Jay A. LeftonJay A. LeftonSenior PartnerSenior Partner

jlefton@ogilvyrenault.comjlefton@ogilvyrenault.com

416.216.4018416.216.4018

EARNOUTS IN EARNOUTS IN BUSINESS BUSINESS

ACQUISITIONS ACQUISITIONS

Presentation at the Sault Ste. Marie Innovation Centre

September 15, 2009

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What is an “Earnout”?What is an “Earnout”?

A contingent payment made in the future related to the post-closing performance of an acquired business

Not a typical “purchase price adjustment” A supplementary payment obligation

A good thing of a bad thing? A useful tool or a recipe for litigation?

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Why have an Earnout?Why have an Earnout?

Bridge the gap between Seller’s and Buyer’s valuation estimates The ability of one or the other to say “I told you so”

Motivate the Seller’s management who will stay on to run the business post-closing

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Off the Shelf Examples?Off the Shelf Examples?

NO STANDARD STRUCTURE!! A simple concept, but difficult to implement Tailored to meet the particular needs of the transaction

Complication is added if the business operations are to be integrated into the Buyer’s operations, and not kept separate What happens if the acquired business makes further

acquisitions? As an aside: consider investment banker’s engagement

letters and “success fee” calculation

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What Business Variables What Business Variables are to be Measured?are to be Measured?

Financial and/or Non-Financial? Top Line vs. Bottom Line Measurement

Top Line is Generally Preferred by SellerBottom Line is Generally Preferred by Buyer

Revenue Gross profit Net income Cash flow Earnings before interest and taxes (“EBIT”) Earnings before interest, taxes, depreciation and amortization (“EBITDA”) Earnings per share Number of units sold Value of the business at a future time

Require consistency of practice/application Deliverables/Milestones

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Seller’s control over the Seller’s control over the outcomeoutcome

An inevitable limitation on the Buyer’s ability to run the businessAn artificial limitation on the Buyer’s ability to integrate the business into the Buyer’s

operations

The business is to be run “in the ordinary course of business consistent with past practices”

How do you translate this into practice? Particular restrictive covenants may be imposed upon the Buyer

Contractual commitment by the Buyer to particular goals

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Seller’s control over the Seller’s control over the outcomeoutcome

Need to ensure that the Buyer is not able to artificially depress the results which give rise to the payment

Need to balance the conflict between the Seller’s short-term focus, compared with the Buyer’s long-term focus

Seller may manage the business in the short-term to maximize the earnout at the expense of the long-term prospects of the business

“Routine” vs. “fundamental” changes

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Seller’s control over the Seller’s control over the outcomeoutcome

Ability of the Buyer to cry “uncle” and take over all controls Payment of full earnout Payment of partial earn-out if the takeover follows particular events (e.g. which the

Seller equates to mismanagement) Compare this to a “kick-out” provision which entitles the Buyer to take over control

without penalty if the Seller has not met certain specified performance thresholds (which are materially below those which would entitle the Seller to the earnout)

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Seller’s control over the Seller’s control over the outcomeoutcome

Is the earnout measured only by existing services and goods that are being sold, or does it include new services and goods that are introduced throughout the period of the earnout? Totally new services and products vs. those that are “related” to the

Seller’s current services and products How do you deal with “bundled” products or “bundled” operations?

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Seller’s control over the Seller’s control over the outcomeoutcome

Is it appropriate/inappropriate to include an express contractual statement that the parties are acting as fiduciaries in this regard to impose a fiduciary duty?

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Considerations of Payment Considerations of Payment of the Earnoutof the Earnout

Period of measurement Quarterly Semi-annually Annually Can periods of good performance (well above anticipated thresholds) in some

periods be used to supplement a lesser performance during another part of the earnout period?

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Criteria for Payment Criteria for Payment of the Earnoutof the Earnout

Flat fee payment? All or nothing vs. graduated payments? A percentage of the amount by which the actual

outcome/performance exceeds the pre-determined threshold

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Duration of Earnout PeriodDuration of Earnout Period

A particular period post-closing Typically 2-5 years, but will vary depending

upon the nature of the milestones to be measured

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Determination as to Determination as to whether the threshold whether the threshold has been satisfiedhas been satisfied

The Buyer must maintain separate books and records for the business unit which is being measured

Do the results need to be audited? This will impose an additional cost upon the Buyer

“GAAP” is not necessarily sufficient define the particular accounting principles to be applied (e.g. based upon

Seller’s existing accounting policies and records)

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Determination as to Determination as to whether the threshold whether the threshold has been satisfied has been satisfied (cont’d)(cont’d)

Particular expenses to be excluded Buyer’s management fees, bonuses, etc. Administrative and general overhead expenses

except to the extent that services are provided by Buyer that were previously undertaken (but no longer undertaken) by Seller

Normalize the business operations to those which were used by the Seller pre-closingCf. increased salaries and bonuses Inter-company transactions to be considered

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Determination as to Determination as to whether the threshold whether the threshold has been satisfied has been satisfied (cont’d)(cont’d)

Particular expenses to be excluded Add-backs

Goodwill amortizationResulting from heightened depreciation caused by a write-up in assets acquired on the

acquisition Consider less advantageous tax treatment post-closing (e.g. no longer a CCPC or no longer

entitled to small business exemption or research tax credits?) How to deal with extraordinary losses/gains?

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Maximum Potential Maximum Potential Payment?Payment?

Is it capped or is the sky the limit?

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Other ConsiderationsOther Considerations

What happens if the acquired business is sold during the earnout period?

What happens if the acquired business makes further acquisitions?

What happens if a change of control or focus of the acquiror? Will the Buyer secure the future payments?

Payment of the earnout depends on the future financial viability of the Buyer

Force Majeure: how is the earnout affected by temporary events (e.g. natural disaster, act of war, labour strike, etc.)?

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Jay A. LeftonJay A. Lefton

Ogilvy Renault LLPOgilvy Renault LLPSuite 3800 – 200 Bay StreetSuite 3800 – 200 Bay Street

Royal Bank Plaza, South TowerRoyal Bank Plaza, South Tower

Toronto, Ontario, Canada M5J 2Z4Toronto, Ontario, Canada M5J 2Z4

416.216.4018 (o)

416.998.1818 (c)

jlefton@ogilvyrenault.com