By Efren Acosta and Ron Scharnberg

Law360 (September 23, 2020, 5:14 PM EDT) --

Efren Acosta

Ron Scharnberg

The global health crisis related to the outbreak of COVID-19, and the resulting business downturn and uncertainty have created unprecedented business, financial and legal challenges.

For private company M&A[1] practitioners and their clients, the second and third quarters of 2020 have been spent navigating a challenging deal environment and adopting new practices to address the effects of COVID-19 and the resulting economic disruption in the context of M&A transactions.[2]

The current disruption in the economy has created opportunities for private equity investors and strategic acquirers with sufficient liquidity or access to capital to pursue acquisitions.

A challenge in pursuing acquisitions in the current environment is closing the gap that exists in an uncertain economic and financial climate, where the parties' expectations as to the valuation of the acquired business are not just misaligned, but rather quite far apart.

For example, when the acquired business has experienced a temporary drop in earnings or is operating in a volatile economy or industry — both of which have been broadly experienced by businesses as a result of the COVID-19 pandemic. Absent the parties meeting in the middle, one party agreeing to the other's position on value or an alternative solution, the valuation gap is an impediment to the successful completion of a transaction.

One such alternative solution is the earnout. This article will focus on the earnout as a mechanism to close the valuation gap, and will discuss certain advantages and drawbacks of utilizing the earnout in the current environment.

Because tax is an important component of any deal structuring discussion, this article will also discuss certain tax considerations in structuring earnouts.

General Overview

First, what is an earnout? The term refers broadly to a mechanism utilized in private company mergers and acquisitions that allows the seller in the M&A transaction to realize value over and above the closing date payment if after closing the acquired business performs up to certain predetermined thresholds.

While earnouts come in various forms, they will involve two features: (1) one or more contingent payments of purchase price after the closing of the transaction; and (2) such payments becoming payable upon the achievement, during the earnout measurement period, of certain predetermined targets or goals that are typically financial in nature.

The appropriate financial target will be very dependent on the nature of the target's business.

The earnout offers some practical advantages to the parties. For the buyer, it reduces the risk of overpaying for the acquired business by allowing the buyer to pay at closing the value it believes is correct, subject to the possibility of making additional post-closing purchase price payments that are conditioned on the acquired business performing as forecast by the seller.

In this way, the earnout helps the buyer shift some of the risk for post-closing underperformance to the seller. This can be very important when making an acquisition of a business at a time when it is not clear how long the direct and indirect economic effects of the COVID-19 pandemic will persist.

For the seller, the earnout provides an opportunity to complete the sale of the acquired business in an uncertain economic environment while achieving a higher overall purchase price than it would have otherwise realized.

This is especially important if the target business is distressed due to circumstances outside of the seller's control that the seller believes are temporary and do not represent a permanent loss of value of the acquired business, such as the COVID-19 pandemic and the resulting industry and economic upheaval.

Discussion of Select Issues

While at a high level earnouts sound straightforward, M&A practitioners know these provisions can be difficult to negotiate. Some relevant examples are discussed below.

Post-Closing Operating Covenants

First, there is the conflict between the buyer's view that it should have full discretion in making decisions concerning the conduct of the acquired business, and the seller's desire to retain and exert some level of control over the conduct of the acquired business during the earnout measurement period to the extent that such conduct can impact the seller's ability to earn its earnout payments.

This natural tension often leads to a negotiation of post-closing operating covenants that function as limitations on the buyer's ability to make significant changes to the acquired business during the earnout measurement period. Examples of these covenants include:

• A requirement to operate the acquired business in a manner materially consistent with the seller's preclosing operation of the business;
  
  
• Restrictions on sales of assets or facilities;
  
  
• Restrictions on employee reductions;
  
  
• Restrictions on incurring material operating expenses that may not be likely to generate revenues or earnings before interest, taxes, depreciation and amortization — or EBITDA — until after the earnout measurement period;
  
  
• A prohibition on termination of key members of management, which may be particularly important where the seller is a private equity firm that is relying on the management team to deliver results post-closing; and
  
  
• Seller veto rights over major decisions that could impact the financial performance of the business during the earnout measurement period.

Such covenants will be particularly difficult for a buyer to accept under the current circumstances, where the buyer may need the flexibility to make extraordinary decisions in order to manage the acquired business through the effects of the COVID-19 pandemic and the resulting industry and economic difficulties.

For instance, the buyer may believe that it needs to shut down or dispose of certain revenue generating assets in order to cut expenses, while the seller may believe that measure would materially decrease the chances that the agreed-upon financial thresholds can be met.

The length of the earnout measurement period will be very relevant to a buyer who is considering agreeing to post-closing operating covenants. Typically earnouts will range from one to three years. The longer the earnout period, the less appetite a buyer will have for such covenants or seller involvement in the post-closing operation of the business. A buyer willing to agree to these types of covenants may consider coupling it with the ability to exercise an option to buy out the earnout.

The buyout option essentially allows the buyer to terminate the earnout obligation early by making a payment to the seller that is a function of the net present value of the earnout payments and the probability that the earnout payments will become due. Such a right would allow the buyer the flexibility to rid itself of any post-closing operating covenants early.

Conversely, the seller may be willing to proceed without any post-closing operating covenants if, in return, the buyer agrees that the occurrence of certain specified material events after the closing, i.e., sales of material assets or facilities, would result in acceleration of the earnout payments — in other words, a forced buyout of the earnout.

Additionally, buyers should be aware that, depending on the applicable jurisdiction's law, it may not be sufficient for a buyer to resist the inclusion of post-closing operating covenants in the purchase agreement.

The buyer may need to negotiate language that either provides the buyer sole discretion in how it operates the acquired business or disclaims any duty to maximize the earnout.

This is because some courts have recognized an implied duty to use reasonable efforts to operate the acquired business to maximize the earnout, in particular when a substantial portion of the total consideration is contingent upon achievement of the earnout targets.

Financial Metrics and Payment Structure

The choice of financial metric can be heavily negotiated. Each party will be inclined to choose the financial metric it believes is less likely to be manipulated in a manner detrimental to it. For example, sellers prefer revenue-based targets that are less prone to manipulation by shifting nonacquired business costs to the acquired business during the earnout measurement period.

Buyers, on the other hand, generally prefer a metric that takes costs into account, in particular in a transaction in which the seller will remain involved in managing the operations of the acquired business during the earnout measurement period because a revenue-based target could provide the seller an incentive to sacrifice cost control in favor of revenue generation.

The often-employed compromise is to use an EBITDA financial metric that accounts for some costs and expenses (i.e., operational) but excludes others (i.e., interest, tax, depreciation and amortization). This usually leads to a negotiation of how EBITDA is to be defined for purposes of the earnout calculation.

For instance, will the buyer's overhead allocations impact EBITDA for purposes of the earnout calculation, and how will nonrecurring or extraordinary items be handled, i.e., expenses incurred in growth through acquisitions?

This issue can be particularly relevant if a strategic acquirer is absorbing the acquired business into the acquirer's larger business, as opposed to a private equity investor making a platform investment in the acquired business that may intend to operate the acquired business on a stand-alone basis during the earnout measurement period.

More specific to the current operating environment, parties may need to address how forgiveness of a Paycheck Protection Program loan would be handled in EBITDA for purposes of the earnout calculation. Perhaps the greatest difficulty in setting financial metrics will be in attempting to predict acquired business performance in the balance of 2020 and beyond, as the full extent of the economic downturn and length of the recovery are speculative at best.

The payment structures of earnouts can vary. Examples include a fixed amount or a percentage of the specific target (i.e., a percentage of revenues or EBITDA during the earnout measurement period), and the payment may be structured as an all-or-none payment or a payment based on a sliding scale.

What is appropriate will be dependent on the specifics of the transaction and the parties' objectives, and this is likely to be heavily negotiated.

For example, if the earnout is structured as a multiyear earnout with multiple earnout measurement periods and individual payments made based on single earnout measurement period performance, the seller should consider requesting a catch-up mechanism to allow the seller to recoup amounts it did not earn in earlier measurement periods if the acquired business overperforms in later measurement periods.

This, coupled with a longer earnout measurement period, would be a way for the seller to mitigate any short-term underperformance of the acquired business related to COVID-19 and the resulting economic downturn, on the assumption that the seller would be able to capture the upside in later measurement periods after the economy has rebounded. From the buyer's perspective, this may be an acceptable arrangement if the buyer is able to cap its aggregate earnout payment obligation.

Another item for consideration is that the current economic uncertainty, together with the inability to predict when the economy will rebound, may drive buyers and sellers to opt for a sliding scale payment structure as opposed to a fixed payment or some other formula.

In a sliding scale structure the earnout payment is determined based on a formula that provides for a minimum payment, a maximum payment or a payment somewhere in between based on the formula. The sliding scale approach can relieve some of the pressure on the parties to agree upon very precise targets based on data that may not be reliable given the economic conditions and difficulty in forecasting performance of the acquired business in 2020 and beyond.

Tax

Parties should involve tax advisers sooner rather than later as they negotiate the terms of a potential earnout because an earnout can result in material tax consequences to both the seller and buyer, which consequences can vary significantly depending on the terms.

While this article is not intended to provide an in-depth discussion of all of the tax issues and consequences associated with earnouts, there are several important federal income tax issues and consequences to highlight.

Generally, the most important federal income tax issue to consider is whether the earnout payments are to be treated as deferred purchase price for the assets or equity interests acquired in the transaction or, instead, as compensation for services.

If treated as compensation for services, a seller would generally be subject to federal income tax at ordinary income rates at the time of the payments with the potential for such payments to also be subject to applicable employment taxes, while a buyer should generally receive a corresponding tax deduction.

If the earnout payments are instead treated as the deferred purchase price for the assets or equity interests acquired in the transaction, a seller could qualify for long-term capital gain treatment and be subject to federal income tax at long-term capital gains rates — which rates for noncorporate taxpayers are currently lower than for ordinary income — on a significant portion of the earnout payments.

In this case, the buyer should generally capitalize the majority of the earnout payments into the tax basis of the acquired assets or equity interests, which capitalized amounts could then potentially be recoverable through amortization, depreciation or other cost recovery deductions depending on the facts and structure of the transaction.

Because an earnout is used by the parties to solve for a valuation gap with respect to the acquired business, in most situations the parties are not intending for an earnout to be treated as compensation for services, so sellers and buyers are often surprised to learn that the proposed terms of an earnout might in certain circumstances be treated as compensation for services for federal income tax purposes.

This analysis is ultimately based on a facts and circumstances test involving several different factors including, among others, whether the total payments to the seller represented a reasonable price, whether the underlying documents treat the payments as compensation or purchase price, and how the payments are reported for nontax purposes.

However, the potential for compensatory treatment generally increases when a seller's eligibility to receive a payment is conditioned on the continued services or employment of such seller or an equity holder of such seller.

Thus, if the parties are not intending for an earnout to be treated as compensation for services, it is recommended to avoid having the earnout payments conditioned on the continued services or employment of any seller or any equity of holder of a seller.

Assuming the parties intend for an earnout to be treated as deferred purchase price for federal income tax purposes and are comfortable that the terms result in such treatment, the impact of the installment sale rules on the seller is another important federal income tax issue.

The installment sale rules are the default rules and will apply to an earnout if the earnout provides for the possibility of a payment after the tax year in which the transaction closes, unless the seller were to elect out or is otherwise ineligible for installment sale reporting. The installment sale rules are generally taxpayer favorable rules, in that such rules generally provide timing benefits to sellers by allowing sellers to defer paying federal income tax on at least a portion of the gain from a transaction until the deferred payments are received.

However, to the extent a seller believes it would have a better federal income tax outcome by not applying the installment sale rules, a seller is eligible to elect out. In connection with earnouts, an election out would generally require the seller to calculate and recognize gain for federal income tax purposes in the year of the transaction based on the fair market value of the right to the earnout payments at the time of closing.

Sellers often consider making election outs in situations where the earnout has a high cap that is unlikely to be achieved or a long period over which payments could be made.

If the installment sale rules are applicable, the installment sale rules generally separate earnouts into three categories:

1. Earnouts with a stated maximum selling price that can be determined by the end of the taxable year in which the transaction closes;

2. Earnouts without a stated maximum selling price but with a specified period for which payments can be made; or

3. Earnouts without a stated maximum selling price or a specified period.

Although sellers should always carefully analyze and consider the application of the rules pertaining to each category to the particular facts and circumstances of each situation, sellers are generally better off from a federal income tax perspective if either category one or two applies.

As a result, to the extent a seller is intending to apply the installment sale rules to a transaction, the general preference from a federal income tax perspective is to have the terms of the earnout include either a maximum selling price or a specified period.

Likewise, in order to minimize potential adverse impacts and distortion under the installment sale rules, sellers should generally avoid agreeing to a cap that is significantly higher than what it is likely to be achieved or a long period.

Conclusion

In summary, the earnout is likely to make a resurgence as M&A practitioners and their clients look for ways to sidestep obstacles to successfully completing transactions. While the earnout has a reputation — perhaps well deserved — for being fertile ground for post-closing disputes, that alone should not be a deterrent to utilizing the earnout as a creative solution to eliminate the valuation gap.

Though the current uncertain economic climate creates some unique challenges in structuring and negotiating earn outs, deal parties determined to complete a transaction should be able to structure earnouts that meet their mutual objectives and manage the risk of future disagreements.

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Efren Acosta and Ron Scharnberg are partners at Baker Botts LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] For this purpose, "private company M&A" refers to an M&A transaction in which the acquisition target is either a private company (as opposed to a publicly traded or listed company) or a business unit/division of a private or public company.

[2] For a discussion on how the COVID-19 pandemic has impacted M&A transactions, refer to Baker Botts L.L.P.'s Private Equity Guide: COVID-19 (https://www.bakerbotts.com/thought-leadership/publications/2020/april/private-equity-guide-covid-19-private-equity-firms-and-portfolio-companies).

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