An earn-out can be an effective tool if used to bridge valuation gaps in merger negotiations and can also help encour-age management retention, but the tech-nique also poses sizable risks for buyers and sellers alike.

The plusses and minuses of using earn-outs during mergers was the subject of a spirited debate at the 2012 M&A Con-ference held on Oct. 11 in Minneapolis that was hosted by the law firm of Faegre Baker Daniels LLP. The panel included Eric Nealy, director of corporate develop-ment at Imation, a maker of data backup and storage equipment; David M. Gale, partner in the Minneapolis Transac-tion Advisory Services practice at Ernst & Young; Louis Lambert, chief counsel for M&A at General Mills; and Richard Mattera, senior deputy general counsel at UnitedHealth Group. The discussion was moderated by David J. Kuker, a partner at Faegre Baker Daniels.

UnitedHealth Group’s Mattera said his firm uses earn-outs often, but not usually during a competitive auction, when it can complicate the process. An earn-out is a provision in a merger pro-viding the seller of a business with addi-tional compensation from the buyer af-ter the business achieves certain agreed financial goals.

Mattera said UnitedHealth Group of-ten uses earn-outs when they are trying to convince someone to sell their busi-ness but are not actively in the market, meaning there is a big gap in valuation to overcome. In such platform plays, Mattera said, it’s really important to

have the current management stay part of the company. “We have found earn-outs to be a very helpful tool for keeping

management engaged over a two-year period of time,” Mattera said.

General Mills’ Lambert said his firm

does not prefer to use earn-outs because of their complexity in negotiating and implementing. He said that General Mills spends a great deal of time and ef-fort building relationships with a com-pany’s sellers and “introducing an earn-out really brings a lot of conflict to that negotiation after you spent so much time building rapport.” He added that inte-grating firms that have been acquired with an earn-out becomes especially difficult.

David Gale of Ernst & Young de-scribed earn-outs as a “double-edged sword,” that can be particularly useful in bridging valuation gaps and reducing the guaranteed purchase price as well as being used to retain management. But they often involve longer, more costly negotiations and can end in litigation.

David Kuker, a corporate law special-ist at Faegre Baker Daniels, showed a slide that indicated that 38% of private target deals use an earn out and that 45% of earn-outs have a time frame greater than two years. Eric Nealy of Imation said he thought the “sweet spot” for an earn-out was in the one to two-year timeframe. He added that he thought three years should be a limit on earn-outs and was shocked to learn that one-third of earn-out deals were for more than five years.

Mattera said his experience showed that earn-outs were used mainly in

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smaller deals and that in public company mergers the use of earn-outs was much rarer than the reported 38% of deals. “As you get into larger deals, it’s difficult to align management incentives with the compensation and retention package,” Mattera said.

Mattera said earn-out proposals are also useful in getting the existing man-agement team to be more realistic about the firm’s future prospects. “When they realize there’s no way they are going to hit the numbers they have modeled for the business in the next two years, they become a lot more in line with how you think the business is going to perform because they’re not willing to put their earn-out on the line on something that’s a bit pie in the sky,” he said.

Kuker said the one instance most people are enthusiastic about earn-outs is the situation of a pharma or medi-cal device company that is waiting for approval from the U.S. Food and Drug Administration to sell a medication or device to the public. “That’s not in any party’s control,” Kuker said. “It will ei-ther happen or not and it will be clear to everyone that it happened or didn’t hap-pen.” There might be timing issues but the so-called binary outcome is a good situation for an earn-out, he said.

While the binary earn-out is a clear-cut example, what is the best metric to use in doing financially–based earn-outs, which are more common? Gale said that a revenue-based earn-out was the easiest to measure and simpler than an earnings-based earn-out. But he cau-tioned that you have to be careful about the incentives raised by a revenue-based plan.

For example, Gale said management could be incentivized to add lower-margin sales to reach their earn-out threshold.

That could be detrimental because that’s not adding the type of business that’s good for the broader company.

Lambert mentioned the food indus-try, where heavy discounts or high mar-keting spending can temporarily boost the top line, which could be problematic for an earn-out based solely on revenue measurements.

Mattera said his firm prefers an earn-ings-based metric, but he acknowledged there could be disputes about what is included in that number. For example, does the management get credit if an-other part of your business succeeds in exploiting cross-selling opportunities? What about the earnings from acquisi-tions -- do they count in the earn-out calculations?

A third possibility was discussed which is an earn-out based on gross profit. This calculated after deducting the cost of sales, but before removing operating expenses.

Gale suggested that that earn-out must be well defined in the merger agreement, with examples and exhib-its, including even sample calculations, which, he said, can be crucial in elimi-nating disagreements down the road.

Gale also pointed out that earn-outs could cause significant earnings volatil-ity after the transaction has closed. He gave the example of things going really well at an acquired business. That would require the buyer to increase the amount being paid out under the earn-out, which could result in a charge to the buyer’s in-come statement. If things are not going well at the acquired firm, that will result in a pickup on the buyer’s income state-ment because of the smaller earn-out, which “is a little bit counterintuitive and needs to be kept in mind,” Gale said. n

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