Earn-Outs

Summary

Can enable buyers and sellers to compromise on valuation differences

Earnout allows ultimate price to be determined over a
period of time as certain financial and/or operational
targets are met
Can be difficult to negotiate and are fraught with
litigation risk
As earnouts may distort incentives for seller-managers
and buyer-owners in running the business over the
earnout period
"Top line" measures such as revenue tend to present less issues than "bottom line" measures such as net income

Securities Law Issues

Right to the earnout may be a security

For purposes of securities laws
Can apply to right to receive cash
as well as right to receive stock
Burden of registering a right to receive stock can be burdensome
Not the case, if earnout consists of securities of the buyer already being registered in connection with the transaction

In making determination, SEC has used five-factor test:

Earnout right is an integral part of the consideration to be received in the transactions
Earnout right is not represented by any form of certificate or instrument
Holders of the earnout have no rights common to stockholders such as voting and dividend rights, nor does the earnout right bear a stated interest rate
Earnout right will not represent an equity or ownership
interest in the surviving partnership or in any
constituent company in the merger
Earnout right will not be assignable or transferable, except by operation of law

Five factor test developed in SEC no-action letters

SEC No-action letters

Lifemark (11.17.81)

Registration not required for earnout tied to future net revenues over 12-year period
No comment in SEC response letter on number of employees where all 100 partners of target hospital were doctors practicing in hospital
Compare Newell National Company (7.14.1971)
Earnout based on targets earnings-per-share
and sales of certain products was a security and must be
registered

Essex Communications (6.28.88)

Contingent payment based in part on indemnity
deposit and purchase price adjustments from subscribers
failure to pay first bill do not need registration

Marriott Residence Inn II Ltd Partnership (4.30.02)

Beneficial interests in liquidating trust holding contingent assets do not need registration

Genentech Clinical Partners (3.23.89)

No registration required for contingent payment based on
"Net Revenues" related to line of products over 10-
year period

Minnesota Mining and Manufacturing Co (10.13.88)

No registration required for contingent payment made annually during three-year period based on annual revenues of target

GID/TL Inc (3.21.89)

Noting that the contingent payment was a "relatively insignificant portion of the merger consideration"

Slater Development (5.09.88)
Quanex (7.28.89)

Celina Financial (2.19.93)
First Boston Inc (12.02.88)

Tax Issues

IRS Rev Proc 84-42; 1984-1; CB 521
Re: contingent issuance of securities

M&A Tax: Escrowed - Contingent Stock

Accounting Issues

FASB has an ongoing project that's expected to change accounting treatment for contingent consideration

Part of project on business combination accounting
Contingent consideration will be recognized at fair value on acquisition date
Contingent consideration will be marked to fair value through earnings in subsequent reporting periods

Current treatment where contingent consideration is based on earnings

Fair value of the additional consideration is recognized as an additional acquisition cost of the Target, once the contingency is resolved

Cases

Offset for contingent liabilities

Boston University v Ligand Pharmaceuticals (3rd Cir 2006)

Opinion
Ligand agreed to buy a biotech company for $30mm and a $37mm contingent payment tied to an FDA approval
After the FDA approval was received,
Ligand refused to make the payment
given its exposure to the Oliver litigation
Third Circuit affirmed District Court judgment
against Ligand

Earnout determination

Chambers v Genesee & Wyoming (Del Ch 2005)

Dispute over adjusted EBITDA calculation
Opinion

"Best efforts" provisions

Bloor v Falstaff Brewing (2d Cir 1979)
Defendant was not required to take action to promote sales of plaintiffs product, where doing so would bankrupt the defendant

Precedent

Skype (Luxembourg) / eBay

Earnout of up to $1.5 billion
e-Commerce Companies

Eontec Ltd (Ireland) / Siebel Systems (2004)

Earnout right was potentially 86% of the original cash consideration but the earnout right was not registered and no-action relief was not sought
Share purchase agreement

USAuto Holdings / Liberte Investors (2003)

Earnout is measured over a one-year period
tied to EBITDA of the acquired target
Merger agreement

ESC / Quanta Capital Holdings (2003)

Earnout is measured over a two-year period
tied to EBITDA of acquired target
Stock purchase agreement

Tsunami Optics / Stratos Lightwave (2002)

Buyer acquired optical technology company for stock
Additional earnout payment in stock for attainment of certain performance goals
Number of shares issued to be based on the average closing price of Buyer's stock
Buyer's counsel: Lord, Bissell & Brook
Seller's counsel: Silicon Valley Law Group
Merger agreement
Press release

Ascent Pediatrics / Medicis Pharma (2001)

Coherent / ESC Medical (2001)

Israeli company acquired US company's medical laser business
In an asset purchase for cash, buyer stock and short-term note
Four year earn-out based on share of revenues over a defined Target

Buyer's counsel: Skadden Arps
Seller's counsel: Wilson Sonsini

Asset purchase agreement

Ivonyx / drkoop.com (2001)

Sale of health information services provider
Asset purchase for cash and stock
Contingent cash payment based on comparison of acquired business' actual "net income" v budgeted "target amount"
Portion of stock held in escrow
Buyer's counsel: Latham & Watkins
Seller's counsel: Zevnick Horton
Asset purchase agreement
Press release

Generac Portable Products / Briggs & Stratton (2001)

Acquisition of manufacturer of engine powered tools
Cash election merger
Total cash payment equal to post-closing "enterprise value" at 6.30.02, as defined
Balance determined as a multiple of one-year post-closing EBITDA, subject to cap

Buyer's counsel: Quarles & Brady
Seller's counsel: Simpson Thacher
Merger agreement
Press release

Sibyte / Broadcom (2000)

Acquisition of developer of high performance processor chips in a stock for stock merger
Earnout shares put into escrow and released upon attainment of certain milestones
Shares in escrow also subject to indemnification claims

Buyer's counsel: Irell & Manella
Seller's counsel: Pillsbury Madison
Merger agreement
Press release

MessageClick / Verso Technologies (2000)

Acquisition of communications solutions company through merger for stock and warrants
Stock earnout based on execution of certain agreements or achievement of certain levels of revenues from the acquired business
Portion of stock held in escrow against indemnification claims

Buyer's counsel: Rogers & Hardin
Seller's counsel: O'Sullivan Graev
Merger agreement
Press release

Bluestar / Covad Communications (2000)

Acquisition of broadband and internet service provider through stock merger
Payout based on 2001 EBITDA and 2001 revenues
Additional Buyer stock put in escrow and subject to earnout payments

Buyer's counsel: Simpson Thacher
Seller's counsel: Brobeck
Merger agreement

Whitman / PepsiAmericas (2000)

Merger of two bottlers for cash, stock, contingent payment or combination of all three
Required minimum stock issuance, to meet IRS 368 requirements
Contingent payments based on 2001 and 2002 adjusted EBITDA, as defined
Buyer's counsel: Sidley & Austin
Seller's counsel: Briggs and Morgan
Form S-4 (9.22.00)
Merger agreement
Press release

Algos Pharma / Endo Pharma (1999)

Issued Warrants tied to FDA approval of drugs
Announcement
Merger agreement

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