Should you fear earnouts in M&A deals?

By Tom McLain

The Corporate Dealmaker section of The Deal.com (the online version of The Deal magazine) recently asked the question: Who's Afraid of Earnouts? The occasion for the question was a study of the deal making philosophy of Jim McCann, founder and CEO of 1-800-Flowers.com Inc., whom Kenneth Klee, writing for The Deal on June 19, 2009, dubbed the "Entrepreneurial acquirer." Mr. McCann says that his company uses earnouts in every acquisition of a company. The counter-argument to the use of earnouts is found in Klee's June 5, 2009 article, Arguments postponed. So we have Mr. McCann extolling the virtues of an earnout and other experts saying that earnouts usually wind up being nothing more than a postponement of an argument. The point behind this article is to weigh in on the question of "Who's afraid of Earnouts?"

Like any good attorney, I'll start by reframing the question before I answer it. The question that is probably a little more appropriate is: "Who's very cautious about using earnouts in an acquisition?" Answer: I am. Perhaps the primary reason for my caution is that, in my experience, a significant number of earnouts creep into deals when buyers and sellers disagree over the value of a business. Since many of these disagreements are based on a different view of the future (the seller claims to see explosive growth and the buyer claims to see conservative growth or even contraction), an earnout serves as a compromise between the optimism of the seller and the pessimism of the buyer. These types of earnouts are usually tied in some way to the revenues (either gross or net) of the business after it has been acquired: if the revenue thresholds are met, the seller will receive some additional compensation. Lets call these "business performance earnouts."

One of the first cautious in connection with earnouts, in general, and business performance earnouts, in particular, is the tendency for both sides to believe that their assumptions will be borne out. This is usually a bigger problem for sellers because they may count the additional compensation embodied in the earnout as “money in the bank.” So if a seller accepts a deal that only works economically if earnout is paid, there is a significant risk of disappointment. Not only is the earnout dependent on how the business does as a unit of the acquiring company, but the earnout can also be influenced by overall economic conditions. It is quite easy to imagine that a significant number of performance-based earnout thresholds have been missed over the last 18 months due in large measure to the overall economic malaise. However there are other reasons to be cautions about earnouts.

Business performance earnouts can be quite tricky to define. Picking an appropriate performance criteria can be much more difficult to do that it may seem. It is not unusual for one of the parties to discover after the fact that the measurement rewards behavior that would not otherwise be desired. So, a lot of careful thought needs to be done by the financial and business due diligence teams before signing off on an earnout formula. The due diligence done in support of developing an earnout formula should include many things, including, without limitation, analysis of historical trends in the business, validation of the sales efforts, determination of the sensitivity of the business to adverse economics or increased competition, careful modeling, understanding the metrics of the business and determining how best to measure its success. Even when all the homework has been done, it is not unusual for me to caution sellers to assume that they will never see a dime of the earnout and to caution buyers to assume that they will wind up paying the entire earnout irrespective of whether either side feels like the performance thresholds have been met or missed. This is because there are often ways to "game" the formula and there are many unpredictable and uncontrollable influences on the formula. In other words, in this regard, I tend to fall into the camp that says that earnouts are merely a way to delay arguments until later.

However, the most difficult part of business performance earnouts can be the way in which they impact the integration the purchased business operations into the acquiring business. This is less of a concern with financial buyer than with strategic buyers, since much less business integration is required in the case of financial buyers. The fundamental obstruction to effective integration is that the former owners of the acquired business tend to want to continue running the business in the same manner as they have always run it in order to make sure they get their earnout. Thus, it is quite easy to have the old owners become quite obstructive to change because of their desire to protect their earnout. Again, this can be controlled to a degree in the manner in which the business performance earnouts formula is designed, but the argument that can often be raised somewhere along the way by the seller is "the buyer's actions prevented me from earning my earnout." The bottom line is that the impediments to business integration that are created by business performance earnouts need to be very carefully considered.

In other cases, the earnout may be more directly related to retention of the seller for a long period of time after the acquisition. Let's call these "retention earnouts." From reading Klee's article about Mr. McCann, this seems to be the primary reason for the earnouts that 1800 Flowers uses. Mr. McCann explains that "about 60% of the company's executive team has joined through deals." If you want to retain the seller's expertise, the challenge is keeping them motivated after they have received a big payday. Thus, retention earnouts are typically less results oriented and more oriented to service longevity and quality. They can simply take the form of requiring the seller to continue to work for a period of time in order to receive the full deal consideration. More often, retention earnouts combine longevity components and revenue components and, as in the case of 1800 Flowers, there may be complimentary programs providing employment incentives. The tension in retention earnouts is not so much over whether there will be problems with integration but over whether the seller will actually remain in productive service. Needless to say, retention earnouts be difficult to design but, since they are not serving as a bridge over a dispute, they can be a little easier to create.

Earnouts have been and will continue to be part of mergers and acquisitions. Earnouts that are created primarily as a way to resolve a current dispute in the future by making payments based on thresholds that are tied solely to company performance are the ones that are least likely to work as intended and the most likely to create future problems. It may be the case that, in these uncertain economic times, there may be an upswing in the use of business performance earnouts to fill in valuation gaps. In contrast, earnouts that are designed to encourage specific behaviors like the retention of services tend to be a little more likely to operate as intended. In summary, there is no need to be afraid of earnouts, but there is every need to be cautious in implementing an earnout.

Lessons from a $1.4 million HSR fine

By Tom McLain

Fines for violations of the Hart Scott Rodino Act are not a common occurrence. However, when they do come along, they tend to be eye-popping. The most recent example resulted in an settlement agreement pursuant to which John C. Malone, CEO and Chairman of Discovery Holding Company, is to pay a $1.4 million civil penalty.

The central theme of the Complaint filed by the Federal Trade Commission ("FTC") against Mr. Malone is that he failed to file the required notification with the FTC and Department of Justice before acquiring voting securities of Discovery Holding Company ("Discovery"). Mr. Malone acquired the securities in a series of transactions beginning in August 2005 and continuing until April 2008. On June 12, 2008, Mr. Malone made a corrective filing with the FTC explaining that he had relied on a 2001 informal interpretation from the FTC that, unbeknownst to him, was replaced and disavowed by a February 07, 2005 informal interpretation issued by the FTC. The corrective filing established a waiting period that was to expire on July 14, 2008.

Had the fact pattern ended at this point, it is a reasonable assumption that civil penalties may not have been sought by the FTC. Based upon prior precedent and general procedures, provided that the reason for the missed filing is reasonable and there has been a demonstration of corrective actions taken to prevent future failures, the FTC has been reluctant to impose penalties. (See, Procedures For Submitting Post-Consummation Filings). In fact, on May 9, 1991, Mr. Malone made a corrective filing under the HSR Act for a previous acquisition made in 1985, and on July 2, 1991 the FTC decided not to seeking civil penalties. In any event, the penalties in effect during the time periods in question were $11,000 per day for each day during which there was a violation. [Note: as a result of a 2009 amendment, the daily penalties have been increased to $16,000 per day].

While the 1991 violation of the filing requirements under the HSR Act certainly did not help Mr. Malone's situation, the events occurring after his June 12, 2008 were far more problematic. On June 14, 2008, before the expiration of the HSR waiting period, Mr. Malone exercised options and acquired more shares of Discovery. These options would have expired before the end of the HSR waiting period on July 14, 2008, but Mr. Malone did not notify the FTC to ask whether it was permissible for him to exercise the options with an escrow arrangement prior to the expiration of the waiting period. There is no indication regarding how the FTC would have responded to the request, had it been made. However, this oversight seems to have weighed heavily in the FTC's decision to seek civil penalties.

The underlying HSR rules which resulted in a determination that a notification filing was required could themselves be the subject of an article. However, the purpose of this article is to provide a reminder of the stiff penalties that can be imposed for violations of the HSR Act and to examine some of intricacies of corrective filings. The series of events for Mr. Malone were indeed unfortunate and lead the FTC to seek to impose civil penalties. The result of the events was the entry of a consent judgment against Mr. Malone personally in the amount of $1.4 million. The consent judgment is testimony to the axiom that "bad fact lead to bad results." The primary lesson to be learned from Mr. Malone's problems is that one must always be mindful of the requirements of the HSR Act and that every merger or acquisition transaction must be weighed in light of those requirements.