07.27.16

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Bridging The Valuation Gap In M&A Transactions With Effective Contingent Consideration Provisions

PRACTICE GROUPS

Bridging the Valuation Gap in M&A Transactions with Effective Contingent Consideration Provisions
Contingent consideration provisions are frequently used in M&A transactions. Such provisions have several advantages, including bridging the gap between the buyer’s and seller’s valuations for the business; shifting some of the risk relative to the future performance of the business to the seller; allowing a seller to participate in post-closing growth of the business; and providing an incentive for the seller to remain involved with—and therefore help contribute to—the continued success of the business.

The most common forms of contingent consideration are:
1.   Purchase price adjustments based on the target company’s closing date balance sheet or net working capital.
2.   Earnouts.
3.   Holdbacks.

Post-Closing Purchase Price Adjustments
One common form of contingent consideration is a post-closing adjustment to the purchase price, based on the tar- get company’s balance sheet or net working capital as of the closing. Since the value of the target company is typically based on its historical financial statements, this adjustment is designed to adjust the purchase price after closing for fluctuations in the target’s balance sheet between the date of the balance sheet analysis and closing. In addition the adjustment is used to ensure that the target has an agreed and sufficient level of working capital at closing. The adjustment to the purchase price is generally dollar for dollar—if net book value or working capital is above a certain target, the difference is paid by buyer to seller; if net book value or working capital is below a certain target, that amount is paid by seller to buyer.1

Drafting Considerations
In a typical purchase price adjustment, within a specified time after closing (60 days is common) the buyer will prepare a draft closing date balance sheet or working capital statement of the target company in accordance with generally accepted accounting practices (GAAP), applied on a basis consistent with the target company’s prior year financial statements. The seller is then given the opportunity to object to the buyer’s draft within a specified time after receipt. Because the buyer is normally in control of all books and records of the target at this point in time, and therefore in the best position to prepare the adjustment, the seller should be given the right to review the documentation used by the buyer in preparing the balance sheet.

The purchase agreement should address how the parties must attempt to resolve any disputes that arise in calculating the adjustment. Attention should be paid to:

How long must the parties attempt to resolve the adjustment among themselves before referring the dispute else- where? To ensure that disputes are resolved quickly, the purchase agreement should identify a fixed period of time during which the parties attempt to resolve any remaining disputes among themselves.

Who will resolve the dispute if the par- ties cannot? Because an adjustment to the purchase price depends on the application of accounting principles and methodologies, the parties will rarely want the dispute to be referred to an arbitrator. Instead, disputes should be resolved by an independent accounting firm. The parties might want to agree on an accounting firm when drafting the purchase agreement; attempt to agree on a firm at a later time; or agree to each pick one accounting firm which will in turn select the firm to be used.

What methodology of calculating the adjustment will the independent accounting firm use? The purchase
agreement might specify that the accounting firm will have the right to independently prepare the balance sheet, or will be constrained to choose between the positions of the buyer and seller.

How will the costs of any dispute be allocated among the parties? The purchase agreement might specify that the parties will share costs equally; that the costs will be allocated among the parties based on the degree to which the accounting firm accepts the position of the other side in the dispute; or that the costs will be allocated in some other manner.

How long does a party have to make the payment that is due? If there is a significant delay between the closing and the payment of the final adjustment, it may be appropriate for the final payment to include interest from the closing date.

Are there any collections issues? If a party suspects that the other will be unable to pay an adjustment to the purchase price when due, the purchase agreement might specify that a certain amount of funds will be held in escrow until the parties agree on the appropriate adjustment.

Earnouts
Earnout have been a historically popular form of contingent consideration used in private, middle market M&A transactions. An earnout is when a portion of the purchase price is made contingent on the future performance of the target business, such as the target company receiving a certain number of hits on its website, or more typically achieving a specified amount of gross revenue or earnings before interest, taxes, depreciation, and amortization (EBITDA). The buyer pays the agreed earnout amount—if at all—in the years subsequent to the sale when and if that specified contingency has been satisfied.

Why Use an Earnout?
An earnout can be a valuable tool to bridge the gap between the buyer’s and seller’s valuations for the business. For example, the buyer may be willing to pay the seller’s price if certain milestones are met after closing, and the seller may be willing to accept less up front if it is confident that the business can achieve post-closing performance goals. An earnout can also allow a buyer to mitigate the risk it may have overpaid for the target by conditioning a portion of the purchase price to future events that may or may not occur, while allowing a seller to share in the potential short-term growth of the business after the transaction closing. In addition, an earnout can be an attractive incentive to retain and motivate key personnel of the target company after closing, as management may be more inclined to continue with the target company post-acquisition if they can reap the rewards of growing that business for the benefit of buyer. Designing the Earnout. Earnouts are complex, and the design of the earnout provisions and method of computing the earnout payment will vary depending on the target company’s industry and the valuation methodology used in calculating the purchase price for the business. When designing an earnout, careful consideration should be paid to the following:

How will the parties allocate the risk of an earnout? Sellers will generally want more cash up front and less on an earnout, whereas buyers will want to pay less up front and more on earnout. The buyer may also prefer a cap on the total future payment.

Will the seller stay involved in the business? A seller will prefer to stay involved in managing the business to ensure that the earnout conditions are satisfied, whereas a buyer will prefer to leave this open ended such that it has the opportunity to make changes to the company’s management structure if needed.

Will the buyer give assurance regarding the level of working capital that will be available?

• Will the new parent have the right to allocate overhead to reduce net income? During the earnout period, a buyer is incentivized to front load costs.

What method of accounting will be used to calculate the earnout? If the accounting method is consistent with target company’s past practices, the buyer may not be able to integrate the business (and reap the benefits of consolidation) until the earnout period is over.

How likely is it that the earnout condition will be satisfied? Seller’s counsel should be wary of the talkative seller that oversells the long term growth or productivity of the business.

If the valuation of the business was based on EBITDA, were expenses deferred to maximize the sales price? For example, if a seller typically spent 5% of sales on advertising, the buyer may wish to make a larger investment in those items, without input from the seller. From the buyer’s viewpoint the additional short terms costs will have long term benefit (which will likely extend past the earnout period), but from the seller’s viewpoint these expenses may reduce the likelihood that the earnout condition will be satisfied.

How will the earnout be measured?
Common options for measuring an earnout include basing the payment on the target company’s future EBITDA (which may be an absolute target EBITDA or an increase in EBITDA over time, or some combination of both); income or revenue growth (typically used in early stage companies before there is positive EBITDA, but which requires clarity in post-closing revenue recognition policies and procedures to be used on computing income or revenue growth), gross profit (generally a simple way to calculate an earnout, though both parties need to agree on the components of cost of goods sold as used to determine gross profit and the allocation of overhead), or the occurrence of a specific event (such as the number of hits on a website; the launch of a new product or acquisition of a new client; the sale of a certain number of products; or the execution or renewal of one or more key agreements). When computing an earnout, the parties should clearly agree on the calculation methodology and involve accountants early on. To reduce the possibility of later disputes when an earnout is tied to the target company’s financial performance, the parties should consider attaching a schedule to the purchase agreement that contains a sample computation of an earnout payment using the agreed methodology.

GAAP. The earnout measurement will almost always have a reference to GAAP, but GAAP is subjective and can be abused. Particular areas of concern include the consistency of the target company’s policies; sales discounts; business methods; business policies; and the inventory accounting method. The parties may want to exclude from GAAP changes in depreciation policies to accelerate expenses; any goodwill included in the purchase price and its amortization; non-recurring expenses related to the acquisition of the target and its integration in the buyer’s business; the allocation of overheard from the buyer’s operations; the acceleration of write-offs for bad debts; and a control over budget and expenses.

What is the earnout period? In establishing the time period for an earnout, a key consideration is how long it will take to properly assess the target company’s future performance. A longer earnout period may not be practical, and if an earnout period is too short, the incentives may promote actions like driving revenue growth without proper regard for issues such as customer creditworthiness, cost of goods sold, product quality, and other issues that have long term importance.

How will the earnout be paid? Sellers will likely prefer annual payments for meeting annual goals (or quarterly), but may be concerned about being penalized for the target company’s performance during the transition period. A buyer that agrees to a year by year earnout may require that seller pay back an earlier earned about for poor results in a later year.

How will the earnout be affected by extraordinary events? The earnout computation methodology should also address the accounting treatment for extraordinary events, such as transaction expenses; the purchase or sale of a line of business or a product line; and the receipt of insurance proceeds from a catastrophic or unexpected loss.

Are there circumstances in which the earnout should be accelerated? In certain circumstances it may be appropriate to provide for acceleration of an earnout. For example, the seller’s right to an earnout may be accelerated if the buyer’s business is sold; the buyer has not met its obligation to properly fund the business; there is a change in management personnel, such as seller’s employment is terminated by the buyer; or key personnel leave the target company, such as key members of the target’s sales or management team.

When will the earnout be paid? An earnout clause will typically provide for a period of time after the end of the earnout period during which the buyer will be required to compute the earnout. The seller should be entitled to all materials relevant to the computation and have a reasonable period of time to makes its own computations and propose any changes. As discussed in the previous section on post-closing adjustments to the purchase price, the parties should also make provision for how disputes will be resolved that relate to the earnout.

Is security needed for the earnout? A seller may seek a third party guaranty or other collateral to assure payment of the earnout, particularly if the transaction is structured as a leveraged buyout or if there are concerns about the target company’s cash flow. The security might be in the form of a guaranty from the parent company, or a security interest in the business being sold.

Drafting the Earnout Clause
Any earnout provision should be specific and address the points outlined above, such as who will control of the post-closing entity; the method of operating the business post-closing; the method of accounting for profits, losses, and expenses; the performance metrics or milestones to be achieved; the timeframe for achievement of the earnout metrics and milestones; methods to be used in determining whether the performance metrics have been attained; and control issues relating to the earnout business against which performance is being measured.

Buyer’s Post-Closing Conduct
After closing a transaction that includes an earnout, a buyer should make a good faith effort to assist the target company in achieving the conditions specified by the earnout payment. If a buyer acts in bad faith, a court may require payment of an earnout even if the metrics are not met. For example, in Horizon Holdings,  LLC  v. Genmar Holdings, Inc.,2 the seller of a business sued the buyer for failure to pay the earnout. The seller was successful in recovering its earnout payment even though the performance targets were not met because it was able to demonstrate to the court’s satisfaction that (1) the buyer undermined the president’s ability to manage the company’s business, which was not in the “spirit of the agreement”; (2) the target company’s brand name was abandoned post-closing, with a negative impact on sales; (3) post-closing manufacturing focused on two less profitable product lines; and (4) reimbursement for manufacturing those lines was accounted for in a manner that increased production costs and negatively impacted the seller’s ability to achieve the earnout.

Tax Consequences
An earnout is contingent consideration, and therefore a buyer cannot generate depreciable basis until the earnout has been earned. Frequently the payment will be allocated to goodwill and amortized over a 15-year period. Unless the taxpayer elects otherwise, the installment sales method will apply to any disposition of property in which at least one payment is to be received after the close of the taxable year in which the disposition occurs, regardless of whether a promissory note is signed or multiple payments are made.3 Taxpayers using the installment method recognize taxable gain on a disposition of property as installment payments are received, rather than all at once in the year of disposition. Because the total sales price of the property can be difficult to determine when there is a contingent payment, special rules apply where there is a contingent payment sale—i.e. a sale of property in which the aggregate selling price cannot be determined by the close of the tax year in which the sale occurs. These rules fall into three categories: sales with a stated maximum selling price; sales with a fixed period, and sales with neither a stated maximum selling price nor a fixed period.

1. Sales with a stated maximum selling price. The stated maximum selling price is used in determining the buyer’s gross profit ratio by assuming that all contingencies will be met or otherwise resolved in a manner that maximizes the payments to the seller and accelerates payments to the earliest date or dates permitted under the purchase agreement. The stated maximum selling price is treated as the selling price in computing the gross profit ratio until that amount is subsequently reduced by the terms of the original purchase agreement, a subsequent amendment or a similar occurrence. Gross profit ratio is recomputed for payments received in or after the tax year of such reduction if the stated maximum selling price is reduced.

2. Sales with a fixed period. If a stated maximum selling price cannot be determined but the purchase agreement fixes a maximum period over which payments may be received, the seller must recover its basis ratably over the fixed period, or, if the payments are not equal each year, based on a formula. Under some circumstances, the payment actually received in any particular year may be less than the amount of basis that should be recovered in that method. In that event, the taxpayer generally does not recognize a loss; instead, the excess is carried forward to the next succeeding year.

3. Sales with neither a stated maximum selling price nor a fixed period. The IRS will closely scrutinize the arrangement to determine whether a sale has actually occurred, or whether the seller is receiving payments as rent or royalties. If a sale has occurred, the seller generally must recover its basis in equal annual installments over a period of 15 years. When contingent payment amounts are high, but the likelihood of receiving the full amount of the payments is not great, the stated maximum selling price rules may inappropriately accelerate recognition of gain or create timing and character issues. Similarly, if gain is recognized in the early years of an installment sale but one or more contingent payments are not earned and paid, a seller may be left with a large loss.

Holdbacks
In a typical purchase and sale agreement, the seller makes certain representations and warranties regarding the business being sold, as well as certain covenants, such as those regarding the operation of the business between signing and closing. The seller typically indemnifies the buyer for losses caused by any breach of the representations, warranties, or covenants. A buyer who is concerned about recovering payment on these indemnification obligations may ask the seller to place a portion of the purchase price in an escrow account for a period of time to secure payment on the  indemnification.

As part of this holdback, the buyer, seller, and an escrow agent will enter into a written escrow agreement that establishes an account in which the buyer deposits a portion of the purchase price. If the buyer makes a claim for indemnification for the breach of a representation, warranty, or covenant, all or a portion of the escrow funds may be used to satisfy the claim. Any funds remaining in the escrow account after the close of the escrow period will be paid to the seller. The major terms the parties should negotiate include:
What is the amount of the holdback? The amount that should be placed in escrow depends largely on the parties’ relative bargaining power, though recent surveys estimate that 5 to 10% of the purchase price is reasonable for a holdback.

How long will the escrow last? Similarly, the length of the escrow  period will depend largely on the parties’ relative bargaining power, but recent surveys suggest that most escrow periods are for approximately 12-18 months.

Should the remaining escrow funds be released over time or all at once? Sellers will generally prefer a tiered escrow where portions of the remaining funds are released over time, whereas buyers will generally prefer the funds to be held in escrow as long as possible.

What are the duties of the escrow agent with respect to investing the funds in escrow? Buyers will generally prefer less risky investments to protect their security, whereas sellers may prefer slightly more risk and possibility of return.

How will claims made on the escrow be resolved? In a typical transaction, if a buyer wishes to make a claim for indemnification under the business purchase agreement an officer of the buyer is required to give written notice of the claim, with specific details, to the escrow agent. The escrow agent gives a copy of the claim to the seller and the seller has a specific time period to respond with specific objections, if any. If the seller objects, the parties attempt to negotiate for a specific period of time (45 days may be reasonable). If the parties agree, the escrow agent can rely on a written direction signed by both parties to make a distribution. But if the parties cannot agree they follow a set dispute resolution procedure, the purchase agreement should specify a procedure by which such a claim will be resolved.

How will disputes be resolved? As mentioned above in the discussion of post-closing purchase price adjustments, the purchase agreement should specify a means for resolving disputes that arise about the holdback.

Tax Consequences
For a transaction using a holdback, use of the installment method is generally mandatory if the seller realizes a gain on the disposition of property and at least one payment is received after the close of the tax year in which the disposition occurs. But when is a payment received in a holdback scenario—when it is deposited in escrow, or when it is paid out of escrow?

Under the constructive receipt doctrine, income is constructively received by a taxpayer when, without substantial limits or restrictions on his control of receipt, the income is either credited to his account, set apart for him, or made available so he may draw on it at any time. Conversely, there is no constructive receipt when the taxpayer enters into an agreement to defer income before it is earned; the taxpayer’s right to the income has not yet matured or vested; or the taxpayer’s right to the income is contingent on the occurrence or nonoccurrence of an event or condition. Similarly, under the economic benefit doctrine, a taxpayer must include immediately in income the value of cash or other property set aside in a separate escrow, fund, or trust for the benefit of the taxpayer and (1) the fund is irrevocable and beyond the reach of creditors of the party who transferred the funds to the escrow; and (2) taxpayer has a vested right to the money, with receipt conditioned only on the passage of time. A taxpayer using the accrual method of accounting must also include income in gross income in the tax year when all the events that fix the right to receive the income have occurred and the amount of the income can be determined with reasonable accuracy. All of the events that fix the taxpayer’s right to receive the income occur at the earliest of the following:

1.    The time that the income is earned.
2.    The time that payment to the taxpayer is due.
3.    The time that payment is made to the taxpayer.

In IRS Publication 537, the Service explained that if an escrow arrangement imposes a substantial restriction on seller’s right to receive the sale proceeds, the sale can be reported on the installment method, provided it otherwise qualifies for that method. For an escrow arrangement to impose a substantial restriction, it must serve a bona fide purpose of the buyer, that is, a real and definite restriction placed on the seller or a specific economic benefit conferred on the buyer. If the terms of the escrow arrangement are such that the nonoccurrence of breach is remote, the IRS may argue that the escrow amount should be recognized in the year the transaction occurs. Thus, direct or indirect control over escrowed funds, even without an absolute right to possess them, may constitute an economic benefit in the year of sale. Some restrictions will not be considered “substantial” if they are or appear to be based solely on the expiration of time; if they are self-imposed; or if they give the seller too much control over the escrowed funds. If the installment method is applicable, gain is recognized over a period of time, as discussed earlier. If the installment method is not applicable, gain is taxed as recognized in the year of sale.

Conclusion
Contingent consideration can be a useful tool in private M&A transactions, but buyers and sellers alike should pay careful attention to how the terms of such payments are drafted. A poorly constructed contingent consideration provision may resolve a valuation dispute today, but create a costly and complex dispute tomorrow.


1 The parties may prefer a different formulation than dollar for dollar. For example, if the buyer’s valuation of the target company is based on a multiple of net book value, the adjustment to the purchase price might include that multiple.

2244 F. Supp.2d 1250 (DC Kan., 2003).

3 Certain transfers are not allowed installment treatment, including sales of inventory and dis- position of depreciable property between related persons.


This article first appeared in Contingent Consideration, Valuation Strategies July/August 2016.

The opinions expressed in this article are those of the authors and do not necessarily reflect the views of Riddell Williams or its clients.  This article is for general informational purposes and is not intended to be, and should not be taken as, legal advice.

The Riddell Williams Corporate Law Group has the breadth and depth to execute virtually any business transaction. Our clients range from small, family owned businesses to large privately-held businesses and listed public companies. We represent both buyers and sellers in all types of strategic relationships involving the purchase, sale or combination of businesses.