Earnouts, balance sheet adjustments used to accommodate mergers and acquisitions risk: Norton Rose

Dealmaking helped by tools to ‘grease the wheels’ of M&A amidst COVID-19

Earnouts, balance sheet adjustments used to accommodate mergers and acquisitions risk: Norton Rose
Eric Vice

While corporate buyers and sellers are using earnouts and reverse earnouts in an M&A world influenced by COVID-19, lawyers at Norton Rose Fulbright LLP suggest dealmakers are also using other methods to negotiate around potential risks.

“Given the uncertainty, we initially thought earnouts would be used to bridge the valuation gap between buyers and sellers,” says Kiri Buchanan.

Those in the profession believed earnouts would be relied upon more heavily to address the risk in overvaluing or undervaluing a business. There were also predictions of earnout timeframe extensions to account for the pandemic’s extended uncertainty.

However, after a Norton Rose survey of private acquisition agreements available on Practical Law – What’s Market, Buchanan says the predicted reliance on earnout clauses in 2020 was not significantly higher than in 2019.

In Canada, the use of earnout clauses decreased to 24 per cent of surveyed deals in 2020, from 28 per cent in 2020. The average use of earnout clauses in Canadian and U.S. deals, combined, stayed consistent at 19 per cent, suggesting that, while Canadian usage of earnout clauses may have decreased, use in the U.S. increased.

A review of past Canadian and U.S. private M&A deals demonstrates that U.S. M&A transactions are more likely to include earnout provisions than Canadian transactions. Further, Norton Rose found that of the 2020 Canadian deals surveyed that included earnout provisions, only 7.5 per cent used reverse earnouts.

A “classic” earnout is when there is a post-closing increase in the purchase price based on achieving specific performance targets. A reverse earnout refers to a decrease in the purchase price if the target doesn’t meet performance targets. Both can help “grease the wheels” and make deals happen in an environment of uncertainty.

In a reverse earnout scenario, the purchaser pays the maximum amount for the target at closing. If the agreed-upon performance targets are not met, the vendor must re-pay an agreed portion of the purchase price, reducing the overall acquisition price. Reverse earnouts are less common, mainly because the risk resides with the buyer rather than the seller.

Buchanan says that sellers may prefer reverse earnouts over earnouts. Unlike earnout payments that may be taxed as income, reverse earnouts are taxable as capital gains in the taxation year in which the closing occurs. Any amount later determined not to be payable results in a capital loss for the seller for the taxation year in which the balance becomes no longer owed.

So, while the seller must bear the total tax liability at the time of the sale, a reverse earnout may still be preferable because it minimizes income treatment and maximizes capital gains treatment of the earnout payment.

Buchanan’s colleague Eric Vice says some of the reasons for not as much uptake on using either kind of earnouts is that while they cover one type of risk — valuation — they create other risks, such as language that could lead to disputes down the road.

As well, Vice says that buyers and sellers in the deal “value finality” on deal closings, “particularly in the fast world we are living in now where three months from now could look very different.

“There is some reluctance to an extended relationship between the buyer and the seller for another 12 to 36 months. Companies prefer to agree on a price and then go about their business.”

Instead, Vice says, some buyers and sellers have been looking at alternatives that focus on the balance sheet, namely a post-closing balance sheet adjustment.

Unlike an earnout where parties look to the future performance of an acquired business, a balance sheet adjustment allows buyers and sellers to compare the firm as it existed at closing to what existed at the time of the agreed-upon purchase price.

Typically, these dates are weeks, if not months apart, Vice says, and without a purchase price adjustment, the buyer bears the risk that the target’s balance sheet at closing may no longer support the acquisition price. A seller faces the opposite challenge — if the business has grown since the negotiated purchase price, it may ask for compensation for the increase in value.

To address this, Vice says a post-closing balance sheet adjustment sees the buyer and seller agree that, upon closing, a chosen financial metric (or multiple metrics) will be compared for the two time periods. The party who benefits from the difference will pay the net difference.

“Conceptually, it is a bit simpler than an earnout,” says Vice. “It’s a matter of parties looking at the balance sheet of the acquired company at closing and then looking at it in a specified period in the future.” He adds the most common metric in these situations is working capital.

(Working capital is calculated by deducting current liabilities, such as accounts payable, from existing assets such as cash and accounts receivable.)

“This is a little more tangible. You’re looking at the difference in real assets, which have a more obvious effect on the working price.” Other metrics used include debt, cash, and assets.

Another adjustment mechanism is an agreement among the parties to have the target firm produce a preliminary estimate on closing. This interim step affects the buyer’s closing price, but the final deal remains subject to the post-closing adjustment.

While valuing a company is typically left to the investment bankers and accountants, both Buchanan and Vice say that lawyers have an essential role in assessing, advising, and negotiating terms that mitigate risk for their clients.

“We have to look out for where the risks are and find ways of making sure that there aren’t disputes after the deal closes,” Buchanan says.

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