Friday,  November 7, 2008  

Topic: Business Transactions

Reference: Brito, Enrique. “Earnouts can bridge gap between buyers, sellers”. Washington Business Journal: October 3-9, 2008. p.35.

As the market continues to drop, it feels as if transactions will be stuck in the deal pipeline forever. Irrational exuberance has given way to irrational pessimism. However, all things are cyclical and eventually credit will flow and transactions will make a come back.  When they do, I suspect that smaller, private company transactions will favor structured earnouts. Earnouts are a bi-modal acquisition structure with cash offered up front by the purchaser (based on seller projections) and a second offering of cash paid to the seller based on the demonstrated performance of the business over a set timeframe (e.g. 1 year). This structure allows the purchaser to hedge bets against future downturns in the business and gives the seller the opportunity to leverage near term performance. As a result, there is risk to both the purchaser and the seller in such transactions. Managing the risk in such transactions is where all the value resides. In the referenced article the commentator makes this a critical point in the article. “Once the seller and the buyer have agreed to an earnout, the next step is to figure out the performance measures and targets that will determine whether the earnout will be earned. Earnout targets that the business must achieve need to be structured to prevent manipulation, whether intentional or otherwise.” Considerations include tax consequences, profitability targets, net versus gross calculations, or an aggregation of several measures. Even employment contracts may be a consideration in the tax treatment and mitigation of risk. I have dealt with earnouts on a number of occasions and another important area is to pre-plan the treatment of disputes. They are likely to happen over business policy, leadership, expenses, and a myriad of other issues. Setting a system to deal with them in advance or to involve a neutral third party (e.g. mediator or adviser) is a good way to preserve operational integrity. In general I believe that earnouts are a good structure, but significant work has to be done upfront to deal with the risk and to manage the expectations of the purchaser as well as the seller. The devil is truly in the details. Let me know your thoughts on this approach to transactions.

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