1 The Interplay Among Purchase Price Adjustments, Earn-outs and Indemnification Clauses in Acquisition Agreements Thomas L. Hanley, Stradley Ronon Deborah Hong, Stradley Ronon Thomas D. Scholtes, Towers Watson & Co. October 3,
2 2 Overview The Purpose of These Provisions To preserve the benefit of the bargain notwithstanding matters that cannot be known at closing. To give life to allocations of risk that have been agreed upon by the parties. The Challenge Understanding accounting principles. The Purpose of Our Presentation To provide a brief overview of each of these provisions. To provide negotiation and drafting insights. To discuss the interplay of these provisions with one another.
3 3 Working Capital Adjustments Purpose To protect the Buyer against a decrease in the amount of working capital of the target business between the valuation and the closing of a transaction. Description Businesses require a certain amount of working capital to maintain operations. A Buyer will want to make sure there is sufficient working capital at closing to continue the operations of the acquired business. If working capital is insufficient, then the Buyer will have to infuse cash into the business post-closing (and, perhaps, immediately post-closing). If the purchase price paid by the Buyer was based on the assumption that the business would have its customary level of working capital at closing, and then at closing, working capital falls below that level, then the Buyer has effectively paid for a level of working capital it did not receive.
4 4 Working Capital Adjustments Description (continued) A working capital adjustment is an adjustment to the purchase price based on a comparison of the amount of working capital of the target business as of the closing date to the customary working capital of the business. The adjustment compensates the Buyer for any deficiency and ensures that the Seller is paid for any overage. A working capital adjustment is made shortly after closing (typically 60 to 90 days). In many instances, the parties will include an adjustment at closing based on estimated information, which is later trued up to actual (or finally determined) closing date numbers determined post-closing.
5 5 Working Capital Adjustments Negotiation and Drafting Considerations Working Capital = Current Assets Current Liabilities Note that while this is the textbook definition, the parties will always negotiate as to what is and is not included in the definition. Specify, to the extent possible, the categories of assets or liabilities to be included or excluded from the definition (use of a schedule setting out the calculation based on the target s current financial statements can be helpful). Current Assets Back out reserves for bad debt. Current Liabilities If you specify the current liabilities (e.g., accounts payable ), then you can eliminate the risk of including short-term liabilities you did not intend to include, such as the current portion of long-term debt, indemnification claims and taxes coming due within a year.
6 6 Working Capital Adjustments Working Capital Adjustment = Working Capital at Closing Target Working Capital Ensure that the calculation of working capital at closing matches the manner in which the target working capital was established. Impact of the deal s timing: I. If working capital displays seasonality, select a target working capital that reflects that seasonality. II. If working capital fluctuates substantially, consider using a target working capital that is normalized (i.e., averaged) over a period rather than actual working capital on a given date.
7 7 Working Capital Adjustments Accounting Specifications Specify methodologies for calculations. Provide illustrations. Simply stating GAAP, consistently applied may not work where Seller s methodologies vary. For example, in Twin City Monorail, Inc. v. Robbins & Myers, Inc., 728 F.2d 1069 (8th Cir. 1984), the Seller used LIFO for inventory valuation purposes in reporting corporate earnings, and FIFO for preparing its balance sheet. Be wary of GAAP in accordance with historical practices. Identify any conflicts between GAAP and historical practices. A historical practice of not recording certain liabilities (e.g., contingent liabilities) does not mean that the liability does not exist. Examples of specificity: Setting forth the amount of reserves for bad debt (as a percentage of sales). How inventory will be valued (lower of cost or market; LIFO vs. FIFO). How cash from A/R will be applied (to the stated invoice or oldest A/R first).
8 8 Working Capital Adjustments Thresholds Triggering Adjustment Some acquisition agreements will provide that an adjustment will not be made unless and until a certain differential exists (e.g., target working capital +/- 5%) Use of such a threshold: acknowledges that working capital is subject to variation; and helps to avoid disputes regarding small discrepancies.
9 9 Working Capital Adjustments Amount of Adjustment An adjustment is typically made based on the actual amount of the shortfall or excess (dollar-for-dollar payment without a floor or cap to the adjustment). Deductible and cap concepts usually do not apply, since the adjusted amount typically represents the actual amount of purchase price consideration that a Buyer has underpaid or overpaid for the business. Nonetheless, the parties can agree otherwise.
10 10 Working Capital Adjustments Dispute Resolution Clauses Where the parties desire to select an arbiter (such as an independent accountant) to resolve disputes, the agreement should specify the intended scope of the arbiter s review and authority. Where the scope of authority is not defined broadly (i.e., final, conclusive and binding on the parties with respect to all matters relating to the adjustment), the parties risk litigating the issue again in court.
11 11 Earn-Outs Purpose The purpose of an earn-out is to close the valuation gap between Buyer and Seller. From the Buyer s perspective, earn-outs reduce the initial cash payment, and provide insurance by minimizing the risk of overpaying for future revenues and profits. From the Seller s perspective, earn-outs allow the Seller to share in post-closing upside performance and to defer taxes.
12 12 Earn-Outs Description Earn-outs are contingent purchase price payments based on post-closing results of the target. Earn-outs are typically paid within one to 10 years after closing, with the average being three years. Practice varies widely from industry to industry (e.g., biopharma versus IT).
13 13 Earn-Outs Negotiation and Drafting Considerations The negotiating tension between Buyer and Seller is that each party wants to shift as much post-closing risk as possible to the other party. The Seller and Buyer may have competing short-term versus long-term goals. The Seller is often interested in maximizing the earn-out variables (such as revenues and profit) during the immediate post-closing period, which may not be in line with Buyer s desire to invest in the business for long-term growth. The Seller s receipt of an earn-out payment depends on the performance of a business the Seller no longer controls. This concern may shift to the Buyer if the Seller (or the Seller s principal) is employed by the Buyer to manage the target business post-closing.
14 14 Earn-Outs Determine the Earn-out Variable(s) The earn-out variable is the metric or performance target that needs to be achieved in order for the earn-out to be paid. The earn-out variable will need to align with the Buyer s return on investment objective. The earn-out variable can be a financial metric (e.g., revenues, margins, profits, earnings) or a non-financial metric (e.g., completion of a project or attainment of new business). In either case, the earn-out variable should be clear and understandable. There should be no ambiguity. Use clearly defined accounting principles and standards where possible.
15 15 Earn-Outs Earn-out Formula Once the performance target is achieved, an earn-out formula will specify how the earn-out amount to be paid is calculated. Use illustrations and define methodologies of calculation, similar to working capital adjustments.
16 16 Earn-Outs Term of the Earn-out From a Seller s perspective, the earn-out period should be a reasonable period of time to allow the performance target to be achieved. From a Buyer s perspective, the earn-out period should align with the amount of time the Buyer desires to achieve its return on investment. Note also that a longer earn-out period would entail a longer relationship with Seller.
17 17 Earn-Outs Payment Structure Consider whether partial satisfaction of milestones should result in partial payment or whether earn-out targets should be all or nothing. Forms of Payment Cash, note or stock (securities law issues). Consider the creditworthiness of the Buyer and whether a parent guarantee is appropriate. Consider whether an earn-out payment can be used as a source to offset indemnity claims of Buyer.
18 18 Earn-Outs Covenants Regarding Operation of the Target During the Earn-out Period Covenants to protect a Seller s interest Covenant not to divert business. Covenant not to assign or sell assets material to the business. Covenant to comply with laws. Covenant to operate the business in accordance with past practices. Covenant to operate the business to maximize the earn-out. Covenants to protect a Buyer s interest Express disclaimer of fiduciary duty of Buyer to Seller in respect of the earn-out. Ability of Buyer to offset an indemnity claim against any accrued earn-out. Ability of Buyer to incur expenses customarily incurred by the Buyer in the operation of its business. Nothing contained in covenants benefitting the Seller should be construed to impose liability on Buyer for business decisions made in good faith, with customary prudence, whether or not such decisions have an adverse effect on the ability of the business to achieve the earn-out targets.
19 19 Indemnification Purpose To give life to the risk allocation agreed by the parties, whether of representations and warranties, or unfulfilled promises and obligations. Description Indemnification constitutes compensation for breaches. Often subject to limitations on time and amount.
20 20 Indemnification Negotiation and Drafting Tips Scope of Indemnification Breaches of representations and warranties. Breaches of covenants. In an asset deal, assumed liabilities (indemnified by the Buyer) and excluded/retained liabilities (indemnified by the Seller). Specific matters listed on disclosure schedules for which the parties agree that the Seller is to remain liable. (e.g., the Seller discloses pending litigation on a schedule, so there is no breach of the no litigation representation. Absent an express indemnification right, the Buyer will have no right to recover the post-closing costs of the litigation from the Seller).
21 21 Indemnification Survival Periods for Representations and Warranties Fundamental representations typically survive indefinitely Should include organization, good standing, authority, execution, delivery and enforceability. In a stock or merger deal, should also include title to shares and capitalization. Some representations survive through the applicable statute of limitations Typically tax, environmental and employee benefits representations; sometimes undisclosed liabilities, no conflicts, intellectual property. Statute of limitations may be tolled, e.g., until a tax return is filed or an environmental claim is discovered. Remaining representations survive for an agreed period Typically 1 to 2 years, with 18 months most common. The period is often chosen to ensure that a full audit cycle is covered. Effect of Survival Requirement Claims must be brought within the applicable survival period. Make this clear: A recent Delaware case found that identifying a survival period, without more, terminates accrual of claims but not the right to bring them.
22 22 Indemnification Limitations on Indemnification Caps Maximum amount that a party is liable to indemnify with respect to one or more categories of claims. Should only apply to indemnification claims based on breaches of representations and warranties, not covenants. Baskets / Thresholds / Deductibles Aggregate claims must exceed this amount before indemnification is available. Basket / Threshold: Once the specified amount is surpassed, claims are indemnified from the first dollar. Deductible: Once the specified amount is surpassed, only claims in excess of that amount are indemnified. De Minimis Exclusions Individual claims must exceed this amount before they count toward a basket / threshold or deductible.
23 23 The Interplay Among These Adjustments Each adjustment addresses a different area of uncertainty regarding valuation of the target A working capital adjustment focuses on the current assets and liabilities to be included on the target s starting balance sheet with the Buyer. Indemnification claims focus on the long-term assets and liabilities to be included in the target s starting balance sheet with the Buyer.
24 24 The Interplay Among These Adjustments Each adjustment addresses a different area of uncertainty regarding valuation of the target (continued) Unlike working capital adjustments and indemnification claims that are based on a given point in time, earn-outs are based on the results of the target business over a period of time, which is an income statement concept. Many Buyers value a target company based primarily on its net revenues (e.g., its projected income statement), assuming that its assets and liabilities (e.g., the target s balance sheet) will remain at a normalized historical level. When the Buyer and the Seller disagree on the level of the target s likely future income, an earnout allows them to take a wait-and-see approach to determining the final purchase price. By definition, the information that determines whether an earn-out will become payable is not knowable at closing because it depends on the future results of the target s business.
25 25 The Interplay Among These Adjustments The timing of each adjustment reflects the nature of the uncertainty that the adjustment is intended to address A working capital adjustment is calculated soon after closing, typically within 60 to 90 days. Indemnification claims have a somewhat longer survival period, typically 18 months.
26 26 The Interplay Among These Adjustments The timing of each adjustment reflects the nature of the uncertainty that the adjustment is intended to address (continued) Unlike the working capital adjustment and indemnification accruals which are based on snapshots at closing, an earn-out is not finished at closing. In fact, the earn-out period will likely just have begun at closing.
27 27 The Interplay Among These Adjustments Interplay Between Working Capital Adjustment and Indemnification Some claims based on financial statement issues may be characterized either as postclosing adjustment issues or as indemnification claims. For example, in OSI Systems, Inc. v. Instrumentarium Corporation, 892 A.2d 1086 (Del. Ch. Ct. 2006), the Buyer claimed that notwithstanding the express language of the purchase agreement the calculation of closing working capital could not be based on the Seller s historical accounting principles because those principles did not comply with GAAP. The Delaware Court of Chancery held that the Buyer s claim did not arise under the working capital adjustment provision. Rather, the Court held that the Buyer s claim should be characterized as an indemnification claim based on Seller s alleged breach of the representation that its financial statements complied with GAAP. Similarly, if the Seller failed to disclose the existence of a short-term contractual liability, the Buyer could likely claim either that (i) this current liability should reduce the target s closing working capital, thereby decreasing the purchase price, or (ii) the Buyer is entitled to damages for breach of the Seller s representation and warranty regarding the target s liabilities at closing.
28 28 The Interplay Among These Adjustments As a practical matter, Buyers will generally want such claims to be applied to the working capital adjustment in order to (a) avail themselves of the streamlined arbitration procedures that apply to working capital disputes, and (b) avoid the caps and baskets that limit the Buyer s right to indemnification.
29 29 The Interplay Among These Adjustments The fact that working capital adjustments and indemnification claims may overlap raises the possibility that items may be double-counted or left out of both provisions. The Seller may seek a provision requiring an election of remedies so that indemnification would not be available based on any set of facts for which the Buyer makes a claim under the working capital adjustment.
30 30 The Interplay Among These Adjustments Interplay Between Earn-outs and Indemnification The parties should specify the interaction between the Sellers indemnification obligation and the earn-out payments. Conversely, Buyers must beware of earn-outs as the sole source of payment on indemnification claims, since the earn-out amount may never be earned. Sellers will want to ensure that a given event does not give rise to both an earn-out and an indemnity because, in such cases, the Seller effectively loses out twice. The Seller must pay the indemnity, but it does not receive the portion of the purchase price that is tied to the earn-out.
31 31 Conclusion Review of purchase price adjustment and earn-out provisions typically requires close collaboration with accountants. But counsel must not abdicate responsibility for understanding the effect of these provisions and the significance of precise drafting to avoid post-closing disputes. Indemnification obligations can result in the double recovery or loss in the context of both working capital adjustments and earn-outs. Understanding the interplay of these provisions and addressing those situations with precise drafting is important in order to avoid double recovery and loss.