Earn-outs raise issue of control in M&As
Any lawyer experienced in the purchase and sale of businesses (“mergers and acquisitions” as we like to say) knows that the advice his or her client will receive will depend in large part on whether the client is a buyer or seller. For example, sellers will want to receive as much of the purchase price as they can at closing (ideally 100 percent), but buyers often want to defer a portion of the purchase price for possible indemnity claims or other negotiated circumstances.
One thing that is almost universally true in selling a business is that early discussions about an “earn-out” are likely a bad sign for the seller. In a “perfect” deal, buyer and seller agree on a price — say $30 million — and that price is paid 100 percent at closing.
Let’s vary the deal terms a bit.
Suppose the buyer says “we’ll pay you $25 million in cash when we close and give you the opportunity to earn another $5 million over the following three years if certain performance criteria are met.” If you are the seller, you prefer the first deal over the second deal.
In the second deal, that $5 million is the amount of the “earn-out.” It signals a disagreement between buyer and seller over valuation (how much the business is worth). In the first deal, buyer and seller have agreed the business is worth $30 million. In the second deal, the buyer is really telling the seller the business is worth $25 million, and the only way the seller will receive the other $5 million (or some portion of it) is if certain milestones are met after the deal closes. While many sellers might view the earn-out as a convenient “bridge-the-gap” mechanism that allows the parties to proceed with the deal, there is a lot at stake when a deal includes an earn-out.
First, the performance metrics must be agreed upon. How will the earn-out be measured? Will it be based on gross revenue, EBITDA, or a milestone like receiving an important regulatory approval? All of these measurements have something in common: uncertainty.
Second, control is an important consideration. Usually when you sell your business, you relinquish control — not only in the pure legal sense that you have sold the business to a third party — but also from a practical standpoint. While you may be engaged as an executive or consultant to the business after closing, it is pretty uncommon that you will be allowed to run the business as you please. The new owner is going to have plenty to say about how the business operates. Because the earn-out is measured based on one or more performance metrics, you have to ask yourself as the seller, “Will I be given enough latitude and control over decision-making and other variables such that I can actually achieve the earn-out?” For example, if investments will be needed to achieve the earn-out, the new owner may be unwilling to allow those investments to be made. Or, if the earn-out is based on profits, what if you aren’t left in control of operating expenses?
Simply stated, where earn-outs are concerned, the motives and objectives of seller and buyer may not be aligned. Many sellers think earn-outs should be simple because they are based on accounting information and calculations that are what they are. After all, an expense is an expense, and a credit is a credit — right?
Not necessarily. How one party computes or calculates something may be very different from how the other party does the computation or calculation. There can actually be a great deal of complexity in how earn-outs are constructed, and the more complex in design usually is more complex (and subject to disputes) in practice.
As a result of these factors, many earn-outs end up in dispute. That means the need for both seller and buyer to spend money on advisors (lawyers and accountants, perhaps others) after the deal has closed. Often the deal documents will include very specific dispute resolution provisions to spell out what the process is if there is a dispute over the earn-out. These provisions are often highly negotiated, but their presence may give sellers a false sense of security. After all, it is not unheard of for the parties to disagree about these very provisions when the dispute occurs.
There are practical concerns to consider as well. If you do stay on as an executive or consultant after the deal closes, how much fun will it be to spend much of your time arguing with the new owner over the earn-out? Many business owners want to sell to simplify their lives and spend less time working. A dispute over an earn-out almost guarantees the opposite.
Many deals don’t get signed or closed without earn-outs. Buyers, particularly those that are sophisticated, reduce their deal-risk with earn-outs.
Before entering into a deal with an earn-out, the seller should ask himself an important question: will I be happy with the deal if I don’t see one dollar of the earn-out? Or alternatively, can the seller think of the $25 million as the selling price and view the $5 million as a very pleasant surprise if things work out?
Jim Newman is a partner in the Reno office of Holland & Hart LLP where he practices primarily in the fields of corporate, mergers and acquisitions and real estate law. He is also the administrative partner of Holland & Hart’s offices in northern Nevada.
Per the agreement, Caesars will continue to operate Harrah’s for the first half of 2020 before it’s redeveloped into a non-gaming hotel and mixed-use development.