Sunday, 10 May 2015

SPA Series Part 8: How To Negotiate M&A Deals In Finland - Earn-Outs

Dear All,

I know it would be interesting to read a bit about bulletproof earn-out clauses but I first have to tell some news from our firm. These days, we have a new website that we are very proud of (see here). In addition, another issue is that we are nominated among the noted M&A firms in Chambers Europe 2015 for the first time. I first of all would like to thank all of you who have voted for us. It is an honour to be in the same category with the leading heavyweight transaction law firms. Already this year we have represented clients in several deals, such as acquisition of Sports Tracking Technologies Oy by Amer Sports Corporation (link to press release) or divestment of private cloud business of F-Secure to Synchronoss Technologies for 60MEUR (link to press release), not to mention energy sector deals with Vapo relating to acquisition of district heating systems (link to press release). Anyway, we have been very fortunate and blessed with great team, which is now expanding with a new member joining to our ranks by the end of summer. The name I will still keep as a secret but this way we ensure that we are able to serve our growing clientele even better. But to the real thing, do you know how to write bullet-proof earn-out clauses? If your answer is no, then you came to the right place!

An earn-out clause is a payment structure, which means that part of the purchase price is connected with the future performance. So typically there is an initial payment on completion of the acquisition and a number of subsequent deferred payments, which are spread over an agreed period post-completion. In a sense this mechanism is contingent for certain events taking place, which creates a challenge for the drafter. One example could be the following: 

“The Purchaser shall pay the Purchase Price in a following manner: ….Provided that the agreed financial targets are reached in the Company, the Seller shall be entitled to an additional payment for the Shares of the amount of EUR____________ (Earn-Out). The Earn-Out shall be calculated in accordance with Appendix X.

The calculation of the Earn-Out shall be based on the annual accounts of the Company for the financial year X, which accounts shall be prepared in accordance with the Accounting Principles. The Earn-Out shall be paid by the Purchaser to the Seller in euros in immediately available funds within X days following the date when the determination of the Earn-Out is deemed final and binding.” 

And naturally there should also be a mechanism to solve disputes if there are disagreements.

What are the advantages and disadvantages of an earn-out? The main point probably is that earn-out enables more precise valuation of the target. This comes with the prices as the control that buyer can exercise during the earn-out period is typically limited. So there is an interesting balancing exercise to be made between the short and long term plans of the Company but for the seller this mechanism might enable higher price even in a situation when there are doubts as to the actual profitability and performance by the contemplated buyer.

Some points on drafting these clauses:

  • The Earn-Out is most often calculated by reference to EBIT, but turnover or net assets could also be used. Not very common though;
  • If you are using several purchase price mechanics simultaneously, see that there is no overlap, e.g., if the project closing is delayed (like overlap between adjustments and earn-out);
  • Profits should be carefully calculated and considered and one issue that relates to this is that accounting principles should be precisely defined. This is a point that the seller and buyer see differently and, as an example, the buyer may want the one-time so-called windfall profits to be taken out; 
  • For the seller, it is preferable to have a model in which there is no "all or nothing" approach but carry-forwards and backs between years if there is a longer period;
  • The responsibility as to who prepares the accounts is also relevant and here we refer to a price adjustment blog that we already discussed;
  • There almost certainly must be provisions relating to the management of the business during the earn-out period and some typical vetoes could include, for example, the right to hire new employees, the right to use subcontractors, board structure, remunerations, the right to promote employees according to the Company’s performance evaluation process. On the other hand, the buyer typically wishes to ensure that capital expenditure is not deferred to drive short-term performance;
  • How synergies are treated is also an important and difficult issue, such as more affordable access to capital, insurances. Buyers may resist these due to the fact that these are difficult to quantify;
  • The relationship with the overall structure of the representations and warranties and indemnities should be defined. So what happens if an event is a warranty claim, indemnification and affects an earn-out in the same time. A point worth considering whether there is a possibility for double-recovery;
  • Also set-off criteria is worth considering and whether there is a need to have withholding rights to expand the scope of set-off that would be ordinarily available under law; and
  • Taxation is something that should always be considered and in particular if you connect the earn-out with employment condition to avoid unpleasant employer payment surprises.

Hope this gives you a head start if you have been unfamiliar with these earn-outs in the past. Next I will focus on escrow payments and new posting coming by the end of this month. We have also started a book project around these M&A themes which will be released in the autumn, but more information on that to follow.

Lovely beginning for your spring week and hope to be in touch with you soon,