Four Key Provisions for Every Earn-Out Agreement
By Barry Jay Epstein, Ph.D., CPA and
Elaine Vullmahn, CPA, CIA
Prevailing market conditions have made it more difficult for buyers and sellers of businesses to consummate transactions. The recessionary environment and diminished market liquidity have resulted in fewer prospective buyers. Recent trends also suggest that the focus of the few buyers with readily available cash and access to debt financing has shifted from an interest in paying for potential to instead paying for delivery of promised post-acquisition performance. Thus, while uncertain market conditions persist, in order to bring a proposed transaction to fruition, buyers and sellers may have to rely more heavily on carefully drafted earn-out agreements.
Attorneys involved in business acquisitions play a critical role in ensuring the ultimately agreed-upon deal creates a win-win situation for both parties. A well structured earn-out agreement can enable the parties to reach an acceptable set of terms, appropriately rewarding the seller for past performance while reserving for the buyer the right to "cut the cards" by retaining a part of the purchase price for realization of promised future performance. Typically, such arrangements do provide sellers with the highest price – if, of course, the company being sold performs to agreed-upon financial criteria, typically over a three to five year period.
Earn-outs are a risk for sellers, however, and a poorly structured deal can lead to opportunistic behavior by buyers, who control the accounting methods applied post-transaction in determining whether earn-out targets are being met. Attorneys should consequently strive to draft an earn-out agreement that is clear on its face, lacks ambiguity, and can easily be interpreted through the plain language contained within the four corners of the document. Poorly drafted earn-out agreements have historically been disproportionately the cause of post-transaction disputes, the cost of which can easily leave even ultimately-successful sellers with Pyrrhic victories.
Earn-out agreements should be sufficiently detailed to avoid disputes over whether relevant benchmarks have been reached. In order to create such a comprehensive agreement, the parties need to thoroughly consider and understand current business operations and how consent is to be given for future practices. Parties should also agree on accounting standards that may affect the seller’s realization of certain thresholds.
The following four points present critical aspects of generally accepted accounting principles ("GAAP") that are often overlooked by both parties and frequently lead to costly disputes.
- Changes in Key Accounting Estimates
An earn-out agreement should document the parties’ understanding of key accounting estimates that will affect future performance measures. Accounting estimates are an integral part of accounting because of inherent uncertainties in business activities. They are utilized, for example, to approximate the collectability of debts, the useful lives of depreciable assets, the needed amount of warranty reserves, and the future economic benefits of intangible assets such as goodwill. There is often a legitimate need to revise estimates due to changes in circumstances on which they were based or as a result of new information, more experience, or subsequent developments. In order to determine whether a change in an accounting estimate would impact compliance with current and future earn-out agreement goals, a seller may request that the buyer disclose the rationale for such a change. If possible, a requirement for formal acquiescence by the seller for such changes might be included, although buyers will naturally resist this.
- Changes in Accounting Policy
An earn-out agreement should describe how the computations would be affected if there is a change in accounting policy. A change in accounting policy is a revision in the way that a company accounts for a particular type of transaction or event, or for any resulting assets or liabilities. Under GAAP, management may voluntarily decide to make a transition from one generally accepted method to another, but only if the change results in a reliable and more relevant presentation of the financial condition and results of operations. However, even if such changes are made for the purest of intentions, unanticipated impacts on the seller’s expected payouts may occur and lead to disputes between the parties.
In order to be alerted to possible alterations in an earn-out agreement calculation, a seller may request that the buyer notify the seller of its intent to voluntarily change an accounting policy that had previously been utilized, possibly coupled with an acquiescence requirement. More extreme, and definitely more effective, would be the inclusion of a “frozen GAAP” provision in the earn-out agreement, which would require that financial results, for purposes of the earn-out calculations, continue to be made using accounting policies in effect at the transaction date, even if changes are implemented for other financial reporting purposes.
- Correction of an Accounting Error
An earn-out agreement should define the effect on the calculation if a company, or its auditors, discovers that there was an accounting error in a prior period. If the error was material on the reported results for any period, GAAP generally requires that the error must be corrected, even if it has self-corrected over the long run. Some of the types of errors that might occur are changes from an unacceptable accounting principle to an acceptable one, misclassification of costs, or a failure to accrue or defer expenses at the end of a period.
Accounting errors require restatement of prior period results, in order to comply with the fundamental qualitative criteria of comparability and consistency that are deemed critical for financial reporting. A retroactive application and restatement of prior period financial statements could impact the original assumptions on which an earn-out formula was derived. Additionally, if such restatements occur during the course of the earn-out period, they could impact payments to sellers. Therefore, a buyer and seller should establish, in the agreement, the precise way that earn-out computations would be affected under all such circumstances.
- Potential Transition from GAAP to IFRS
It may be appropriate for the earn-out agreement to include a provision detailing what would occur if the entity exercises an option, or is required by law, to prepare financial statements in conformity with International Financial Reporting Standards (“IFRS”) instead of GAAP. Over the last several years the Financial Accounting Standards Board and the International Accounting Standards Board have jointly made progress on converging GAAP and IFRS. The SEC is deliberating, and likely to endorse, ultimate replacement of GAAP by IFRS for public companies, and a recent IFRS standard geared to the needs of privately held companies may spur widespread IFRS adoption even by U.S.-based private entities.
While there are now many similarities between these sets of standards, many differences still remain. If a buyer adopts some variant of IFRS, the change will likely impact the remaining earn-out calculations, in possibly unpredictable ways, exacerbated perhaps by the fact that any such transition can prove to be a challenge and result in misapplication of the new standards, even with the best of intentions. If appropriate, then, the parties should discuss and agree upon how a change from GAAP to IFRS would impact an earn-out agreement. “Frozen GAAP” is one such solution, but buyers may rebel against the need to maintain GAAP-basis financial records after making the change to IFRS.
When it comes to structuring business acquisition agreements, careful attention to these matters may indeed be the ounce of prevention that saves many pounds of costly, and problematic, dispute-driven cures.
Note: This article was first published on Law360.com, March 23, 2010.
About the Authors: Barry Jay Epstein, Ph.D., CPA, (mailto:mailto:bepstein@RNCO.com?subject=Website-Inquiry-for-Barry-Epstein) is Partner in the Chicago, Illinois firm, Russell Novak & Company, LLP, where his practice is concentrated on technical consultations on GAAP and IFRS, and as a consulting and testifying expert on civil and white collar criminal litigation matters. Dr. Epstein is the co-author of Wiley GAAP 2010, Wiley IFRS 2010, Wiley IFRS Policies and Procedures, and other books. Elaine Vullmahn, MBA, CPA, CIA is a Senior Litigation Accountant with Russell Novak & Company, LLP, specializing in internal control matters and litigation consulting. Ms. Vullmahn is also a J.D. candidate at the John Marshall School of Law, class of 2011.