EXIT STRATEGIES: Earnout traps to avoid

When the selling shareholders argue the business being acquired has unrealised potential and they wish to be compensated for that – the earnout is correctly paid out to all shareholders. However, when the new owners wish to motivate the newly-employed managers to achieve certain objectives or targets, the additional value should be included within employment agreements as additional bonuses or compensation.

The difficulty here is to separate that which rightly belongs to the shareholders as a group, and that which is reasonably held to be personal effort. Shareholders may well object to one of their number being offered an overly generous package when they think the compensation should go to them all for creating the foundation on which the near-term benefits are being achieved.

Where business deals or significant milestones are clearly in progress, the shareholders could argue that the benefits should accrue to all shareholders even if some additional compensation was paid to an individual to see it through to completion.

As a general rule, the more certain the target is to being achieved, the more the compensation should be directed to the selling shareholders as a group. Alternatively, where significant effort is still required, compensation should be directed to the individuals who can best deliver the results.

Whatever is agreed, it is best if all the selling shareholders, or at least the larger non-continuing owner/managers, sign off on the deal as this should avoid future litigation.

Here is an example involving Billabong International:

“Billabong International Ltd., Australia’s largest publicly traded surfwear manufacturer, has acquired the Honolua Surf Co. apparel brand and its 19-store retail network.

“Depending on the eventual payout, the acquisition will cost Billabong between $10 million and $15 million. The acquisition will be funded by debt and paid in two installments.

“The initial payment to Honolua is 75% of the agreed purchase price. After three years, Honolua will receive 25 percent of the initial purchase price plus an incentive-based payment calculated on the increase in retail profits over the period. In addition, Honolua’s co-founders, Tom Knapp and Randy Blumer, receive an annual earnout over three years based upon continued employment.”

Renegotiation or payout

Not all events can be forecast and there will be occasions when the earnout is frustrated by events outside one or both parties’ influence. Some of these may be anticipated, such as the resale of the acquired firm and an agreement entered into about the resulting impact on the earnout.

What happens, for example, if the prior management is unable to continue due to ill health or if actions of the buyer cause the acquired business to be severely disrupted?

Earnouts are frequently renegotiated as events unfold. This, however, requires goodwill on both sides.

Here’s a real-life example involving a British company called Anite which bough Parsec.

“In July we indicated that 100% of the group’s total potential earnout liabilities had been realised, renegotiated or capped. Further progress has been made in renegotiating Parsec’s earnout due to some major changes in that business. Agreement has therefore been reached with the vendors of Parsec to settle their outstanding earnout (maximum total of £6.8m payable in Anite’s financial year 2005/6) for £873,000, to be paid in guaranteed loan notes, repayable after one year.

“This, together with other minor adjustments, has reduced the total future cash earnout liability from £25.4m to £19.5m, whilst bringing forward all remaining 2005/6 financial year liabilities, thus ensuring that all outstanding earnouts will have been paid out by the year ended 30 April 2005, subject to performance.”

“Best efforts”

Where the owner/managers are not employed by the new owner, they are very dependent on the buyer following through with agreed programs of promoting the product or services to achieve potential revenue and profit targets. However, many times the buyer has other priorities and the potential may not be realised. This is a recipe for litigation.

Here’s an example from Melbourne company Biota Holdings:

“Biota Holdings Limited (ASX:BTA) announced today that it had issued a writ in the Victorian Supreme Court, claiming breaches of contract and fiduciary duties by the worldwide GlaxoSmithKline (GSK) group for failing to promote and support RelenzaTM. The writ seeks unspecified damages for lost royalty revenues to date, as well as future losses through the life of the product’s patents.

“Relenza was a breakthrough influenza drug that had great potential, but it was effectively abandoned at birth,” said Biota’s chief executive, Peter Molloy. Biota claims that the product failed not because of any inherent disadvantages or deficiencies, but principally because support for the product was withdrawn immediately after the launch year.”

Taxation implications

The payment of cash or shares after the closing date of the acquisition may be treated as income or capital gains, depending on the way in which the compensation is worded, calculated and timed. Different rulings may apply in different states and countries. Before any earnout is agreed, both parties should take professional advice on the matter. With some change in structure, the same end result may be achieved with different tax consequences.