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EARNOUTS IN
BUSINESS
ACQUISITIONS
Jay A. Lefton
Senior Partner
[email protected]
416.216.4018
Presentation at the
Sault Ste. Marie Innovation Centre
September 15, 2009
What is an “Earnout”?
 A contingent payment made in the future related
to the post-closing performance of an acquired
business
 Not a typical “purchase price adjustment”
 A supplementary payment obligation
 A good thing of a bad thing?
 A useful tool or a recipe for litigation?
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Why have an Earnout?
 Bridge the gap between Seller’s and Buyer’s
valuation estimates
 The ability of one or the other to say “I told you
so”
 Motivate the Seller’s management who will stay
on to run the business post-closing
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Off the Shelf Examples?
 NO STANDARD STRUCTURE!!
 A simple concept, but difficult to implement
 Tailored to meet the particular needs of the
transaction
 Complication is added if the business
operations are to be integrated into the Buyer’s
operations, and not kept separate
 What happens if the acquired business makes
further acquisitions?
 As an aside: consider investment banker’s
engagement letters and “success fee”
calculation
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What Business Variables
are to be Measured?
 Financial and/or Non-Financial?
 Top Line vs. Bottom Line Measurement
 Top Line is Generally Preferred by Seller
 Bottom Line is Generally Preferred by Buyer
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Revenue
Gross profit
Net income
Cash flow
Earnings before interest and taxes (“EBIT”)
Earnings before interest, taxes, depreciation and amortization
(“EBITDA”)
 Earnings per share
 Number of units sold
 Value of the business at a future time
 Require consistency of practice/application
 Deliverables/Milestones
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Seller’s control over the
outcome
 An inevitable limitation on the Buyer’s ability
to run the business
 An artificial limitation on the Buyer’s ability to
integrate the business into the Buyer’s
operations
 The business is to be run “in the ordinary
course of business consistent with past
practices”
 How do you translate this into practice?
 Particular restrictive covenants may be imposed
upon the Buyer
 Contractual commitment by the Buyer to
particular goals
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Seller’s control over the
outcome
 Need to ensure that the Buyer is not able to
artificially depress the results which give
rise to the payment
Need to balance the conflict between the
Seller’s short-term focus, compared with
the Buyer’s long-term focus
 Seller may manage the business in the
short-term to maximize the earnout at the
expense of the long-term prospects of the
business
 “Routine” vs. “fundamental” changes
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Seller’s control over the
outcome
 Ability of the Buyer to cry “uncle” and take
over all controls
 Payment of full earnout
 Payment of partial earn-out if the takeover
follows particular events (e.g. which the Seller
equates to mismanagement)
 Compare this to a “kick-out” provision which
entitles the Buyer to take over control without
penalty if the Seller has not met certain
specified performance thresholds (which are
materially below those which would entitle the
Seller to the earnout)
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Seller’s control over the
outcome
 Is the earnout measured only by existing
services and goods that are being sold, or
does it include new services and goods that
are introduced throughout the period of the
earnout?
 Totally new services and products vs. those
that are “related” to the Seller’s current
services and products
 How do you deal with “bundled” products or
“bundled” operations?
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Seller’s control over the
outcome
 Is it appropriate/inappropriate to include an
express contractual statement that the parties
are acting as fiduciaries in this regard to impose
a fiduciary duty?
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Considerations of Payment
of the Earnout
 Period of measurement
 Quarterly
 Semi-annually
 Annually
 Can periods of good performance (well above
anticipated thresholds) in some periods be used
to supplement a lesser performance during
another part of the earnout period?
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Criteria for Payment
of the Earnout
 Flat fee payment?
 All or nothing vs. graduated payments?
 A percentage of the amount by which the actual
outcome/performance exceeds the predetermined threshold
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Duration of Earnout Period
 A particular period post-closing
 Typically 2-5 years, but will vary depending
upon the nature of the milestones to be
measured
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Determination as to
whether the threshold
has been satisfied
 The Buyer must maintain separate books
and records for the business unit which is
being measured
 Do the results need to be audited?
 This will impose an additional cost upon the
Buyer
 “GAAP” is not necessarily sufficient
 define the particular accounting principles to
be applied (e.g. based upon Seller’s existing
accounting policies and records)
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Determination as to
whether the threshold
has been satisfied (cont’d)
 Particular expenses to be excluded
 Buyer’s management fees, bonuses, etc.
 Administrative and general overhead expenses
 except to the extent that services are provided by
Buyer that were previously undertaken (but no
longer undertaken) by Seller
 Normalize the business operations to those which
were used by the Seller pre-closing
 Cf. increased salaries and bonuses
 Inter-company transactions to be considered
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Determination as to
whether the threshold
has been satisfied (cont’d)
 Particular expenses to be excluded
 Add-backs
 Goodwill amortization
 Resulting from heightened depreciation caused by
a write-up in assets acquired on the acquisition
 Consider less advantageous tax treatment postclosing (e.g. no longer a CCPC or no longer
entitled to small business exemption or research
tax credits?)
 How to deal with extraordinary losses/gains?
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Maximum Potential
Payment?
 Is it capped or is the sky the limit?
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Other Considerations
 What happens if the acquired business is
sold during the earnout period?
 What happens if the acquired business
makes further acquisitions?
 What happens if a change of control or focus
of the acquiror?
 Will the Buyer secure the future payments?
 Payment of the earnout depends on the future
financial viability of the Buyer
 Force Majeure: how is the earnout affected by
temporary events (e.g. natural disaster, act of
war, labour strike, etc.)?
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Jay A. Lefton
Ogilvy Renault LLP
Suite 3800 – 200 Bay Street
Royal Bank Plaza, South Tower
Toronto, Ontario, Canada M5J 2Z4
416.216.4018 (o)
416.998.1818 (c)
[email protected]
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