Merger and acquisition transactions (M&A) are diverse transactions which can be done in a large number of manners and features, while being assisted by many complex legal mechanisms. One of the main topics discussed between parties is the nature of the consideration. Sometimes the parties agree to defer and condition some of the consideration as a function of the acquired activity reaching future business goals. Mechanisms of conditioned consideration (earn out) which are prevalent in recent years, emphasize the importance of reaching an agreement on goals which can be objectively and measurably quantified, in order to attempt to limit future disputes.
Preamble
When formulating an optimal outline of a merger and acquisition transaction (M&A), there are many considerations which affect the decision regarding the outline of the transactions and its legal mechanisms. It is impossible to cover all legal, taxation, floe, organizational and other considerations, which are made when deciding on the nature of the transactions, its corporate structure and the business mechanisms inherent to the transaction, whose purpose is to maximize the benefits of parties involved.
Obviously, one of the most significant topics in the transaction regards the nature of the consideration, and the many forms in which it is paid (which is separate from the question of total payment).
In essence we will state that there are three main outlines for executing the transaction: (1) a transaction for purchasing shares, as part of which the purchaser buys shares of the purchased corporation; (2) a transaction for purchasing activity (“a property transaction”), as part of which the purchaser buys commercial activity, including properties, from the selling corporation; and (3) a merger transaction (regular, invert), as part of which the purchased corporation is engulfed within the purchasing corporation and in fact ceases to exist while its activity is assimilated in the activity of the purchasing corporation. In each outline, it is possible to pay whether in cash or shares of the purchasing corporation, and of course it is possible to combine both methods of payment.
Another topic regarding the consideration and its method of payment is the application of the conditioned consideration (earn out) mechanism, according to which some of the consideration will be paid to the seller subject to the purchased activity meeting pre-agreed business goals.
Earn Out – the Consideration in Applying the Mechanism
Allegedly, the purchaser’s considerations in applying the mechanism of earn out are clear and even trivial. The purchaser will always prefer to defer some of the consideration, and to condition it in achieving business goals within a defined period of time. Many times, as part of due diligence performed by the purchaser, he discovers diverse variables, which can have a dramatic effect on the business outcome of the purchased activity: competing factors, intellectual property which is critical to the continuation of the purchased activity, wear of significant assets, the importance of senior employees and such. In these situations, the purchaser will look for ways to minimize risk in order to ensure that the consideration he is paying which is based on past results, will also be worthwhile to the purchaser based on future business outcomes in the period of time after finalizing the transaction.
Another significant advantage to the purchaser in deferring the payment is a flow-funding advantage. Obviously, it is preferable for the purchaser to defer some of the consideration payments and to spread them over several years. This minimizes the cost of initial funding required for executing the transaction, and even enables funding some of the consideration payments by working capital from the purchased activity.
It is important to state that the seller can also have an advantage by conditioning some of the consideration in future performance, in cases where the seller predicts that the performance of the purchased activity are expected to improve. As part of negotiations, it will be easier for the seller to convince the purchaser to reflect the improvement in performance in the purchased activity and to request higher consideration, provided that it will be conditioned on the actual achieving of goals. In cases where the seller (and anyone on his behalf) continues to personally hold senior positions in the company after the transaction was completed, it will make it easier for him to continue to guide the purchased company to the direction of achieving those business goals.
The Importance of Accurate Goal Definition
There is great importance in accurately defining the business goals which constitute a condition for paying the future consideration. The goals themselves can be varied, for example: total incomes, total operational profit, market share, successful completion of a significant transaction, achieving a number of users and such.
Upon formulating the transaction, the parties must aspire to agreement and drafting measurable objectives which in the future will enable the parties to understand, clearly and relatively simply, whether the goal was in fact achieved or not.
Sub-topics which are examined with regards to the business goals are whether achieving the goal is one-time, or over a period of time; is there an external professional factor which should approve achieving the goal, for example with regards to market shares (Nielsen and such); can the company pay money in order to achieve the goal, or should it reach it organically, for example: in the case of number of users as a goal? And so on.
Moreover, many times the parties agree in advance on an objective professional factor who in the future will be responsible for deciding whether the company has indeed reached the goal or not, in order to try and prevent future disputes between the parties on this matter. Additionally, sometimes the said objective factor also receives in trust the total conditioned consideration, and transfers it to the relevant party according to his ruling on the matter of achieving the goal.
Summary
In complex merger and acquisition transactions, a mechanism of earn out is often formulated. When formulating the transaction and drafting the agreements between the parties, it is important to pay attention to drafting business goals which will be quantifiable in a professional and objective manner, in order to prevent future disputes regarding the question of whether the purchased activity has indeed reached the goal or not.