Public company take-over bids typically consist of all cash or a combination of cash and shares. Consideration in private company acquisitions will usually include a sizable portion in cash (50 to 100%) but will often include an unsecured note and/or an earn-out. This is typically because: (i) the buyer does not have (or have access to) the amount of cash required to complete the acquisition (particularly in the case of an MBO), (ii) the greater risk surrounding private companies (risks such as customer concentration, dependence on key suppliers, etc.) and (iii), buyers can usually stretch to a higher price if the purchase price is not all cash. For example, $25 million all cash vs. $30 million two-thirds cash and one-third note …which one would you pick?
A dollar not received at closing is a dollar at risk
There are a number of issues to consider when assessing the likelihood of realizing deferred consideration. A dollar not received at closing is a dollar at risk. In the case of a vendor note, the first question is, can it be fully secured by hard sale-able assets (such as land, a building or other fixed sale-able assets owned by the acquirer). This is often not the case. If the amount is under-secured (i.e. 50% asset coverage) or unsecured, the terms have to reflect increased risk and due diligence should be performed on the buyer to get comfortable with their risk profile and prospects. The higher the risk the higher the interest rate, and the more covenants and timely reporting are required. Perhaps the most important item is timely reporting allowing for quick remediation. Issues such as lawsuits, product defects/recalls, loss of customers can turn the fortunes of a company very quickly.
Earn-outs are tricky
Earn-outs are more prevalent when the seller presents a strong growth forecast (for which he/she wants value). For example, a business has grown at 5% per year for the last 5 years but they expect next year’s revenue to grow by 50%. If the seller will not entertain an earn-out, does that mean he/she does not believe in the forecast?
Many earn-out proposals begin with a premise along the following lines. If you achieve $5 million in EBITDA next year then we will pay you another $x amount in purchase price. Does this mean that if the company generates $4.9 million the seller gets nothing? … and how is EBITDA calculated? The acquiring company could incur discretionary expenses that they attribute to newly acquired subsidiary that were not incurred before, or layer on additional overhead or, most drastic, a fundamental change of business direction could be required?
The reason earn-outs are tricky is that they require the seller to be in control of the business to deliver on the earn-out. This would be fine if the business continues to run as a stand-alone business but generally speaking the basis for interest in an acquisition is synergies. Improved cash-flow by integrating the acquirer and target and eliminating redundant personnel and/or assets. If there are plans for fundamental changes to the target business then an earn-out will not work.
Avoid earn-outs unless…
Certain businesses are difficult to finance (i.e. small private consulting businesses) or, in some cases the buyer does not have access to capital to complete an all-cash purchase (i.e. in the case of an MBO); in these cases an agreement by the seller to be paid over time from the business’ cash-flow can bridge the purchase price to an acceptable amount.
Apply the KISS principle
There are many possible situations to consider and many creative mechanisms and approaches to making vendor notes and earn-outs work. For example, if the seller agrees that 75% of the earn-out will be paid if 75% of the target revenues are reached then he/she should also seek 125% of the earn-out when 125% of the revenues are reached. Earn-outs can be tied to achieving development milestones, securing customer contracts but if earn-outs are based on the financial statements, then the higher up the income statement (i.e. sales vs. profit) the better… less room for manipulation. From a legal perspective it is important that purchase and sale contracts are clear, account for all possible scenarios, and that security is properly perfected in all relevant jurisdictions.
Un(der)secured notes and earn-outs can get very complex and this is where experienced advisors and lawyers really earn their stripes.
Recommended Further Reading
For more on how long an acquisition takes, see: How Long Does it Take to Sell a Business?
For more on how to optimize net proceeds, see: Share Sale or Asset Sale: It is Mostly About Minimizing Taxes