P A , E

Leigh Walton
Bass, Berry & Sims PLC
Nashville, Tennessee
Kevin D. Kreb
PricewaterhouseCoopers LLP
Chicago, Illinois
December 2007
Table of Contents
FORMS OF CONSIDERATION ........................................................................................1
A. In General.................................................................................................................1
B. Cash Payment...........................................................................................................2
C. Payment by Stock ....................................................................................................2
Valuation Issues ..............................................................................................2
Restrictions on Resale .....................................................................................4
Shareholder Approval .....................................................................................4
Tax Considerations .........................................................................................5
D. Payment by Promissory Note...................................................................................6
Set-Off Rights .................................................................................................6
Tax Benefits ....................................................................................................6
Security for Payment of the Notes ..................................................................6
HOLDBACKS OF PURCHASE PRICE IN ESCROW ....................................................7
A. Overview ..................................................................................................................7
B. Benefits and Risks....................................................................................................7
C. Tax Treatment ..........................................................................................................7
PURCHASE PRICE ADJUSTMENTS ..............................................................................8
A. Overview ..................................................................................................................8
B. Construction of the Post-Closing Adjustment .........................................................9
C. Typical Mechanics .................................................................................................10
D. Drafting Considerations .........................................................................................11
Amount Paid at Closing ................................................................................11
Accounting Specifications ............................................................................12
“Preferable” versus “Acceptable” GAAP .........................................12
GAAP versus Consistency. ...............................................................13
Interim versus Year-End Reporting. .................................................13
Errors or Irregularities Discovered after Closing..............................14
Materiality. ........................................................................................14
Changes in Accounting Policies or Practices....................................15
Hindsight. ..........................................................................................17
Right to Offset...................................................................................17
Issues of Control ...........................................................................................18
Caps and Floors.............................................................................................19
Interplay Between the Post-Closing Adjustment and Indemnification.........20
Dispute Resolution: Designation of Independent Accountants ....................20
Mechanisms to Ensure Payment of the Adjustment Amount .......................21
EARNOUTS ........................................................................................................................22
A. Overview ................................................................................................................22
B. Some Risks Associated with the Use of Earnout Provisions .................................23
C. Drafting Issues .......................................................................................................23
Establishing the Earnout Benchmark; Types of Possible Benchmarks ........23
Financial Benchmarks .......................................................................24
Non-Financial Benchmarks ..............................................................24
The Formula for Calculating the Payment Amount ......................................25
The Length of the Earnout Period .................................................................26
Determination of Whether the Threshold Has Been Satisfied ......................26
Determination of the Earnout............................................................26
Accounting Issues .............................................................................27
(1) Consistency of Practice in Post-closing Accounting .............. 27
(2) Potential Exclusions in Calculating the Payout and Other
Possible Adjustments ....................................................................... 28
(3) Payments Pursuant to Tax-sharing Agreements ..................... 29
(4) Accounting Treatment of the Contingent Consideration When
Linked with Future Employment ..................................................... 30
(5) Other Issues to be Considered................................................. 32
Form of Payment of Earnout Obligation ......................................................32
Valuation Issues ................................................................................33
Securities Issues ................................................................................33
Related Tax Questions ......................................................................34
Operation of the Acquired Business During the Earnout Period ..................34
Operation by the Buyer Post-closing ................................................35
Operation by the Seller’s Management Team Post-closing ..............36
Protection Placed in the Acquisition Agreement ..............................36
Payment of Earnouts to Public Shareholders ................................................42
Shareholders Designated to Act for the Seller ..............................................42
Sale of the Target or the Buyer During the Earnout Period ..........................42
10. Integration of the Target into the Buyer’s Other Businesses ........................43
11. Averaging Periods of Strong Performance With Weak Performance ..........44
12. Dispute Resolution ........................................................................................44
13. Registration Issues for Earnout Rights .........................................................44
14. Special Industry Limitations .........................................................................45
CONCLUSION ...................................................................................................................47
Leigh Walton
Bass, Berry & Sims PLC
Kevin D. Kreb
PriceWaterhouseCoopers LLP
December 2007
This article considers the various ways in which payment of the purchase price in an
acquisition can be structured. Variations can occur in the types of consideration payable at the
closing, and many acquisitions provide for a post-closing adjustment or true-up. Further, the
acquisition may include an earnout payable over a considerable period of time after the closing.
Each of these purchase price provisions significantly impacts the leverages of the parties, the tax
and accounting treatment of the transaction, the securities laws ramifications of the acquisition
and the relationship of the buyer and seller after the closing.
In General
The purchase price in an acquisition is typically paid by cash, stock of the
acquiring entity, installment notes, the assumption of indebtedness or some
combination thereof. Factors that affect the way the purchase price is paid
the buyer’s access to cash;
the seller’s desire or willingness to invest in the buyer’s business;
the seller’s desire for a tax-free transaction;
the structure of the transaction as a stock purchase, merger or asset
the buyer’s desire to extend payments past closing, creating a source to satisfy
indemnification claims; and
the regulatory environment of the industry in which the target operates.
©2007 Leigh Walton and Kevin D. Kreb. The views expressed are solely those of the authors and do not
necessarily represent the views of their respective firms or the firms’ clients. The authors express their appreciation
to Bryan Metcalf, Laura Brothers, Angela Humphreys and Krista Thornton of Bass, Berry & Sims PLC for their
assistance with this article. The authors wish to thank William B. Payne of Dorsey & Whitney LLP for his
Cash Payment
Payment by cash is appealing in its simplicity and because (absent a holdback to
secure post-closing claims) it will largely terminate the relationship between the
buyer and the seller at the closing. A cash payment, however, will result in the
seller realizing an immediate gain for tax purposes on the transaction.
The Financial Accounting Standards Board (“FASB”) issued Statement of
Financial Accounting Standards (“SFAS”) No. 141, Business Combinations, in
2001. SFAS No. 141 eliminated the pooling of interests method of accounting for
transactions initiated after June 30, 2001. SFAS No. 141 requires all business
combinations initiated after June 30, 2001 to be accounted for using the purchase
method of accounting. See Jan R. Williams, 2004 Miller GAAP Guide, at 4.0.
With the elimination of pooling of interests, cash-based transactions have
increased, with cash being used as the sole consideration for the transaction or in
combination with stock.
Cash payment, when chosen, may be made by bank cashier’s check, certified
check or wire transfer. The seller generally will insist on same day funds through
a wire transfer.
Payment by Stock
In transactions in which equity securities are used as consideration, complex
issues of valuation are presented. Further, the securities issued in the transaction
must be registered under the Securities Act of 1933, as amended (the “Securities
Act”), or an exemption from registration must be available.
Valuation Issues
Once the parties agree to use stock as consideration and a purchase price
has been determined, the parties must value the stock to be transferred.
They may agree that the stock is to be valued at the market price as of the
moment of their agreement on the price, as of the date the acquisition
agreement is signed, as of the closing date or at or during some other time
period. If the stock is not registered under the Securities Act, or if the
transfer of the stock is otherwise restricted, the seller may demand a
discount from market price. If the buyer’s stock will be registered under
the Securities Act, the Securities and Exchange Commission (“SEC”) will
insist that the number of shares to be issued to the seller’s shareholders be
clearly indicated in the proxy statement for the meeting at which the
transaction is approved, or be ascertainable from external sources at that
To avoid the obvious risk posed by using a single day’s stock price in the
valuation, the parties typically choose to use an average market price of
the buyer’s stock over some specified period of time, for example, the 10
trading days immediately preceding the third business day prior to the
closing. To protect against extreme fluctuations in price, the parties will
may place an upper and lower limit – a collar – on the range within which
the stock price may vary for the purposes of valuation. The collar may be
defined by either share price or shares issuable in the transaction: for
example, no greater than 1,500,000 shares to be issued but no fewer than
1,350,000; or a share price of no greater than $55, but no less than $45.
Although it is most common for both components of the collar to be
present in a transaction, occasionally deals are structured having only one
component, the upper limit or the lower limit, depending upon the
bargaining power and strategic positioning of the parties.
In a stock purchase price formula using both a collar and an average
closing price to value a listed security, the parties might agree to the
following provision:
“The aggregate number of shares of Buyer
Common Stock issuable to Seller shall equal that
number of whole shares of Buyer Common Stock
equal to the quotient of (a) $100,000,000, divided
by (b) the average of the closing prices of Buyer
Common Stock as reported on the New York Stock
Exchange for the 10 trading days ending on the
date that is three Business Days prior to the Closing
Date (the “Average Price”); provided, however, if
the Average Price is less than $45, the calculation
shall be made as if the Average Price were $45, and
if the Average Price is greater than $55, the
calculation shall be made as if the Average Price
were $55.”
The parties also may agree that there is a right to terminate the contract if
the price extends beyond the collar limits. For example, the definitive
agreement may provide that in the event the purchase price falls below the
lower limit, the buyer may, but is not required to, provide additional
consideration, in cash or stock, to bring the purchase price up to the lower
limit. If the buyer is unwilling to provide such additional consideration,
the seller may terminate the agreement if it is unwilling to accept the
lower purchase price. In drafting provisions of this type, it is important to
consider the notification requirements of the parties. Once it is determined
that the lower limit of the collar will not be met, must the buyer first notify
the seller whether it is willing to provide additional consideration to
increase the purchase price to the lower limit, or must the seller notify the
buyer whether it will terminate the agreement if the purchase price is not
increased to the lower limit? Such provisions should be clearly addressed
in order to avoid uncertainties and will be subject to negotiation.
Finally, as is discussed later in this article, many acquisition agreements
contemplate a post-closing adjustment that can result in the buyer paying
additional consideration, or the seller in effect refunding previously paid
consideration to the buyer. If a portion of the consideration involved in
the post-closing adjustment is stock, the mechanism for valuing the stock
delivered in the adjustment should be specified.
Restrictions on Resale
Securities issued in an acquisition (like any other type of securities
issuance) must be registered under the Securities Act, or an exemption
from registration must be available. Typically Form S-4 is used for
registration (although the use of Form S-1 or S-3 may be mandated if no
shareholder approval is required or if a majority shareholder of the seller
has agreed to support the transaction, thus assuring shareholder approval).
If the seller agrees to accept unregistered securities, a private placement
exemption through Section 4(2) or Regulation D under the Securities Act
is the typical route to securities laws compliance. When the seller’s
shareholders receive stock that is issued under an exemption, they must
hold the stock until it can be sold publicly under Rule 144 (typically a
minimum one year holding period), another exemption from registration is
available or the stock is registered. Even if received in a registered
transaction, securities held by affiliates of a seller prior to the acquisition
will, pursuant to Rule 145, be subject to the resale limitations of Rule 144
(other than the holding period limitations).
The seller may demand registration rights that obligate the buyer to
register the seller’s resale of the stock. This provision may be constructed
as a “demand registration right,” whereby the seller may require the buyer
to register the securities upon demand, or a “piggyback registration right,”
whereby the securities are registered as an add-on to another registration
statement being filed by the buyer. Faced with the prospective expense of
filing a registration statement for the stock, the buyer may resist this type
of a provision or may seek to limit it. The buyer may limit the number of
registrations that will be effected, may place time limits on the rights or
may require that a minimum number of shares from the seller’s
shareholders be available for sale. The seller may insist that no other
registration rights be granted that are on terms more favorable than those
granted to the seller’s shareholders and that the buyer pay all expenses (to
the extent allowable under NASD regulations) of the registration.
Shareholder Approval
Approval of the buyer’s shareholders may be required for the issuance of
the buyer’s stock as consideration for the acquisition. Approval of the
buyer’s shareholders is necessary when the stock issued in the transaction
is in excess of the buyer’s authorized shares or, in some instances, when
the buyer’s shares are listed on the New York Stock Exchange (“NYSE”),
the American Stock Exchange (“AMEX”) or the Nasdaq National Market
(“Nasdaq”). The requirements for shareholder approval vary, but
generally approval is necessary for transactions in which the buyer is
issuing (or in the case of AMEX and Nasdaq, has the potential to issue)
20% or more of its outstanding common stock, or if the issuance will for
some other reason impact control of the buyer. The NYSE, AMEX and
Nasdaq each have specific rules in effect in this regard.
Of course, state law also may require that the buyer’s shareholders
approve the transaction. For example, under Section 6.21(f) of the Model
Business Corporation Act, action by the shareholders of the surviving
corporation in a merger is required if, among other conditions, the voting
power of shares that are issued and issuable as a result of the merger will
comprise more than 20% of the voting power of the shares of the
corporation that were outstanding immediately before the transaction.
It is important to monitor a fluctuating purchase price involving the
issuance of stock to determine if approval of the buyer’s shareholders is
required. Upon execution of a definitive agreement including a purchase
price based upon a fluctuating per share price, it may be anticipated that
the price will remain high enough that the number of shares of buyer stock
to be issued at closing will not reach the threshold requiring shareholder
approval. However, if the buyer’s stock price drops, assuming the number
of shares to be issued at closing is not first capped by the lower limit of the
collar, the number of shares of buyer stock to be issued at closing could
reach the threshold requiring shareholder approval.
If obtaining
shareholder approval is a concern, one alternative may be to pay the
balance of the purchase price in cash.
Tax Considerations
In order to minimize the tax consequences of a transaction, an all stock
transaction typically is structured as a reverse triangular merger. That is,
the acquiring entity will form a merger subsidiary that merges into the
target. If a combination of cash and stock is used, a reverse triangular
merger typically will be tax-free if the stock constitutes at least 80% of the
aggregate consideration for the transaction. Because the value of the stock
is determined on the closing date, parties intending their transactions to be
tax-free under these provisions should provide some adjustment
mechanism in the contract if market fluctuations cause the value of the
stock in the deal to dip below 80% of the aggregate consideration. If the
stock involved is less than 80% of the aggregate consideration, a forward
triangular merger often will afford partially tax-free treatment. That is, the
acquiring entity will set up a merger subsidiary and the target will merge
into the merger subsidiary. If the stock involved falls below 40% of the
aggregate consideration, the stock component of the transaction generally
will be taxable unless a complex structure is used. In determining this
40% threshold, however, Treasury Regulations require the stock to be
valued on the date of signing the definitive contract if the contract
provides for “fixed consideration.” In any reorganization, shareholders
will pay tax on the lesser of their gain realized and the cash received; thus,
it may not be worthwhile to structure a tax-free transaction with respect to
the stock being issued if cash comprises a large portion of the deal
Payment by Promissory Note
Use of promissory notes as consideration can be attractive for several reasons.
The buyer may wish to pay by note if it is cash-constrained or for some other
reason wishes to lower its original cash outlay. By retaining a portion of the
purchase price, the buyer retains leverage with the seller for payment of
indemnification claims. Payment by note may also be beneficial to the seller for
tax reasons.
Set-Off Rights
The buyer may desire to use non-negotiable installment notes as part of
the consideration to create a source against which indemnification claims
can be offset. Although the right of offset is automatic under most state
laws, the buyer’s counsel is well advised to clearly establish the right in
the promissory note.
Tax Benefits
If payment is made by note, the seller will generally report any gain from
the sale on the installment method under §453 of the Internal Revenue
Code of 1986, as amended. Reporting on the installment method permits
the seller to defer a portion of its tax liability until it receives installment
payments on the note. The note cannot be secured by cash or certain cash
equivalents. Furthermore, the seller must make interest payments to the
government on the deferred tax liability on installment obligations
generally to the extent they exceed $5,000,000 in the year they arose.
Security for Payment of the Notes
The seller may wish to negotiate security for payment of the note accepted
in the acquisition. The seller may demand a security interest in the
buyer’s assets, a letter of credit or a guarantee by a third party. The seller
also may accept a pledge of the target’s stock acquired by buyer.
If this last technique is used, the seller should negotiate protections to
ensure that the business, if returned in the event of default, has not been
stripped of all of its value by the buyer. Provisions to protect against such
a possibility include stipulating a minimum level of working capital to be
maintained until the note is paid, prohibiting the buyer from engaging in
the target’s line of business except through the target, restrictions on the
sale of certain assets, restrictions on dividends from the target to the buyer
and requiring the business of the target to be maintained in a separate
The buyer may demand a readily accessible pool of money to cover post-closing
indemnification claims and other specified contingencies. One common way to
provide such a pool is an escrow arrangement providing that a part of the
purchase price be placed in escrow, usually with an independent escrow agent, for
a specified period of time after the closing. With the elimination of pooling
transactions, restrictions regarding the types of contingencies and number of
shares (previously, no more than 10%) with respect to which an escrow may be
established have been eliminated.
Benefits and Risks
The escrow fund established will provide greater ease of recovery for the buyer in
the event of indemnification claims, alleviating concerns about the seller’s
ongoing solvency and potential problems in locating the seller’s assets for
executing judgments. Buyers should be aware that the seller will likely propose
that the escrow fund be the sole remedy for the buyer’s post-closing claims.
Sellers should realize that the existence of the escrow fund significantly changes
the leverages for the post-closing resolution of disputes.
Tax Treatment
Funds paid into escrow and later paid to the seller generally will be taxed under
the installment method described in I.D.2. above. In most escrow situations, the
tax on payments received from escrow will be based on the presumption that all
of the escrow amount will be paid to the Seller. Adjustments are made in the
subsequent year if the seller receives less than the full amount.
Purchase price adjustments (as contrasted to earnouts, discussed later) are used
when there is a fundamental agreement between the parties as to the value of the
target, but when there is a period of time between the signing and closing of the
acquisition. A target’s value is usually determined on the basis of the most recent
financial information available at the time of pricing. Generally, the purpose of a
purchase price adjustment provision is to reflect changes in certain values of the
target between the signing of the acquisition agreement and the closing date. This
period can be significant for a variety of reasons, including:
a Hart-Scott-Rodino filing or other regulatory approvals are required;
third party consents must be gathered;
the buyer requires time to finance the transaction;
securities are to be registered; and
shareholders’ approval must be sought.
The length of the pre-closing period varies, but is often one to three months.
Even in circumstances in which none of these factors is present, there is typically
a gap in time between the latest available financial statements and the closing
date, which may cause the parties to consider a post-closing adjustment. Further,
in seasonal businesses, there are often large fluctuations in working capital
balances that lead to the use of a post-closing adjustment.
These circumstances provide the primary rationale for the use of a post-closing
adjustment: it bridges the gap between the financial condition of the seller at the
time of signing the definitive purchase agreement and its condition as of the
closing date. Thus the buyer receives the benefit of its bargain by receiving the
agreed upon balance sheet (or an adjustment in the purchase price).
An additional rationale for use of a post-closing adjustment is that it effectively
allocates the economic risks and profits of continued operations during the preclosing period (at least in transactions other than asset purchases). During the
pre-closing period, the seller typically manages the business being sold. The
post-closing adjustment usually (but not always) allocates to the seller the
economic risks and profits of continued operation of the target during this period.
If a purchase price adjustment is not used, the earnings generated by the target
between the signing and the closing would accrue to the benefit of the buyer,
since most acquisition agreements prohibit the seller from making distributions
during this period. Conversely, losses would be borne by the buyer absent a
post-closing adjustment. A post-closing adjustment may also be structured to
protect the buyer against potential seller abuses, such as selling inventory without
replacement, accelerating the collection of accounts receivable, stretching
payables and other manipulative practices.
A post-closing adjustment is not a substitute for a “material adverse change”
closing condition, which allows the buyer to refuse to close if the target’s
financial results have materially deteriorated. The adjustment only becomes
operative if in fact the transaction closes; it allows the parties to fine tune the
purchase price after the transaction has been consummated.
Construction of the Post-Closing Adjustment
A post-closing adjustment can be constructed in a variety of ways. The structure
of the post-closing adjustment often varies depending on the theory under which
the entire transaction is valued. These theories include applying a multiple of
earnings or cash flows, measuring the fair value of assets, estimating the value
based on amounts paid in other comparable transactions and calculating a value or
adjusting the value based on information regarding potential synergies with the
buyer’s existing businesses. Regardless of the theory used, the buyer will
typically arrive at a purchase price based, in large measure, on information in the
latest available financial statements and the earnings trend reflected therein.
Thus a properly constructed post-closing adjustment assures that the business the
buyer pays for is the business it ultimately receives at the closing. And regardless
of the theory under which the business of the target is valued, cash is generally
paid for on a dollar-for-dollar basis (or excluded from the acquisition in an asset
deal and left with the seller). Thus an adjustment that takes into account the
target’s current assets and its current liabilities at closing assures that the closing
working capital is accounted for.
Common post-closing adjustments compare working capital, net asset value or net
worth variances between the most recent financial statements available at signing
and the closing date financial statements.
The Market Trends Subcommittee of the American Bar Association’s Negotiated
Acquisitions Committee studies the prevalence of selected provisions in publicly
available acquisition agreements. The Subcommittee’s survey of purchase price
adjustments in acquisitions of private companies by public corporations analyzed
143 publicly filed purchase agreements entered into in 2006 with a transaction
value range between $25-500 million. W. Chu and L. Glasgow, “2007 Private
Target M&A Deal Points Study” (the “Survey”). The Survey found that 69% of
surveyed transactions included purchase price adjustments. The most common
purchase price adjustment identified in the surveyed transactions was the net
working capital adjustment, which is intended to reflect the change in the current
assets and current liabilities from the signing date to the closing date. Working
capital adjustments were used in more than 69% of the transactions reviewed.
Other than working capital, the purchase price adjustment mechanism identified
in the Survey as most heavily utilized was change in net debt. Many other
matrices can be compared, however, such as net book value, tax liabilities,
shareholders’ equity, cash expenditures, net worth, capital expenditures and
number of customers.
Commonly, post-closing adjustment clauses call for a dollar-for-dollar adjustment
to reflect changes in the net working capital, net debt, net asset value or other
measured financial data point between the pre-closing balance sheet and the
closing date balance sheet.
Typical Mechanics
The essential concept of most post-closing adjustments is to compare a specified
financial measure taken from the pre-execution financial statements (often
referred to as a “reference balance sheet”) of the target to the same measure in the
financial statements of the target prepared as of the closing date. The comparison
can be made between balances in the reference balance sheet and the closing date
balance sheet or the comparison can be made between a specified amount and the
closing date balance sheet amount. In a transaction with a post-closing
adjustment, the closing is often scheduled for a month-end (or, even better, a
fiscal quarter-end) to avoid difficult cut-off issues. The closing date financials are
then prepared as of this date so that the comparison to the reference balance sheet
amount can be made. If a period end closing is not feasible, special procedures
should be agreed to that deal with the cut-off issues.
A critical issue relating to the mechanics of the post-closing adjustment is the
decision as to which party is charged with the preparation of the closing date
financial statements. The buyer and its accountants often contend that they
should prepare the closing date financial statements, since the buyer has assumed
control of the business. The seller may argue that it should prepare the closing
date financial statements since consistency with the pre-closing financials is of
paramount importance. According to the Survey, in 79% of the agreements
analyzed, the buyer was assigned the task of producing the post closing
calculation. In 13% of the agreements, the seller was responsible and in 7%, the
parties relied on financials prepared by an independent accounting firm.
Within a specified time period after the closing, usually between 30 and 90 days,
the responsible party delivers the closing date financial statements (often only a
balance sheet) to the other party, along with the preparer’s initial determination of
the purchase price adjustment amount.
Most disputes arising out of acquisitions and divestitures that involve accounting
and financial reporting issues result from the buyer’s preparation or review of the
closing date balance sheet and its divergent presentation of the way the seller
accounted for (or did not account for) items in the balance sheet. The buyer has
increased opportunity after the closing to understand these issues because it now
controls and operates the company it has purchased, thus allowing it access to
information that it may not have had before closing. The buyer can examine the
financial statements in more detail and use the knowledge of company personnel
who are familiar with the company’s accounting systems, practices and
procedures. In the presentation of a closing date balance sheet it prepares or by
objecting to certain amounts or balances in the seller’s closing date balance sheet,
the buyer is, in effect, proposing adjustments that, if proper, would reduce the
purchase price.
Notice of Objection. Under most agreements, the party not responsible for
preparing the closing date balance sheet has a specified period – often 30 to 60
days – during which it can object to items in the closing date balance sheet and
propose an alternative purchase price adjustment. If objectionable items are
discovered, the reviewing party generally must file a notice of objection within
this time. For example, a contract may state, “the Seller may dispute any amounts
reflected on the closing date balance sheet or the net asset value reflected thereon,
provided that the Seller shall notify Buyer in writing of each disputed item, and
specify the amount thereof in dispute, within 30 days of receipt of the Buyer’s
proposed closing date balance sheet.”
Some agreements set forth the required form and scope of response and mandate
that the notice of objection be specific, whereas some contracts have more general
terms. Specific notices usually must identify and explain the item in dispute and
require the objecting party to state the individual dollar amounts of all of its
objections at that time. Some general clauses require only that the notice identify
the objection, without disclosing details until a later date.
Parties often dispute whether the objecting party can submit new items after the
initial objection and whether it can revise items included in the initial notice, and
to what extent. In situations in which the contract is ambiguous, an independent
trier of fact must decide the issue, reducing the predictability of outcome on this
Preparers of closing date balance sheets have incentives to carefully define the
parameters for the notice of objection, allow a short time period between the
presentation of the closing date balance sheet and the required objection cut-off
date, mandate complete and specific disclosure of the disputed items by the
deadline, and allow little flexibility for changing the basic theory or amount of the
buyer’s position. Parties who receive and review the closing date balance sheet
generally prefer the opposite.
Drafting Considerations
Amount Paid at Closing
In many transactions, the buyer pays the fixed amount of the purchase
price at closing, not reflecting any purchase price adjustment. Another
possibility is for the buyer to pay at closing the fixed amount plus or
minus an estimate of the purchase price adjustment, as determined by the
seller employing the post-closing adjustment procedure to pre-closing
financials that are more current than those available at signing. In either
case, one party will have to settle with the other when the closing date
financial statements are finalized and the purchase price adjustment is
calculated. As discussed below, the mechanics of the payment at closing
includes a consideration of whether a portion of the purchase price should
be paid into escrow to ensure the expedited payment of the adjustment
Accounting Specifications
The parties should be wary of merely stipulating that the adjustment
amount will be determined in accordance with generally accepted
accounting principles (“GAAP”) consistently applied with past practice.
GAAP embraces a wide range of acceptable accounting practices. GAAP
is also constantly in flux, with FASB bulletins presenting new guidelines
on an ongoing basis. Described below are many of the accounting issues
that are implicated in drafting a quality post-closing adjustment.
“Preferable” versus “Acceptable” GAAP
Most post-closing adjustments contain a clause requiring that the
closing date balance sheet conform to GAAP consistently applied
over a relevant period that predates the sale. As noted above,
parties involved in transactions often mistakenly believe that
GAAP clearly defines one right number, and that little or no
disagreement can arise. Arguments often ensue as to whether the
method the seller used is more appropriate than the method the
buyer prefers. Such disputes may arise in at least two situations.
First, the buyer may propose an adjustment to the closing date
balance sheet based on an accounting method different from that
applied by the seller. Second, the seller may have prepared the
financial statements used in negotiating and executing the purchase
agreement according to one accounting method and subsequently
may have switched, often subtly, to a method more favorable to the
seller before the closing. This would arguably result in a closing
date balance sheet prepared using a different accounting method
than the historical information provided to the buyer, although both
may be acceptable methods under GAAP. Obviously, these
differences have the potential to significantly affect the final
purchase price.
In these scenarios, each party may make a reasonable argument for
its case. The consistent use of an acceptable accounting method,
however, usually will prevail over a claim to change to a preferable
accounting method. If the financial statements’ preparer has
consistently applied an accounting principle that is in accordance
with GAAP, an accountant would not normally take exception.
Accountants know that GAAP provides little, if any, guidance
regarding more acceptable or preferable methods in the application
of GAAP. Much uncertainty can be removed by specifying which
among the various acceptable GAAP approaches is to be utilized.
GAAP versus Consistency.
Another common issue involves the concepts of GAAP and
consistency. Conflicts often arise regarding whether GAAP or
consistency takes precedence in applying an accounting method to
a particular transaction or a particular account balance. When
GAAP and consistency requirements appear to conflict, experts
usually designate GAAP as the higher and controlling standard.
Though important, consistency normally is a secondary
consideration to the use of GAAP. For example, a seller may have
used consistent, non-GAAP accounting. In that case, absent other
pertinent, contractual provisions or intent of the parties,
appropriate adjustments should be made to conform the financial
statements with GAAP if GAAP is the agreed upon standard.
In some instances, an agreement may specify consistency with
respect to certain items. In such a case, consistency may prevail
over GAAP, especially if the agreement clearly specifies a nonGAAP presentation of such items.
In addition, disputes may arise over the application of the term
consistent. For example, consider the following language: the
company “consistently provides an allowance for bad debts,”
versus “provides an allowance using a consistent calculation
methodology,” versus “provides a consistent amount in the
allowance.” Careful drafting is thus required to capture the
parties’ intent.
Interim versus Year-End Reporting.
The acquisition agreement may mandate consistency between the
pre-closing financial statements used in negotiations and the final
financial statements at closing. Because most companies apply
more rigorous and in-depth closing procedures at year-end,
questions may arise regarding which procedures the preparer of the
closing date balance sheet should apply. The interpretation of such
an issue may differ depending on whether the closing date balance
sheet or the financial statements used in negotiations were monthor period-end, but not regular reporting year-end. For example, if
the financial statements used in negotiations were for an interim
month-end, and the agreement calls for consistently applied
accounting principles, on what basis should the closing date
balance sheet be prepared if the closing date falls at year-end?
Conversely, if the financial statements used in negotiations were
the last year’s audited financial statements and the closing date is
an interim date, on what basis should the closing date balance sheet
be prepared? If these timing issues are present in the acquisition,
the drafter should specify the degree of rigor to be used in the
preparation of the financial statements forming the basis of the
post-closing adjustment.
Errors or Irregularities Discovered after Closing
Sometimes disputes arise as a result of information that becomes
available after the closing date, such as the discovery of previously
unknown errors, irregularities or material departures from GAAP.
Because parties usually do not anticipate errors in the financial
statements, most agreements do not address the treatment of such
issues. The handling of this situation depends on the circumstances
of the error and its discovery. For example, if the financial
statements used in the negotiation process contained the error, but
the seller corrected it to its benefit in the closing date balance
sheet, the buyer will object by arguing that the seller should not
benefit from its own errors. If the buyer, however, detects an error
detrimental to it in the closing date balance sheet and this error was
not present in the financial statements used in the negotiations, the
buyer generally should receive a purchase price adjustment. The
circumstances surrounding the error – when it occurred, when it
became known, when the seller corrected it – will influence how it
should be treated in the purchase price adjustment, or whether it
should be treated as a matter more appropriately dealt with as a
indemnification matter.
Interpreting and applying the accounting concept of materiality to
individual items, transactions, balance sheet or income statement
line items, or the financial statements taken as a whole can result in
dispute. In purchase price disputes, the buyer usually will claim
that all purchase price adjustments, if deemed proper, should be
awarded to it regardless of materiality, unless the contract contains
a threshold, basket or other similar clause.
Agreements occasionally contain clauses indicating that postclosing adjustments will be made only if they exceed a specified
dollar amount in the aggregate – a materiality threshold. The
contract clause may provide that once the adjustments exceed such
levels, the benefiting party receives the entire amount; or the
clause may read that such party will receive only the amount by
which the adjustments exceed the specified level (a basket or
deductible limitation). A materiality level may also be implied
through contract clauses. For instance, a contract may read that no
post-closing adjustment is necessary if the net asset value changes
less than 5% from the net asset value in the financial statements
used in the negotiations process. This implies that the parties
agreed upon a materiality level of 5% of the net asset value. In
many true-up formulations, however, the purchase price is adjusted
upward or downward based on the precise result of the postclosing adjustment.
Accountants have traditionally evaluated materiality with respect
to the financial statements taken as a whole. Occasionally,
however, a purchase agreement indicates that materiality applies
on a line-item basis, thereby lowering the materiality threshold.
If the agreement does not address materiality in any context, either
party may have a difficult time arguing that a materiality threshold
should apply to proposed purchase price adjustments. The seller
may argue that it represented that the financial statements would be
prepared in accordance with GAAP, which contains the concept of
materiality. Therefore, to the extent that the buyer proposes
adjustments that are immaterial, either individually or in the
aggregate, the seller may successfully argue that it did not violate
the representations made in the purchase agreement. In contrast,
the buyer will argue that material for financial statements of a
going concern business means something different from material
for balance sheets closing a purchase transaction. For the going
concern, an item can be in error, but the same error occurring year
after year will not significantly affect recurring operating income
numbers and computations made on them. For a buyer, an upward
change in purchase price of $250,000, for example, may be worth
arguing about even though the amount would not be material to the
financials as a whole. Carefully drawn purchase agreements will
address the materiality standards to be used in balance sheets
closing a purchase transaction.
Changes in Accounting Policies or Practices.
Buyers often will argue that sellers have changed their accounting
policies or practices in preparing the closing financial statements,
and that this change violates representations or covenants in the
agreement. The following list includes common arguments with
respect to balance sheet allowance or valuation accounts:
inventory obsolescence or excess inventory;
doubtful accounts receivable;
returns and allowances; or
estimated liability amounts.
The process of deriving the balances in these accounts involve
judgments that the seller may not closely review and adjust during
interim periods.
Examples of common disputes include a
downward adjustment to an accrued liability by the seller in
preparing the closing date balance sheet, or reducing a general
portion of the allowance for doubtful accounts. Again, these
disputes raise consistency issues. The seller may indicate that it
reviews such accounts only periodically and at year-end, so that
presenting a balance sheet in accordance with GAAP required the
adjustment. The buyer may contend that the seller did not
consistently apply the accounting practices because the seller did
not adjust the accruals downward when it prepared the pre-closing
financial statements used in negotiations. These issues arise so
often that parties should anticipate them in drafting contracts. The
following chart indicates the most common sources of controversy
for major balance sheet items.
Accounts Receivable Allowances
Adequacy of Allowances
Consistency of Allowances (methodology
and amount)
Hindsight Issues
Allowances for Obsolescence
Excess Inventory
Interim versus Year-End Count
Valuation Procedures
Application of Standard Costs
Revenue Recognition
Accounts Payable
Complete Recording
Cut-Off Procedures and Consistency
Management Judgment Issues
Corporate Provisions
Standards No. 5 – Accounting for
Interim versus Year-End Recording
Materiality, Consistency
Recognition and Treatment of Interim
“Smoothing” of Accruals for Annual
Deliveries under Long-Term Production
Recording of Revenue under Government,
Construction or Other Long-Term Contracts
Recording of Revenue and Amortization of
Cost Relating to Intangibles
Deferral and Subsequent Recognition of
Capitalization Issues
Capitalization of Development Costs
Deferral and Subsequent Recognition of
Income Capitalization of Tangible and
Intangible Assets: Amortization Periods
Often, a buyer may contend that allowances reflected in the
closing date balance sheet (such as those for bad debts) are
inadequate and were therefore not stated in accordance with
GAAP. For example, a buyer may argue that a seller’s
$100,000 bad debt allowance was inadequate because the
buyer has learned post-closing that $200,000 of accounts
receivable are uncollectible. The buyer may have a valid
argument if it can prove that information justifying a
$200,000 allowance was available to the seller when it
prepared and finalized the closing date balance sheet. For
instance, the auditors may have identified this exposure and
recommended an allowance of $200,000. If the buyer does
not have reasonable evidentiary indications that information
or knowledge existed prior to the preparation of the closing
date balance sheet, it will likely rely on hindsight.
Generally, the buyer’s use of hindsight beyond the issuance
date of the financial statements is not persuasive, especially
if the seller’s method to calculate the amount prospectively
conforms with GAAP and the seller’s historical practices.
Right to Offset.
Though not written into purchase agreements, sellers often
claim a right to offset as a defense against paying purchase
price adjustments proposed by a buyer that has objected to
balances or items in a closing date balance sheet prepared
by the seller. Buyers typically will review the closing date
balance sheet and identify areas or accounts that contain, in
their view, overstated assets or understated liabilities.
Acceptance of these adjustments would result in purchase
price adjustments favorable to the buyer.
Because buyers seek to reduce the purchase price, they may
identify only those items favorable to them, even though
they may be aware of contractually required adjustments
that would be unfavorable to them. For example, in its
post-closing review of a closing date balance sheet
prepared by a seller, a buyer might note that the vacation
liability is under-accrued by $300,000 and that the worker’s
compensation liability is over-accrued by $300,000. The
buyer may ignore the over-accrual and claim $300,000 in a
purchase price adjustment relating to the under-accrual
associated with the vacation liability. This may lead the
seller to claim the right to offset an under-accrual by a
corresponding over-accrual. The seller may argue that this
right to offset must exist to prevent the buyer from
selectively objecting to the closing date balance sheet. In
some instances, the seller may have been aware of both the
over-accrual and under-accrual, but chose not to record the
offsetting adjustment. The seller, additionally, may claim
that the financial statements, taken as a whole, accord with
GAAP, because the items offset each other.
Because agreements seldom provide for rights to offset, it
may be difficult for the trier of fact to ascertain the intent of
the parties and decide whether to adjust the purchase price
in the event the parties do not settle the issue. Careful
drafting can reduce uncertainty with regard to offsets.
Issues of Control
Issues of control arise in situations in which the party in control of
the operations can potentially manipulate accounting and financial
reporting to its benefit through the post-closing adjustment
process. For example, in a management buyout, the buyer in effect
runs the company during the period between signing the agreement
and the post-closing adjustment. This time period presents an
opportunity (whether exercised consciously or subconsciously) for
management to manipulate the accounting and financial reporting
to benefit its members through the post-closing adjustment.
Alternatively, when a seller operates the company during the stub
period between the date of signing the agreement and the closing
date, it may take advantage of its control and clean up the balance
sheet to the buyer’s detriment. Buyers recognize this potential and
therefore require several provisions in the form of representations,
warranties or covenants in the contract to prevent the sellers from
doing so. Buyers are cautioned not to place undue reliance on
general covenants, such as the requirement that the seller operate
the target in the ordinary course of business between the signing
and the closing. First, this provision at best protects against
manipulation after the signing (and not before). Second, proving
that a practice does not comport with the seller’s ordinary course
of business is difficult. If a particular form of manipulation is
feared, carefully crafted restrictive covenants should be
considered. Further, these carefully crafted representations should
be bolstered with a post-closing adjustment that reflects changes
occurring in the stub period, regardless whether they occur in the
ordinary course or are the result of manipulation.
Conversely, it should be noted that the post-closing adjustment is
not a substitute for thoughtful representations and warranties. If
the seller generates or preserves cash by cutting back on
discretionary expenses, the result will be an increase in cash but
not necessarily an offsetting increase in accounts payable. Thus for
example, the seller might decide to cut back on advertising
expenses resulting in a short-term increase in cash but no change in
accounts payable. Under a working capital post-closing
adjustment, the purchase price will increase even though the
business is arguably worse off and in fact may suffer lower
revenues in the future because of the failure to advertise. Thus, the
manipulation is rewarded by the post-closing adjustment. Only a
representation can provide the buyer with a remedy in this
situation. See M. Tresnowski, “Working Capital Purchase Price
Adjustments – How to Avoid Getting Burned,” The M&A Lawyer,
Oct. 2004.
Issues of control are almost inevitably present when the target is a
division or subsidiary of the seller. In this context, working capital
is managed centrally and thus not part of a “closed system.” Thus
the opportunity for significant movements in working capital is
present and should be anticipated by careful drafting. Similarly, in
this situation, the buyer should guard against disappearing
intercompany assets, such as deferred tax assets.
Caps and Floors
Although relatively uncommon, the purchase price adjustment
provision may contain a provision for a “cap,” which is an upper
limit on the adjustment amount that may be paid out by the buyer
and a “floor” that limits the adjustment amount that may be
refunded by the seller.
Some risks are inherent in employing caps and floors. Parties
should consider whether the use of a cap or a floor will grossly
disadvantage one party if no other contractual remedies are
provided. Employment of a cap or a floor may give rise to a risk
that the party thus constrained will turn instead to contractual
remedies in “unwind” provisions, deferred payment provisions and
indemnity provisions.
Interplay Between the Post-Closing Adjustment and
Carefully crafted acquisition agreements will explicitly deal with
the impact that the post-closing adjustment has on the
indemnification provisions of the agreement. Sellers should insist
that buyers not be allowed to “double dip” by a recovery first
under the post-closing adjustment and then again as
indemnification. For example, if an error in the pre-closing date
balance sheet line items of inventory or accounts receivable causes
a net working capital post-closing adjustment, the seller should
stipulate that this error should not also give rise to indemnification
for a breach of the representation that these line items are stated in
accordance with GAAP. The buyer should be allowed to recover
the damage only once. The buyer may respond, however, that its
loss from the inaccurate inventory or accounts receivable line item
is greater that the mere impact on the post-closing adjustment, and
insist upon collection the full loss, offset by the amount of the
post-closing adjustment.
Dispute Resolution: Designation of Independent Accountants
Because it is not uncommon for disagreements to arise in the
determination of the post-closing adjustment, the parties often
agree upon a dispute resolution mechanism in the acquisition
agreement rather than forcing the parties to resort to litigation. A
common provision for dispute resolution is to designate a firm of
independent accountants to review the closing date financial
statements. These accountants may act as auditors (who review
the financial data and provide an audit of the information) or as
arbitrators (who make a determination as to the proper resolution
of the disputes that have arisen regarding the closing date
financials). If the identity of the independent accountants is not
stipulated by the parties, the parties should specify the procedure
for their selection.
The lawyers drafting the provision should state whether the
independent accountants are to examine only the disputed line
items, or whether they may review the entire closing financial
The Model Stock Purchase Agreement with
Commentary, published in 1995 by the Committee on Negotiated
Acquisitions, Section of Business Law of the American Bar
Association (the “Committee”), provides for submission only of
the “issues in dispute” to the independent accountants, effectively
eliminating this uncertainty. Model Stock Purchase Agreement,
§ 2.6(a). Likewise, the Model Asset Purchase Agreement with
Commentary, published in 2001 by the Committee, provides only
for the submission of “issues remaining in dispute” after
negotiations between the parties to the independent accountants.
Model Asset Purchase Agreement, § 2.9(d).
To avoid the cost of third-party accountants’ fees on smaller
issues, the parties may set financial limits on the issues that may be
submitted to the third-party accountants for review. They may
provide that they will split the amount in dispute or ignore those
smaller issues.
Other issues to be considered in drafting the dispute resolution
provision include:
Should the arbitrator be required to have industry
Will the arbitration process include discovery and written
Will the arbitration be final and binding?
What time frame allowing for negotiations should precede
the arbitration and how long should the arbitration process
Will interest accrue during the arbitration period?
What rules should apply to the arbitration process?
In any event the dispute resolution provisions should clearly
designate the party who is responsible for the payment of the
expenses of the dispute resolution. Typically the costs are split, or
the non-prevailing party is held responsible.
Mechanisms to Ensure Payment of the Adjustment Amount
The parties may place part of the purchase price in escrow to
ensure expedited payment of an adjustment amount.
If a
promissory note has been used to finance the sale, the parties may
agree to increase or decrease, as appropriate, the payments under
the note to reflect the results of the purchase price adjustment.
An earnout provision makes a portion of the purchase price contingent
upon the acquired company reaching certain milestones during a specified
period after the closing. The benchmarks used are typically financial,
such as net revenues, net income, a cash flow measure or earnings per
share. Non-financial benchmarks are appropriate in some circumstances.
When the benchmark being measured reaches a negotiated threshold, an
earnout payment is triggered.
Earnouts (as opposed to typical post-closing purchase price adjustments)
are most often utilized when the buyer and seller cannot agree on the value
of the target. They are particularly useful in dynamic or volatile
industries, or when the buyer’s projections for the target are fundamentally
more pessimistic than those of the seller. An earnout arrangement rewards
the seller if its projections are accurate, while protecting the buyer from
overpaying if they are not. Buyers can use earnouts as a source from
which they can offset indemnification claims. An earnout also may be
attractive to a buyer desiring to bridge a financing gap.
In situations in which the seller’s management will continue to run the
target after the closing, an earnout arrangement may be used by the buyer
to motivate management with performance incentives. If the earnout is
used in this context, however, it may be characterized as compensation
rather than payment for the business and, as discussed later in this article,
there may be accounting implications for the buyer. This use of earnouts
as a performance incentive could have unanticipated impacts in some
areas. In particular, such incentives in the healthcare industry may raise
significant regulatory concerns, as addressed later in this article.
Earnouts are used in transactions large and small, involving acquisitions of
private and, to a lesser extent, public companies. While less common,
recent large public transactions have utilized earnouts. For example, the
$2.6 billion acquisition by eBay Inc. of Skype Technologies SA,
consummated in 2005, contained a complex earnout keyed off gross profit
and net revenue targets, as well as benchmarks based on the number of
users of the target’s technology. A review of the terms of this publicly
available earnout agreement provides meaningful direction on the degree
of specificity required in a sophisticated earnout arrangement.
The previously-referenced Survey of 143 publicly filed purchase
agreements involving private targets found that approximately 19% of
analyzed transactions included earnout provisions. Earnouts are most
likely to be used when the target is private since market valuations assist
in the valuation of the public target. If an earnout is used to compensate
public company shareholders, logistical problems will ensue unless careful
planning is employed. To facilitate payments, a paying agent should be
employed to disburse payments when received by the buyer. As discussed
below under “Registration Issues for Earnout Rights” and to minimize
logistical issues, typically earnout rights are structured so as to be nontransferable (except under the laws of descent and distribution).
Some Risks Associated with the Use of Earnout Provisions
If inappropriately drafted, an earnout can hinder a purchaser’s efforts to
reorient or restructure the target, misappropriate future value to the wrong
party or motivate the earnout recipients to focus on short-term goals that
will maximize the earnout. Further, earnouts have great potential for
engendering later disputes about the contingent payment. Disputes often
arise when the seller suspects that the buyer is using different accounting
techniques during the post-closing period to diminish the payout, or is
artificially depressing or diverting revenues or earnings during the earnout
period. The seller also fears that the buyer simply will not run the
business successfully. Buyers face the risk that the payout formula will
overcompensate the seller in some unforeseen way, due to other
acquisitions or a change in the buyer’s post-acquisition business plan that
essentially has nothing to do with the target. These fears, many legitimate,
should cause counsel for the buyer and the seller to carefully craft the
earnout provisions.
The Model Asset Purchase Agreement with
Commentary contains as an attachment a separate earnout agreement that
provides drafting guidance. Since each earnout is unique, reliance on
forms must be measured.
Drafting Issues
Establishing the Earnout Benchmark; Types of Possible
Earnout benchmarks may be financial or non-financial in nature, or
both. In choosing milestones, and in drafting the acquisition
agreement, the parties should identify and deal with any
post-closing contingencies that could potentially alter the target’s
ability to meet the earnout benchmarks.
Financial Benchmarks
Common financial benchmarks include the target’s net
revenue; net income; cash flow; earnings before interest
and taxes or “EBIT”; earnings before interest, taxes,
depreciation and amortization or “EBITDA”; earnings per
share; and net equity benchmarks.
Revenue-based benchmarks are often thought to be more
attractive to sellers, since they will not be affected by
operating expenses or acquisitions.
The buyer’s
post-closing accounting practices will likely have less
impact on revenue than other items. Buyers are more likely
to agree to a revenue–based benchmarks if costs of goods
sold and overhead have little variability. Generally,
however, buyers oppose revenue-based benchmarks and
favor net income benchmarks on the ground that they are
the best indicator of the target’s success.
Parties often use EBIT or EBITDA measures as milestones
in order to allay sellers’ concerns about net income
measures. EBIT and EBITDA reflect the cost of goods and
services, selling expenses and general and administrative
expenses, and thus are more difficult to manipulate. They
are additionally desirable because they exclude interest,
taxes, depreciation and amortization, which may vary based
on the buyer’s capital structure or the way in which the
acquisition is financed. Finally, for a transaction that is
initially valued using a multiple of post-closing cash flow,
the use of EBIT or EBITDA for the earnout is logical to
determine what is in essence deferred purchase price.
Regardless of the financial benchmark chosen, the parties
should carefully analyze the potential of the earnout to
distort the incentive for producing long-term, sustainable
Non-Financial Benchmarks
Non-financial benchmarks often are used in acquisitions of
development-stage companies. These companies may be
difficult to value, due in part to their high growth rates, and
are particularly suited to the use of non-financial
milestones. In some industries, non-financial milestones
may be the best indicator of fair value. Non-financial
benchmarks may also serve the purpose of giving
operational focus to the target.
A non-financial benchmark could be the introduction by the
company of a new product, inclusion of a favorable article
in a publication that meets specific criteria or the receipt of
a “best technology” or “best in show” award for the
company’s technology or product.
See Spencer G.
Feldman, The Use of Performance (Non Economic) Earnouts in Computer Company Acquisitions, INSIGHTS, August
The Formula for Calculating the Payment Amount
For financial benchmarks, the parties may stipulate the flat amount
of consideration to be paid if the threshold is met. More typically,
the buyer will pay the seller a specified percentage of the amount
by which the target’s performance surpasses the threshold. For
example, the buyer may make an annual payment to the seller
equal to a percentage by which the target’s EBITDA for the year
exceeds the threshold EBITDA agreed to by the parties. The
payment also may be adjusted so that any shortfall in EBITDA for
a previous year will reduce the payment otherwise due for the
current year. An often difficult negotiation ensues regarding
whether payments are prorated if the threshold is only partially
achieved. This negotiation is sometimes settled by establishing a
minimum hurdle before any payment will be made and providing a
sliding scale or proration after that hurdle is achieved. For
non-financial thresholds, the parties must agree upon an amount of
cash consideration or a number of shares of stock that will be
delivered for each milestone that is met. In any event, the payout
is often capped at a specified amount.
Care must be taken to specify with particularity the source of the
earnout –whether the threshold is to be applied to a product line,
the entire target, the division into which the target is absorbed or
some other source.
Lenders will often consider the recipient of an earnout an equity
holder and seek to subordinate the payment to the lender's
unsecured obligations, including seeking to limit payments while
the lender's debt is outstanding. The seller will object strenuously
to such a limitation, likely making its objection known early in the
negotiation. On the other end of the spectrum, the seller may
demand credit enhancement (for example a letter of credit) for the
earnout. These negotiations will turn on the leverage of the parties
and the financial position of the buyer.
The Length of the Earnout Period
Most earnout periods conclude after the expiration of a specified
length of time – generally between two and five years after the
closing. The appropriate length will be determined based on how
long it will take to measure the projected value of the target or the
period during which the buyer desires to incentivize the former
owners. On occasion the earnout is payable upon the occurrence
of a specific event, such as the sale of the target, a change in
control of the buyer or the termination of the earnout recipient's
employment. Because earnouts may affect the flexibility of the
post-closing operation of the target, and few subsequent purchasers
of a business will accept assets burdened by an earnout, it is
usually advisable to the purchaser to have a buyout option for the
earnout. Crafting the valuation of the earnout buyout is generally
difficult. Often parties rely on a multiple of historic payments or
an expert valuation of the target.
Determination of Whether the Threshold Has Been Satisfied
Determination of the Earnout
The seller should insist that the buyer maintain separate
books and records for the target, division or other source of
the earnout throughout the earnout period. The buyer
should covenant that these financial records will be made
available for review upon reasonable notice.
The buyer and its accountants typically will make the initial
determination of whether the milestones have been reached.
The seller then will review the calculations and challenge
them if necessary. In certain situations, it may be
appropriate to require that the results of the earnout period
be audited. The parties should consider requiring quarterly
or some other periodic reporting of the results of the
benchmarks used in the measurement of the earnout. This
early exchange of information can highlight disagreements
in calculation methodologies at a time when their resolution
can possibly avoid later disputes. The potential earnout
recipient should demand access to information sufficient to
verify the underlying data critical to the earnout
Accounting Issues
For financial milestones, the parties should stipulate with as
much detail as possible the accounting principles that will
be used to calculate whether the thresholds have been met.
As noted above, GAAP embraces a wide range of
acceptable accounting practices, and is consistently in a
state of flux. The ability to manipulate the results of an
earnout through adjustment to GAAP is often legitimately
of great concern to the seller. Particular care in delineating
the calculation principles should be used if the threshold is
a non-GAAP financial measure, such as EBIT or EBITDA.
The parties thus should incorporate into the acquisition
agreement a description of the accounting principles to be
employed. Listed below are specific accounting issues that
may arise:
A problem may arise in the form of movement of
revenue and expenses by the party in control of the
target after closing. The lawyers drafting the
earnout provision should address this possibility and
stipulate that post-closing accounting in this regard
should not vary from prior practice. Special care
must be taken, however, if the target was
fundamentally different in the hands of the seller
than the way it will be treated by the buyer (e.g., if
the seller was an S corporation or compensation
expense of the target as a C corporation was
artificially high).
Diligence into the pre-sale
accounting policies of the seller will clarify past
practice and reveal any areas of potential dispute.
The parties should consider specifying whether
changes in GAAP promulgated by the FASB after
closing will affect the determination of the earnout.
Potential Exclusions in Calculating the Payout
and Other Possible Adjustments
The seller should seek to exclude all transaction,
restructuring and integration related expenses
that are charged against the earnings upon
which the earnout is calculated.
When net income is used as the performance
yardstick, parties almost always adjust for
heightened depreciation caused by a write-up in
assets obtained in the acquisition. Prior to the
FASB’s adoption of SFAS No. 142, Goodwill
and Other Intangible Assets, required to be
applied starting with fiscal years beginning after
December 15, 2001 (provided that goodwill and
intangible assets acquired after June 30, 2001
became subject to the amortization and
nonamortization provisions after June 30, 2001),
parties also almost always added back goodwill
amortization in calculating an earnout based on
net income. SFAS No. 142 eliminates the
amortization of goodwill for calendar year
companies for (a) goodwill acquired after June
30, 2001, and (b) for goodwill existing on June
30, 2001, after December 31, 2001. Instead,
SFAS No. 142 requires an annual impairment
test based on a comparison of the fair value of
each reporting unit that houses goodwill
acquired to the carrying amount of the reporting
unit’s assets, including goodwill. Parties should
consider the impact of the annual impairment
tests in determining the earnout with respect to a
When net income, EBIT or EBITDA are used as
the performance measures, the seller should
ascertain what administrative or general
overhead expenses the buyer will allocate to the
target after closing and determine how those
expenses will impact the post-closing figures.
For example, the allocation of corporate
headquarters’ expenses and services allocated
among affiliates should be carefully considered.
The seller will likely attempt to exclude
executive compensation expense allocated to the
The seller’s counsel also may argue that
indebtedness resulting from the acquisition
allotted to the target after closing should be
excluded when calculating the earnout. If
interest is excluded, care should be taken to
exclude expenses associated with financings and
prepayment penalties.
The exclusion that
covers the initial acquisition indebtedness
should also cover subsequent refinancings.
The parties also may desire to exclude
extraordinary gains and losses.
Intercompany transactions between the target
and the buyer or its affiliates also require
adjustment to reflect the amounts that the target
would have realized or paid if dealing with an
independent third party on an arm’s length
basis. If an intercompany charge from the
parent (even if characterized as a management
fee) is actually a distribution of profits, the
payment should not be treated as an expense in
the calculation of the earnout.
While most exclusions from the earnout
calculation are demanded by the seller, the
purchaser should consider whether exclusions
are appropriate. In some situations it may be
appropriate for synergies arising out of the
combination to be excluded from the earnout.
Particularly if the buyer intends to use the target
as a platform for future acquisitions, revenue,
income or cash flow from these acquisitions
may need to be excluded in the earnout
Payments Pursuant to Tax-sharing Agreements
In most situations the target, once acquired, will
become a party to a tax-sharing agreement with the
buyer’s taxpayer group, or become a part of the
buyer’s consolidated tax reporting group. The
seller’s counsel should assure that payments made
by the target pursuant to the agreement or as a
member of the group do not have unanticipated
effects on the attainment of the earnout thresholds.
Accounting Treatment of the Contingent
Consideration When Linked with Future
A difficult accounting issue arises in those
transactions in which contingent consideration is
linked with the continued employment of the
seller’s management. In transactions in which the
contingency is based on the future earnings of the
seller and the management of the seller enters into
employment contracts with the new entity, the
question arises whether the substance of the
additional payments is truly a payment for the seller
or rather a salary expense in the form of bonuses
based on production. The issue is particularly
relevant to acquisitions of small businesses.
In 1995, the FASB’s Emerging Issues Task Force
reached a consensus on this issue in EITF 95-8,
Accounting for Contingent Consideration Paid to
the Shareholders of an Acquired Enterprise in a
Purchase Business Combination. The consensus
opinion notes that the following factors should be
considered when evaluating the propriety of
accounting for contingent consideration based on
the formula for determining contingent
treatment of the contingent payment for
tax purposes;
linkage of payment of contingent
a composition of the shareholder group;
other arrangements with shareholders,
such as noncompetes, consulting
agreements and leases.
The determination as to whether payment of
contingent consideration represents purchase price
or compensation is based on facts and
circumstances. The EITF notes that if a contingent
payment arrangement is automatically forfeited if
employment terminates, a strong indicator exists
that the arrangement is, in substance, compensation.
The EITF goes on to note, however, that the
absence of linkage between continued employment
and payment of contingent consideration does not
necessarily imply that the payment of a contingency
represents purchase price. Another factor is the
proportionality of the seller’s right to receive
earnout payment compared to the seller’s ownership
interest. If proportionality exists, the earnout is
more likely to be characterized as a deferred
payment. If proportionality is lacking, then the
earnout is more likely to be compensatory in nature.
See Kimberly Blanchard, The Taxman Cometh,
BUSINESS LAW TODAY, May/June 1997, at 61.
It is important to note that an earnout must be
treated consistently as to avoid re-characterization.
“As a threshold manner, an earnout should be
treated as compensatory only if the seller actually
performs services for the buyer after the sale or
gives an economically meaningful covenant not to
Kimberly Blanchard, The Taxman
Cometh, supra, at 60.
The same principles that are relevant for the
accounting characterization of the earnout payment
apply to the tax treatment of the payments. Earnout
payments to sellers who participate in running the
business of the target during the earnout period may
be treated, not as a capital gains, but as ordinary
Other Issues to be Considered
Other potential areas for variation that should be
addressed include inventory valuation methods
(LIFO versus FIFO, as well as the manner of
treating inventory as obsolete), depreciation
schedules, accounting for retirement and welfare
benefits and reserves for bad debts. The parties
should carefully consider whether there are matters
of heightened concern or specific to the target's
industry, often mandating that the parties specify
the accounting methodology to be used.
A recent federal court decision, Didion Milling, Inc.
v. Agro Distribution, LLC, No. 05-C-227, 2007 WL
702808 (E.D. Wis. March 2, 2007), highlights the
perils of imprecise drafting, especially when an
earnout is based on a financial measure other than
revenues. In this case, the earnout was pegged to
changes in net cash flow, with the agreement
specifying that the calculation would be made in
accordance with GAAP and on an after-tax basis.
Difficulties arose when the earnout agreement was
assigned from a corporation to a limited liability
company, making the after-tax calculation subject
to ambiguity since the LLC is a pass-through entity.
Further there was disagreement as to the appropriate
interest deduction against the earnout calculation,
including whether the buyer’s overall cost of capital
could be used to apply across the board. Both of
these issues deserved more precise treatment in the
merger agreement.
Form of Payment of Earnout Obligation
Cash is often used as the earnout payment, but not infrequently the
contingent consideration is stock. Another variation is to allow the
buyer the option to pay in stock or cash. The use of cash may be a
problem when the target is thriving and the buyer’s other
businesses are performing poorly. On the other hand, the use of
stock to satisfy the earnout may dilute the buyer’s earnings per
share. Additionally, the use of stock raises various valuation,
securities and tax issues. The purchaser may be required to specify
the maximum number of shares that will be issued as part of the
earnout arrangement for securities and tax reasons that are detailed
Valuation Issues
The parties to the acquisition agreement must determine the
date as of which the stock used in the earnout will be
valued, which will likely be at either the time of the closing
or the time of issuance. If the time of the closing is
selected, the buyer likely risks an increase in the acquisition
price caused by a run-up in the stock price between closing
and the issuance.
The seller runs the risk that the buyer will issue additional
common stock during the earnout period that is priced
lower than the market price or the per share value assigned
in the acquisition. Counsel for the seller may suggest a
provision designed to protect against dilution of the shares
that are earned but have not yet been distributed.
Securities Issues
The stock that is issued in an earnout must, of course, be
registered or exempt from registration. Affiliates of the
target who receive stock and affiliates of the buyer must
abide by the selling restrictions of Rules 145(d) and 144,
respectively, of the Securities Act.
Practitioners should examine Rule 144(d)(3)(iii), under
which the earnout stock may be deemed to have been
acquired at the time of the transaction’s closing for
purposes of calculating the holding periods of Rule 144 if
the issuer or affiliate was then committed to issue the
securities subject only to conditions other than the payment
of further consideration for such securities. An agreement
to remain employed or not to compete entered into in
connection with a transaction, or services performed
pursuant to such an agreement, are not deemed payment of
further consideration. See also Medeva PLC, 1993 SEC
No-Act LEXIS 1145 (concluding that the holding period
for shares issued as deferred consideration commenced on
the date the target shareholders elected to receive payment
in shares rather than cash).
Additionally, in connection with the listing of the buyer’s
stock at the time of the acquisition, a securities exchange
will likely require that the buyer specify a limit on the
number of its shares to be issued as contingent
Related Tax Questions
If the acquisition is structured as a tax-free reorganization,
the use of contingent consideration may cause difficulties
for the parties. In all types of tax-free reorganizations,
there are limits on the amount of cash or other property
(other than stock) that can pass as consideration. The
permissible amounts vary by transaction form. Care must
be taken to limit cash earnout payments to that allowed
under the applicable reorganization type or to pay the
earnout in additional stock that meets the applicable
Similar to escrow payments, amounts paid to the seller in
years following the year of sale generally will be taxed on
the installment method described above. The specific
treatment will depend on whether there is a stated
maximum earnout amount or simply a period over which
the earnout payments will be made.
With respect to otherwise tax-free transactions, the Original
Issue Discount Rules of Section 483 of the Internal
Revenue Code require that some portion of the deferred
consideration, if made in stock, must be allocated to
interest, reportable as such by the seller and deductible as
such by the buyer. The remaining portion of the stock is
generally treated as additional tax-free consideration
emanating from the original purchase. The IRS has issued
ruling guidelines relating to the treatment of this contingent
stock in Rev. Proc. 84-42, 1984-1 C.B. 52.
Operation of the Acquired Business During the Earnout
Both the buyer and the seller may fear mismanagement during the
earnout period that could affect the payout.
Operation by the Buyer Post-closing
The seller typically has concerns that the target will not be
properly managed after the closing. The seller may require
that the buyer operate the target in the ordinary course of
business consistent with past practice, and may attempt to
reserve, through contractual covenants, some authority
regarding major decisions made during the earnout period.
The seller will likely demand that the target be operated as
a distinct business entity or division so that its results can
be verified. The seller may require that the buyer
adequately fund the target during the earnout period so that
it will be able to capitalize on opportunities presented to it.
For example, the target may negotiate that the buyer
provide, post-closing, minimum absolute funding levels or
cash sufficient to meet the external cash needs
contemplated by annual budgets after they are adopted.
The agreement may be so specific as to provide that the
cash will be provided as an equity contribution, or if
provided as an intercompany loan, that the loan will be
subordinate to other indebtedness and that no payments in
respect of the loan will be made (or accrued to affect the
earnout) until after the earnout period (and payment of the
earnout if due).
Earnout agreements often contain generalized “good faith”
clauses. The agreement may require, during the earnout
period, that the parties act in good faith and in a spirit of
fair dealing or may require that the buyer refrain from any
transactions, the purpose of which, or one purpose of
which, is to undermine the ability of the target to achieve
the earnout. The earnout may be crafted to acknowledge
the parties’ agreement or intent to exploit specified
opportunities or to promote the target products or services
generally. The earnout will often provide that the buyer
will not compete with the target’s business during the
earnout period.
In many earnout agreements, the target demands a role in
the oversight or management of the buyer or the division
that is operating the target after the closing. For example,
the potential earnout recipients may demand seats on the
parent’s board, quorum requirements, super-majority votes,
specified management roles, designated incentive packages
for management, rights with respect to the termination of
employees or a role in the development of operating plans
or capital budgets. Critically, the well drafted earnout
provision specifies in detail the consequences of the breach
of any of the governance or other provisions.
Any limitation of the buyer’s freedom to run the target as
circumstances require should be carefully analyzed by the
Operation by
Less commonly, the seller’s management will continue to
operate the target post-closing. In this situation, the
buyer’s risk is that the seller’s management team will
operate the business so as to unfairly maximize the payout
amount. Counsel for the buyer should attempt to provide
appropriate controls over the target, including a
mechanism for reviewing decisions that can affect the
Protection Placed in the Acquisition Agreement
The parties also may wish to include detailed post-closing
operational procedures in the acquisition agreement in
order to avoid uncertainty. For example, the buyer might
covenant to operate the company consistent with past
practice subject to certain exceptions, or the buyer might
agree to restrictive covenants that prevent the target from
taking specified actions (such as making large
expenditures) during the earnout period. Recent case law
explores the performance of the parties to the earnout
arrangement, in light of provisions contained in the
acquisition agreement and principles of good faith and fair
The Survey found that 63% of analyzed transactions
contained neither a covenant to run the business consistent
with past practice nor a covenant to run the business in
order to maximize the earnout.
Several recent decisions have addressed the issue of the
operation of the acquired business during the earnout
period. In Horizon Holdings, LLC v. Genmar Holdings,
Inc., 244 F. Supp. 2d 1250, 1257-58 (D. Kan. 2003), the
trial court held that when evaluating the principles of good
faith and fair dealing, a court may imply terms to honor the
parties reasonable expectations. In Horizon, the seller had
remained employed as president of the new entity in an
attempt to realize the $5.2 million earnout. The earnout
was defined in the agreement as part of the purchase price.
The seller had been assured that he would be given
autonomy as president and that he had a realistic
opportunity to receive the earnout.
However, upon
acquiring Horizon, the seller alleged that the buyer
interfered with business operations and prevented the seller
from meeting the earnout threshold. In sweeping language,
the court held that it could imply terms in an agreement to
honor the parties reasonable expectations when those
obligations were omitted from the text of the contract. In
determining whether to imply terms in an agreement, the
court noted that the proper focus was on “what the parties
likely would have done if they had considered the issue
Using language unusual in contract
interpretation cases, the court stated that the jury could
have readily concluded that the parties would have agreed,
had they thought about it, that the buyer would not be
permitted to undermine the president’s authority, to
abandon the companies brand name or to mandate
production of a rival product thereby impairing the
realization of the earnout. The jury award of $2.5 million
was upheld.
The buyer appealed the District Court’s decision, arguing
that the “implied covenant claim…fails because there is no
evidence the parties would have agreed to the obligations
the District Court imposed by implication.” O’Tool v.
Genmar Holdings, Inc., 387 F.3d 1188 (10th Cir. 2004).
The argument was rejected by the court, which stated that
such an argument “ignore[s] the spirit of the parties’
agreement.” Rather, the appellate court found that the
inclusion of the earnout provision as part of the purchase
price of the business necessarily implies that the seller
“would be given a fair opportunity to operate the company
in such a fashion as to maximize the earnout consideration
available under the agreement.” Id. at 1196-97.
The court in Rumis v. Brady Worldwide, Inc., 2007 U.S.
Dist. LEXIS 37190 (S.D. Cal., May 21, 2007), granted the
buyer’s motion for summary judgment using the same
analysis as the District Court in the Horizon Holdings case.
In attempting to determine to what the parties would have
agreed, had they thought about it, the judge found no
evidence that the agreement would have affirmatively
required the buyer to market the target's products through
its various distribution channels, even though the
agreement included an earnout based on the sales of the
target’s products. Further, the court found that, lacking
some clear evidence of ulterior motives on the part of the
buyer, there was no violation of the implied duty of good
faith and fair dealing. Rather, in this case the court found
that a general reorganization of the buyer was undertaken
for valid business reasons, and the seller’s failure to
achieve the earnout was the result of a valid shift of focus.
The United States District Court for the Southern District
of New York, in Woods v. Boston Scientific Corporation,
2006 U.S. Dist. LEXIS 96050 (S.D.N.Y., Nov. 1, 2006)
also analyzed the requirements of good faith and fair
dealing in the context of an earnout provision. In this case,
Boston Scientific negotiated a merger with Advanced
Bionics Corporation (“ABC”), a medical products company
that focused on cochlear devises and neural electrical
stimulation systems to treat chronic pain.
negotiations, the parties agreed upon certain acquisition
terms, including a $742 million payment to ABC
shareholders as well as the opportunity to receive additional
consideration through earnout payments based on ABC’s
post-merger sales growth in four specified products. The
earnout payments were to be based on revenues, rather than
profits, which were projected to be at least $3.2 billion. In
addition, Boston Scientific agreed to provide cash in an
amount “reasonably sufficient” to meet the cash flow needs
of ABC, up to $100 million of which would be provided
without additional approval.
The merger agreement, under which ABC would become a
wholly owned subsidiary of Boston Scientific, provided for
a system of joint control of the ABC subsidiary. The dayto-day management was to be conducted by its co-CEOs,
Alfred Mann and Jeffrey Greiner, employees associated
with the target pre-closing, who reported to an executive
board comprised of three ABC subsidiary members and
three members designated by Boston Scientific. As the
ABC subsidiary’s performance fell short of expectations,
Boston Scientific attempted to replace Mann and Greiner
without using the procedures enumerated in the merger
ABC’s shareholders sought temporary
injunctive relief, claiming that Boston Scientific’s plans to
replace the current management and reorganize the
business structure would permanently and adversely affect
the shareholders’ bargained-for right of joint control with
the Boston Scientific, putting the earnout payments at risk.
After analyzing the merger agreement and facts of the case
in detail, the court found the evidence of the ABC
subsidiary’s lapses in quality control and poor financial
performance to be inconclusive, but stated that Boston
Scientific appeared to have a valid cause for concern. The
court further indicated that Boston Scientific’s executives
appeared to genuinely believe that their concerns merited
the replacement of Mann and Greiner. However, the court
stated, “Nevertheless, no matter how legitimate the reasons
are for firing Mann and Greiner, they do not justify the
means by which Boston Scientific has proceeded.” Id. at
70. Further, “Defendant must proceed in good faith under
the joint management structure of the Merger Agreement.”
Id. at 71.
The court related, “consider[ing] the overall thrust of the
Merger Agreement, which provides for the Earn Out
Recipients ongoing involvement in the management of
Bionics, and various safeguards for the protection of their
interests,” Boston Scientifics’ interpretation of the merger
agreement “frustrates those purposes.” 1
The court
recommended the issuance of a preliminary injunction
enjoining Boston Scientific from dismissing Mann and
Greiner until the parties completed the dispute resolution
process in good faith. The injunction was thereafter upheld
Id. at 39
on the same grounds. 2 This decision highlights the
difficulties of negotiating and operating under complex
provisions that give the sellers’ representatives joint control
over the target post closing.
A recent ruling by the Delaware Court of Chancery
contains strong admonitions to lawyers writing earnout
provisions that imprecise drafting can undercut potential
earnout recipients’ chances of a favorable outcome. The
case further highlights the difficulty faced by the earnout
recipient of proving damages even if it can establish that
the purchaser breached its post-closing obligations. In
LaPoint v. AmerisourceBergen Corp. (Del. Ch., No 327CC, decided Sept. 4, 2007), former shareholders of Bridge
Medical, Inc. (“Bridge”), the developer of a bar-code
enabled bedside point-of-care solution for use in the
healthcare services industry, sued Bridge’s buyer,
AmerisourceBergen Corporation, over an earnout. As is
often the case, the earnout was crafted to bridge the
optimism in the startup technology company’s forecasts
and the buyer’s valuation, more grounded in its historical
results. As part of the earnout, which was based on
achieving EBITDA targets, the buyer agreed to exclusively
and actively promote Bridge’s products. The merger
agreement required the buyer to act in good faith during the
earnout period, and prohibited it from taking any actions
any purpose of which was to impede the ability of the
Bridge shareholders to achieve the earnout.
Chancellor Chandler described these provisions as
“aspirational statements,” “gossamer definitions” and
“nebulous requirements.” Nonetheless, the court found that
Bridge’s shareholders were validly aggrieved by the
behavior of the buyer during the earnout period.
Chancellor Chandler also wrote that Bridges was not
without fault, noting that considerable evidence was
presented that Bridge’s management was pre-occupied with
maximizing short-term EBITDA, which led it to cut
marketing and R&D spending at the expense of long-term
Despite the court’s finding that the buyer failed to promote
Bridge’s products as contractually required, Bridge was
See Woods v. Boston Sci. Corp., 2007 U.S. Dist. LEXIS 20056 (S.D.N.Y., Feb. 20, 2007).
largely unable to demonstrate that the buyer’s general
failure to promote Bridge during the earnout period led to
damages that could be established with a reasonable degree
of certainty.
The court noted that the buyer produced convincing
evidence to suggest that even had it acted in complete good
faith, Bridge was unlikely to have achieved considerably
greater success. This recent case shows the precision that
courts expect in the crafting of earnouts, as well as the
difficulty of establishing damages when enforceable
contract provisions are breached.
In addition to contract provisions and implied duties of
good faith, at least one case analyzes whether a seller could
establish that buyer breached a fiduciary duty in connection
with an earnout. In Richmond v. Peters, 155 F.3d 1215 (6th
Cir. 1998), plaintiff sold his business to defendant with the
price and payments to be determined, in substantial part, by
reference to the profits of the continuing business in excess
of an agreed upon base-level amount. The agreement
between them provided that the business was to be
managed in accordance with “sound business practices.”
Plaintiff claimed that defendant breached their agreement
and further breached a fiduciary duty owed by defendant to
the seller. On motion for judgment as a matter of law after
plaintiff presented his case, the trial court ruled that Ohio
law imposed no fiduciary duty upon defendant and that
plaintiff had presented no evidence that defendant had
breached any provision of the agreement. The court held
that the facts of the case should be reviewed with respect to
the contract claim. It is significant, however, that the trial
court found, and the appellate court agreed, that under Ohio
law, the earnout agreement created no fiduciary duty
between the parties.
A key lesson to be learned from the above-referenced cases
is that the parties should be explicit in crafting the
expectations for the post-closing conduct of the parties to
circumvent a court setting the ground rules.
Payment of Earnouts to Public Shareholders
Payment of earnouts to public shareholders of a seller that does not
survive the transaction can be a logistical problem. One common
solution is to establish a paying agent to disburse earnout payments
to the seller’s former shareholders. This paying agent may handle
any disputes with the buyer during the earnout period as well.
Shareholders Designated to Act for the Seller
In situations in which the entire seller is sold to a buyer in a
transaction with an earnout, the parties should consider
establishing a committee to act on behalf of the persons who were
shareholders of the seller at the closing. The committee would
speak for the shareholders on matters relating to the earnout and
indemnification. The provisions establishing the committee should
delineate its powers and how it can act. Funds should be set aside
to cover the expenses of the committee and its counsel. Often, the
acquisition agreement simply will specify that the buyer will
communicate with the committee, or shareholders’ representative,
post-closing. In such case, the obligations of the committee to the
shareholders will be addressed in a separate shareholders’
representative agreement.
Sale of the Target or the Buyer During the Earnout Period
The parties should determine whether the target or a portion
thereof may be sold to a third party during the earnout period, and
the effect of such a sale should it take place. A similar problem
arises when a third party acquires the buyer during the earnout
period. As suggested above, the lawyers for the seller may suggest
that the third party buyer be obligated to pay off some or all of the
earnout amount at the time of the second sale.
A similar concern arises when a seller desires to liquidate or
completely close down the operations of the target during the
earnout period. In a February 2007 case, Chabria v. EDO Western
Corp., No. 2:06-CV-00543, 2007 WL 582293 (S.D. Ohio Feb. 20,
2007), the agreement between the parties included a provision that
the purchase price for the target would be $669,107.85, with an
additional royalty to be paid to the sellers in the amount of five
percent of the gross sales from the target’s product line. When the
buyer quickly shut down operations of the target, but enforced a
six-year non-compete agreement, the seller sued claiming fraud,
breach of contract and breach of duty to act in good faith. The
court found that the fraud action could not be maintained, but
based on the implied covenant of good faith and fair dealing, the
promise to pay royalties necessarily implies a promise to use
reasonable efforts to sell the product line.
Integration of the Target into the Buyer’s Other Businesses
The parties must decide how to calculate the earnout if the target
should be merged into similar entities owned by the buyer. The
difficulty of measuring performance in this case may make buyers
reluctant to fully integrate the acquired business into the rest of the
buyer’s business. A parallel difficulty arises when the buyer
acquires additional, similar businesses during the earnout period.
In these situations, the buyer and seller must work with
accountants to formulate a plan for segregating the financial
statements that form the basis of the target’s earnout thresholds.
This segregation can preclude the buyer from achieving the
economies of scale and synergies it anticipated in consummating
the acquisitions.
One solution is to assess the financial
performance of the whole group and, for purposes of calculating
the earnout, assign to the target its pro rata share of the overall
amount. Alternatively, some buyers pay off the sellers during the
earnout period to end the arrangement early.
A recent earnout case, Vaughan v. Recall Total Information
Management, Inc., 217 Fed App. 211, 217 (C.A.4 2007),
underscores how important this concept can be, particularly to
buyers. In this case, the part-owner and general manager of the
target was hired by the buyers as the Executive Vice President in
charge of sales after the acquisition. The earnout payments were
based upon the target meeting certain sales revenues requirements.
While the general manager and the target did not meet the sales
revenues requirements independently, the court agreed that the
term “Sales Revenues,” which was defined in the agreement to be,
“All gross revenue generated by the Company from new contracts
or agreements from any source,” included revenue generated due
to the buyer’s acquisition of additional businesses that it merged
with the target. Therefore, the target’s former owners were able to
collect a significantly higher earnout due to the buyer’s subsequent
acquisitions. Careful drafting of the earnout provision or different
structuring of the buyer’s acquisitions could have altered this
Averaging Periods of Strong Performance With Weak
The parties must decide whether performance well above threshold
levels in one part of the earnout period may be applied to
supplement a lesser performance during another part of the earnout
Dispute Resolution
Disputes regarding earnouts are commonplace, and the lawyers
drafting the earnout provision are well advised to consider the
appropriate form of dispute resolution under the circumstances.
Many earnouts require binding arbitration of disagreements that
the parties cannot resolve within a brief period of time. Arbitration
is favored over litigation because the former generally is faster,
less expensive and a better forum within which to deal with
complex financial issues. However, the growing perception that
arbitrators render “split the baby” decisions that attempt to satisfy
both sides has caused some advisors to favor litigation as a more
predictable source of appropriate outcome. If litigation is favored,
jurisdiction and venue should be specified. All provisions
regarding dispute resolution should be detailed and carefully
crafted anticipating all plausible scenarios.
Registration Issues for Earnout Rights
Under certain circumstances earnout rights may be deemed
securities under the Securities Act. To prevent the necessity of
registration, acquisition agreements usually prohibit any transfer of
the right to the earnout payment and assert that the right is not an
investment contract or other type of security.
In a series of no-action letters, the SEC evaluated whether or not
specific earnout agreements constitute a security. 3 The SEC
emphasized that the facts of any particular situation must be
evaluated closely, but it concentrated on the following factors
when deciding that a particular earnout did not constitute a
For further information, refer to Great Western Financial Corp., SEC No-Action Letter, No. 042583014
(April 4, 1983); Northwestern Mutual Life Insurance Co., SEC No-Action Letter, No. 030783002 (March
3, 1983); Lifemark Corp., SEC No-Action Letter, No. 112381006 (November 17, 1981); and Kaiser Aetna,
SEC No-Action Letter, No. CCH19730730010 (July 30, 1973).
The earnout right was granted to the sellers as part of
the consideration for the sale of their business and
neither the purchasers nor the sellers viewed the right as
involving an “investment” by the sellers;
The earnout right did not represent an ownership
interest in the purchaser and was not evidenced by any
The earnout right could not be transferred except by
operation of law; and
The earnout right did not entitle the owner to voting or
dividend rights.
Special Industry Limitations
Advisors to parties desiring to structure post-closing adjustments
and earnouts are cautioned to ascertain the legality of the
arrangement under the regulatory laws applicable to the parties to
the transaction. Certain industries have laws that may impact the
structure of post-closing adjustments in unique ways. For
example, healthcare transactions are heavily regulated by federal
law. Two federal statutes, commonly known as the Anti-Kickback
Statute 4 and the Stark Statute 5, may impact the use of earnout
provisions in healthcare transactions, particularly when the sellers
are parties with the potential to refer business to the buyer postclosing.
The Preamble to the Stark Phase II regulations
specifically indicates that post-closing adjustments that are
commercially reasonable and not dependant on referrals or other
business generated by the referring physician are permitted if made
with six months of the purchase or sale transaction, and the
transaction otherwise complies with the isolated transaction
exception, the analysis does not necessarily end there.
Earnouts in the healthcare industry raise thornier issues. While
earnouts are not per se illegal in the healthcare industry, an earnout
payment may be suspect and raise potential issues under the AntiKickback Statute. The Office of Inspector General of the
Department of Health and Human Services (“OIG”) has indicated
that earnout arrangements may violate federal anti-kickback laws if
42 U.S.C. §1320a-7b(b).
Social Security Act § 1877; 42 U.S.C. § 1395nn.
the earnout payment is tied to the volume or value of federal or
state healthcare program referrals or business directly or indirectly
made, influenced, generated or arranged for by the seller. For
example, if an earnout will be paid only if the seller continues to
refer patients to the facility post-closing, the earnout payment may
be viewed as potentially problematic by the OIG. Whether these
arrangements are direct (for example, the parties explicitly know
that referrals must be made in order to receive earnouts) or indirect
(for example, the physician knows that referring many patients will
maximize profits for the facility and therefore the earnout), the
earnout payment might be deemed as impermissible remuneration
in return for or to induce referrals or the arranging of business to
the facility post-closing.
Additionally, under the Stark Statute, a hospital likely may not pay
for a physician practice it acquires in installments or through an
earnout (assuming the physicians will refer to the hospital after the
The rationale for these regulatory restrictions is to eliminate the
motivation for improper referrals to the facility, which could
otherwise benefit the referring practitioner by enhancing the
financial strength of the buyer so it can pay the earnout. Moreover,
the statute has been interpreted to indicate that such improper
remuneration is illegal if only one purpose of the remuneration is
to induce referrals, even when such compensation is paid as
legitimate consideration in a sale of assets. 6
Finally, the use of earnouts in the healthcare industry could prompt
a regulator to carefully scrutinize all earnout-period reimbursement
requests that are presented to Medicare or Medicaid, especially if
the regulator considered the earnout to provide an incentive to bill
Medicare or Medicaid more than what the facility is owed under
the Medicare and Medicaid regulations. An earnout could be of
particular concern to a regulator if part of the earnout is tied to
financial performance that is directly or indirectly related to the
receipt of payments by Medicare or Medicaid. Such concerns
should be fully vetted prior to utilizing an earnout provision in a
healthcare acquisition. Other industry-specific requirements may
affect the ability to structure acquisitions with earnouts.
United States v. Kats, 871 F.2d 105 (9th Cir. 1989); United States v. Greber, 760 F.2d 68 (3rd Cir.), cert.
denied, 474 U.S 988 (1985).
There are many forms of consideration paid in acquisitions, all with their own
advantages and disadvantages. The most common forms of payment are cash,
stocks, promissory notes, the assumption of indebtedness or some combination
thereof. The parties should pay close attention to the accounting, tax, securities
laws, industry-specific regulations and practical consequences of each form of
consideration. Importantly, the chosen form of consideration may affect the
leverage between the parties after the closing.
In many transactions, some form of purchase price adjustment is appropriate.
Even when there is fundamental agreement between the parties as to the purchase
price, if there is lag time between the pricing and closing, some form of “true-up”
may be appropriate.
Earnouts are usually employed when there is a disagreement as to the value of the
target, but may also be useful in other scenarios such as a performance incentive.
Parties should take great care in crafting the earnout. They should specify, in
detail, the nature of the hurdle giving rise to the earnout obligation, the accounting
methods that will be used in ascertaining whether the earnout has been achieved,
the inclusions and exclusions from the earnout calculation, the specific
obligations each party must undertake in order to reach the hurdle or prevent
improper barriers, and who will determine whether the earnout threshold had been
met. It is essential that all possible scenarios be explored as the earnout is crafted
to avoid future conflict. Industry-specific regulations can implicate the legality of
both post-closing adjustments and earnouts.