Ten Critical Elements of M&A Agreements: Earnouts, Between Sign and Close, and Closing

Joel Espelien (cont’d)

Next, we go to Peter Prince in London, to talk about earnouts.

Peter Prince

Earnouts are common contract components. They tie a payment to the sale of the part that the total transaction price to the company's future performance. In other words, the seller is required to hit financial targets, such as annual revenues, EBITDA, or customer growth, typically over one to three years. Often earnouts bridge gaps between the buyer and seller proposals for the total sale price. The earnout's key contractual terms for the seller include: control of resources, attainable targets, and clear definitions of expectations.

Without these, a seller might not be able to meet the goals. We once created a 50-page earnout rule book governing how the seller could and would be in control of achieving his earnout. Using those rules, he did meet his goals and got fully paid. In another agreement we closed, the buyer and seller essentially agreed to agree on three million in earnout to the CEO, the main owner. Both sides of the vested interests, and it worked.

Joel Espelien

Thanks, Peter. Earnout discussions often turn into a whole negotiation within the larger negotiation. Next, we go to Bruce Lazenby in Ottawa, to talk about what happens between sign and close.

Bruce Lazenby

We often say that nothing good happens between signing and closing. As time lingers on there are many internal and external factors that can affect the deal. We managed a deal a few years ago in France with BMC, based in Texas. The deal got locked in US dollars, however, it was important to our client's VCs that the price be fixed in Euros, since that is how their distribution to their LPs would be made. The problem was that the investors weren't in a position to fund the hedge. And the M&A contract locked down the balance sheet, preventing the company from investing in a hedging strategy and on behalf of the shareholders.

We solved the problem by renegotiating the balance sheet lockup in the contract, so that the company could hedge the deal consideration, and lock in a Euro value. Cross-border deals with always expose either a buyer or a seller, or both to foreign currency movement. And how the balance sheet is treated is always a critical part of the contract.

Joel Espelien

Thanks, Bruce. And finally, to close out our top 10, we have Jim Perkins in Arizona, to talk about closings.

Jim Perkins

Signing the contract is an important step, but it's not the final step. It is possible to sign the contract and never close the deal. You'll need to avoid contingencies to close it. Most importantly you will need to create urgency to close. And ideally, you will sign and close simultaneously. But often, there are items that need to be addressed between signing and closing.

If these items will take more than a week, you might be better off postponing until they have been addressed and negotiated away. Buyers often ask for a six-month lock-up from signing. With the reasoning that they are committed to the deal and only wanted to make sure there is enough time to manage all of the moving parts and get to closing. The problem is that the schedule with always extends to use all of the available time, and then it'll be extended again. You'll want to set a deadline and work towards it and have enough teeth in the agreement that you have other options if you get stalled on your way to closing.

This is a segment from Tech M&A Monthly: Best Practices for Definitive Agreements in Tech M&A (August) webcast. For more information, please visit Corum Group's Software M&A Webcast Archive.