Global menu

Our global pages

Close

Coronavirus - Bridging valuation gaps with earn-outs and put/call options - Global

  • Global
  • Coronavirus - M and A issues
  • Corporate
  • Mergers and acquisitions

29-04-2020

The continued impact of the coronavirus pandemic is undoubtedly increasing uncertainty around asset valuations. With the need to bridge valuation gaps in order for parties to strike deals, this article looks at two key tools to navigate this tension: earn-out mechanisms and put/call option structures.

Earn-Outs

Whilst there are other forms of deferred or contingent consideration, an earn-out mechanism is different to others as it involves at least part of the purchase consideration being calculated by reference to the future performance of the target business. Traditionally, earn-outs have been used particularly where there is a desire to incentivise a seller that is to continue to be involved in the target business during a period post sale. However, such mechanisms are also a useful tool where there is a valuation gap between the parties – often caused by perceived risks around the target business’ future performance.

Over the last decade, during which valuations have generally been strong, the use of earn-outs has declined. This will have caused a significant ‘knowledge gap’ in relation to the inherent complexity of such mechanisms in the dealmaking community – which brings a risk of difficulties in implementation and an increased potential for dispute. However, lessons from previous downturns, such as in 2008-09, suggest that earn-outs become a more prominent feature of M&A transactions during periods of economic uncertainty. In our view, the era of coronavirus will prove to be no exception and we can expect an increase in the use of earn-out mechanisms.

Competing commercial interests can mean a conceptual difference in approach to earn-outs: buyers will view future payments as highly contingent (‘if, not when’), while sellers may feel some entitlement to payments which are merely deferred. This variance has implications for the (often fraught) negotiation and drafting process that surrounds an earn-out. Some of the most significant and frequently recurring issues associated with structuring earn-out mechanisms are discussed below.

Performance Targets

What should the triggers for earn-out payments be? Typically, this will be tied to profits or turnover of the target business during relevant periods. Our M&A Market Monitor report, which tracks international M&A trends across the transactions we advise on, shows around the majority of the earn-outs we see on UK and US deals apply a period of 1 – 2 years. The trends elsewhere in Europe and in Asia are towards slightly longer periods (often between 2 and 3 years). In the context of unusual circumstances such as the coronavirus pandemic, we could also see the rise of other specifically focused trigger events (for example, the non-termination of a key commercial agreement) supplementing the more traditional profit/turnover targets.

Buyers will naturally favour higher thresholds, while sellers should be wary of ‘all or nothing’ situations. As a compromise it is common for a waterfall or sliding scale approach to be used. Such an approach would typically see performance targets split periodically (say each year or each quarter) through the earnout period. Within each period the performance targets would be structured such that, once a minimum threshold is met, the entitlement to the earnout increases incrementally depending on the level of performance over such threshold.

The calculation of the earn-out parameters to be applied can also be controversial. For instance, to what extent should the calculation of the earn-out be insulated from the impact of adverse extraordinary events (such as the impact of the coronavirus related lockdown) or, more generally, force majeure events. There may also be debate over the inclusion or exclusion of ‘windfall profits’, whether or not certain expenses are booked during an earn-out period, the impact of other acquisitions post-completion, and so on. If a possible on-sale is envisaged during the earn-out period, the buyer will also need to be particularly careful that the calculation mechanism for performance targets is structured in a way that can accommodate this.

As with other consideration adjustment mechanisms, due to their inherent complexity, the accounting policies and earn-out calculation mechanisms are common areas giving rise to post-acquisition disputes. It is therefore crucial that lawyers and accountants are engaged at the outset so that accounting policies and a detailed process for calculation (which should be crafted with a view to minimising subjectivity) can be agreed. This should be backstopped by a robust dispute resolution mechanism (typically backed up independent expert determination).

Conduct of Business

Regardless of whether an earn-out is profit or turnover driven, the question of how the target business is run during the earn-out period will be highly relevant. Sellers will want to impose restrictions preventing, for example, increased non-ordinary course costs in the business, interruption to supply chains or a reorganisation of the business within the wider buyer’s group. It may also be important to prevent members of the buyer’s group from competing with the target. The seller will also likely require access to information regarding the conduct of the business.

Clearly this must all be balanced with the buyer’s business plans and expectations. Since much of the value of many M&A transactions is linked to business synergies and other integration benefits, there will often be challenges in enabling these to be carried out, whilst preserving ability to accurately judge the earn-out performance targets. Whilst conduct of business covenants are often highly negotiated, it is common for these to include, among others, restrictions (or seller approval rights) over material non-ordinary course transactions, group reorganisations, ‘leakage’ of value to the buyer group, changes in key personnel, material changes in the nature of the business, and restrictions on competition with other buyer group entities. Often there are also positive covenants by both parties as to implementation of an agreed business plan.

Relationship to the other transaction terms

The earn-out provisions will need to be cohesive with the rest of the transaction documents. For example, buyers will want to ensure that the warranty ‘jeopardy’ period is no shorter than the earn-out period. This is to ensure that the seller, if it remains with some control of the business post-completion, cannot (inadvertently or otherwise) hide a potential warranty claim so that the jeopardy period would expire whilst they still held an element of control. This will also be significant where the earn-out provisions allow for set-off against warranty or indemnity claims by the buyer.

Sellers, on the other hand, will want to be sure that any matter which is an adjustment to the accounts for calculating earn-out figures is not also used as the basis for a warranty claim. Sellers should also consider whether an escrow retention, security or guarantee in the transaction documents will be extended to cover earn-out payments (absent this, the seller would be an unsecured creditor of the buyer in respect of its earn-out entitlements).

Taxation

Tax aspects of earn-outs are complex and tax advice should always be taken early, ideally at the heads of terms stage. Stamp duty (applicable to the total consideration for shares, including earn-outs in certain circumstances) and capital gains tax (where proceeds will generally be deemed to comprise any initial payment and the market value of the earn-out at the point of sale) should always be considered to ensure that the full tax impacts of the earn-out mechanism is clearly understood. Further tax issues may arise if any consideration is in non-cash form (such as shares or loan notes). Where the seller is a director or employee of the target it will also be important to consider the rules around employment related securities.

Put/call option structures

Partial acquisitions coupled with put/call options may also become more prevalent in M&A transactions to bridge the valuation gaps in the context of the co pandemic. Under such structures the seller is left with a (usually minority) equity stake, typically with the parties each having the benefit of an option to require the sale of that stake to the buyer at a later date at a price usually based on a metric such as multiple of earnings or revenue (and possibly subject to certain conditions). The seller would have an option to ‘put’ its shares on to the buyer and the buyer would have a corresponding option to ‘call’ those shares from the seller – the idea being that either party can initiate the exercise of the option at a prescribed time (subject to its terms). The seller thereby takes some exposure to the trading of the business during the option period (and also the opportunity to realise value above that implied by the original valuation) whilst allowing the buyer to ensure that this element of the valuation is supported by the actual performance of the business during the option period.

Determination of the option price

Where price is to be determined at a later date by reference to a formula (for instance by reference to earnings or revenues), the basis and method of calculation will need careful consideration. It is likely that, as with an earn-out mechanism, a detailed set of accounting policies will be needed. As with earn-outs, this is always an area that is ripe for dispute and the parties should agree a robust dispute resolution mechanism at the outset (typically backed up independent expert determination).

The parties will also need to agree any minimum or maximum price limits that are to apply. Where the seller has the ability to put the shares on the buyer, the buyer will want to understand its potential maximum payment obligation. Where either of the parties is part of a group which is listed on a stock exchange, the potential maximum price payable may also impact the classification of the transaction under the rules applicable to that stock exchange and the need to disclose the terms of the transaction and potentially seek shareholder approval.

Conditionality

The issue of conditionality to the exercise of put/call options needs to be carefully considered. Where the purposes of a put/ call option structure is to bridge a valuation gap, it may be argued (from a purist’s perspective) that there should be no conditionality to the exercise of the options (i.e. the transaction is always for 100% of the target business and it is only the valuation of the optioned stake that is deferred). It is, however, not unusual for some form of conditionality to be included, particularly where the buyer has a strong bargaining position and is looking for MAC protection or where there are applicable regulatory requirements necessitating a condition. As discussed below, the inclusion of conditionality has knock-on impacts provisions regulating the conduct of the target business and the relationship of the buyer and seller whilst they each own a stake in the target.

Gap-period and exit provisions

The transaction documents will invariably need to deal with the conduct of the target business, the governance rights of the parties and transfer restrictions during the ‘gap-period’ prior to the exercise of the options. Whilst the seller may (as is typically the case) retain only a minority stake, it will want to ensure that it has an appropriate degree of influence over the target business to protect and maximise the value of its put option. The buyer will want to ensure that the seller’s involvement is not at the cost of the long-term value and prospects of the target and that the seller’s governance rights do not go beyond those appropriate to the size of its retained stake. Common governance rights for a seller retaining a minority stake will include, among others, the right to appoint a director, the benefit of shareholder reserved matters over certain material (non-ordinary course) matters and information rights. There will usually be a prohibition over transfer of the target by the seller or buyer during the option period (although sometimes exceptions to this are negotiated where commercially agreed).

Where the ability to exercise the options is conditional, the transaction documents will also need to address what happens if the conditions are not met – including appropriate exit provisions providing an orderly process to allow the parties to part company. This highlights one of the potential downsides to the use of put/call option structures – in that the transaction inevitably moves away from a purely buyer and seller relationship and, to a varying degree, a number of joint-venture related issues (such as governance rights, dividend policies, transfer restrictions and exit provisions) fall to be addressed. This is particularly the case where the option period is lengthy or the exercise of the option is contingent.

Warranties and W&I insurance

As is usual on a share purchase, business warranties will usually be given in respect of the target as at the date that the sale of the initial stake is agreed. Whether the warranties (or a sub-set of them) are repeated at the point the subsequent optioned stake is acquired is a matter for commercial negotiation. If warranties are repeated, sellers will usually expect to be able to update their disclosures (such that matters disclosed that occurred after the original date of the warranties will qualify the repeated warranties). If the transaction is backed by warranty and indemnity insurance, the insurer will generally only cover repeated warranties if the disclosures are updated (and matters disclosed would be excluded from the coverage for the purposes of the repeated warranties). A put/call option structure will also need to be considered with the insurer to agree the basis of coverage under the policy given the split between the initial acquisition and the exercise of the option – i.e. whether the buyer will obtain insurance coverage reflecting that it ultimately acquires 100% of the target.

Merger control

The buyer and seller (particularly where they are competitors) should seek competition advice at an early stage to clear any competition concerns that may arise from the parties having joint control of the target during the gap period. The put/call option structure (including the governance rights, information rights and any conditionality to the exercise of the options) is likely to be relevant to this analysis.

Taxation

Just as with earn-out structures, a partial acquisition with a put/call option structure is likely to bring into play a number of tax considerations beyond those that would otherwise arise in the context of a more simply structured (one-time) sale of the whole target business. Accordingly, tax advice should always be taken at an early stage.

Final remarks

The issues above are far from exhaustive, but should highlight that earn-out mechanisms and put /call option structures, while extremely useful tools - particularly in the current dealmaking environment and for the foreseeable future, are complex and require careful strategic and technical advice from the outset.

For over a decade, we have used our M&A Market Monitor report to monitor and analyse developments in the M&A market, both regarding consideration structures and also other key deal terms. This brings together the collective experience of our specialist M&A lawyers around the world. We continue to monitor closely the emerging effects of the coronavirus pandemic on the structure of M&A deals.

You can read more about our views on the emerging effects of the coronavirus on the M&A market on our Coronavirus Hub. To discuss the issues explored in this article, or issues relating to coronavirus or M&A more generally, please contact any of the individuals below or your usual Eversheds Sutherland lawyer.