Earn-Outs Can Help Bridge Pandemic-Related Valuation Gaps During M&A Negotiations
August 21, 2020
Because the extent of COVID-19’s impact remains uncertain, it may be difficult to properly value the target company at the time of signing a transaction – especially if there is a delay between signing and closing. This issue can be addressed in a variety of ways, including the use of an “earn-out” if the buyer and seller cannot agree on the value of the target company. Earn-outs generally call for future consideration to be paid to the seller in a transaction upon the achievement of certain thresholds or other metrics relative to the business (e.g., revenue growth, the achievement of certain margins or other pre-determined quantitative hurdles). Though earn-outs are one method to bridge the valuation gap in an uncertain economic environment, using an earn-out approach can result in complex and challenging negotiations. Further, and because of the complexity of drafting, earn-outs have a potential for disputes later.
In addition to achieving consensus on valuation, another challenge may be negotiating the post-closing process for “trueing-up” the target company’s working capital. Most M&A transactions include the customary post-closing purchase price adjustment whereby the buyer in the transaction will either pay to the seller, or be owed from the seller, additional cash based on the difference between (i) the expected amount of the target company’s working capital at closing, and (ii) the actual amount of the target company’s working capital at closing. The expected amount of the working capital (sometimes referred to as the “working capital target”) is most frequently established based on a trailing 12-month historical average of the target company’s working capital levels.
However, because of the disruption to business caused by COVID-19, what constitutes a “normalized” working capital number may need to be reconsidered to account for shutdowns or other disruptions during the past several months. Understandably, the target company will want to seek floors or collars in the purchase price adjustment mechanics to avoid being penalized for fluctuations in working capital during this crisis. Conversely, a buyer is likely to be focused on ensuring that they will be acquiring a business with sufficient levels of working capital and liquidity to manage the challenges ahead.
The Corporate Group at Levenfeld Pearlstein guides clients through a wide range of deals. We share tips and considerations for getting a deal over the finish line during the COVID-19 pandemic here. To stay up-to-date on legal developments, follow along with our Daily 3.