProblemsThe biggest problem with the earnout is structuring the mechanism so that both parties incentives are consistent and compatible. That is, that both parties gain as the value of the business increases. Often parties take a short-sighted view of their own interests. A poorly structured earnout arrangement can incentivise the Purchaser to operate the business post- completion in a suboptimal way, so as to decrease the operating revenue and thus the earnout payments. Conversely, the Vendor (particularly if they are still part of the management team) may manufacture a situation where profits or revenues are stacked into the earnout period (and thus increasing the earnout payment) but this may be detrimental to the business in the long term.
Another drawback with earnouts in the technology sector is that the acquired business is often partly or wholly integrated with
the purchasing company post completion, making earnout measurements more unwieldy and difficult. Earnouts should not be used when the operations are tightly integrated and are most successful when the business being sold continues to be
independent after the acquisition.
Definition problems can also plague the earnout mechanism. No matter how well drafted an agreement is one can not think of all the contingencies. The first major stumbling block is to determine what criteria should be used for the basis of the earnout.
Another problem with the earnout mechanism is that the structuring of an earnout may change the character of a payment, which may ordinarily be considered to be capital in nature (e.g. goodwill) to that of revenue (i.e. taxable). Such a consequence can be expensive for the Vendor since it will be liable for tax on an amount which it might have expected to be
capital. The risk can be diminished, but it should be borne in mind that the reclassification of payments is a risk that arises in relation to earnouts.
Two of the most commonly used criteria for determining earnouts are sales (revenue) and profit. Revenues are the easiest to compute and are less likely to be affected by accounting practices. Profits are more difficult to calculate and define.
Post-completion involvement can also pose problems. The Vendor must negotiate how much control it is to have over the business post-completion. They are no longer the owner, and the Purchaser may take actions that could adversely affect not only Vendor's ability to receive the earnout but also the level of the earnout. For example, if the earnout is based on the present level of profit and the Purchaser wants to spend large sums on research and development, then this would decrease the present profit and thus the Vendor's earnout. However, if this strategy leads to higher profits in the future, even though it is outside the earnout period, the Purchaser may be justified in making such an investment at the expense of the Vendor.
This implies that otherwise reasonable business decisions - such as research and development expenditures, advertising, and long-term investments - could lead to major conflicts between the Vendor and Purchaser under an earnout agreement.
In determining profit level, the costs that are included can also greatly affect profit and thus earnout. How is operating income or profit calculated? How are net sales defined? Should depreciation or non-recurring events affect the measurement?
Rules Earnouts can be based on revenues, operating income, development goals, or any number of factors. The performance goals should be obtainable, not pie in the sky. Graduated payments are better than an all-or-nothing scheme. Use easily measurable milestones. Make sure the calculations for the earnout formula are straightforward. Commit to a budget upfront. Put a time cap on the earnout. At some point operations will become integrated and it will make sense to eliminate the trouble of earnout calculations. The time frame for the earnout should be one to three years. Any longer than that and the mechanism becomes too burdensome. Consider the need for a dollar cap on the earnout. Take good advice including tax advice. ConclusionEarnout clauses can be extremely beneficial for both Purchaser and Vendor but they can also lead to considerable conflict and uncertainty. Before entering into an earnout agreement, the various problems and pitfalls should be considered carefully and the issues discussed above should be addressed in the sale and purchase agreement to avoid misunderstanding
between the parties.
A good advisor will uncover as much as possible about each sides' risk preference, needs and motivations in order to structure an earnout that meets each party's objectives. KPMG Legal along with its KPMG colleagues in Corporate Finance are well positioned to provide integrated advice to ensure your position whether as a Purchaser or Vendor is protected.
If you would like more information or would like to speak to someone in our M&A team, please contact:
David Lewis: dlewis@kpmg.co.nz
Matthew Pasley: mpasley@kpmg.co.nz
David Shillson: dshillson@kpmg.co.nz
Nick Scott: nscott@kpmg.co.nz
Rob Noakes: rnoakes@kpmg.co.nz,
Martin Dalgleish: mdalgleish@kpmg.co.nz
Ross O'Neill: rsoneill@kpmg.co.nz.
John Land: jland@kpmg.co.nz
The contents of this document are for information purposes only and should not be acted upon without specific legal advice. KPMG Legal does not accept any liability other than to its clients and only then in relation to specific requests for advice. KPMG Legal is an independent law firm.
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