Investment Banking

• Skip The Block Party, Since Big Profits Await In Smaller Equity Deals

Financial Reporting, Taxation, & Accounting

• Establishing A New Internal Control Function: Tough But Essential Task

• Sarbanes-Oxley Rule 404 Now A Costly, Time-Consuming Reality Show

• Sarbanes-Oxley 404 Software Helps To Bridge Compliance Gaps

Equity & Debt Offerings

• Allowing The Use Of Unregistered Finders Would Help Small Businesses

• Going Public With A Commercial Bank May Reduce IPO Underpricing

Corporate Governance & Directors' Duties

• Board Work Is Tougher These Days, But Precautions Can Minimize The Risk

• Canadians Consider National Compliance Guidelines

Corporate Entities & Structures

• Public To Private: The New Small And Mid-Cap Choice

Mergers & Acquisitions

• Acquiror’s Shareholders Tend To Approve Mergers, But Not With A Rubber Stamp

• Structure Deals With Earnouts Clearly And Carefully To Avoid Future Trouble

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Resolving spreads, overcoming viewpoints. Need an original, powerful way to resolve the gap between the bid and ask valuations in an acquisition? Consider the earnout, suggests Michael Frankel, a corporate development and finance executive. The earnout is a payment resulting from performance after a deal is closed. Future performance may seem a simple criterion—giving the seller the benefit of post-closing earnings arising from its pre-closing efforts—but it can also stir intense disagreement between the parties. Earnouts are useful when an outcome is difficult to predict, for example, in deals involving startups and early-stage companies, firms with new products or technologies, and those in highly volatile industries. They are an attempt to resolve the contrasting viewpoints of the buyer (i.e., pessimistic) and the seller (optimistic) as to future performance. The higher a company’s projected growth, the greater the valuation gap; the slower or more predictable the growth, the narrower the gap. Contingent payments—based on future revenues, profits, or cashflow—can bridge the gap and sometimes are the only way to get a deal done. However, view them as a last resort, remembering that deals with earnouts are complex, demand precise drafting, generally seem difficult to manage, and hold great potential for conflict.

The devil in the details. While earnouts offer a reasonable solution, they succeed only when the details, terms, and metrics of the deal are accurate. Using contingent payments to put off solving a disagreement can cause more problems than it attempts to fix. The rules must be clear and easy to carry out, the author warns, or else the parties will unhappily meet in court. The triggers must be specific, precise, and capable of easy measurement; ambiguity in terms, measures, or responsibility for performance just delays the inevitable disagreement. Problems can also occur when the earnout is a large percentage of the purchase price. Financial metrics (including revenues, EBITDA, and net income) and nonfinancial metrics (such as product development milestones) are sound criteria for contingency payments. Occasionally, even the metrics are subject to interpretation regarding calculation methods, data sources, and payment circumstances. Align metrics with the goals and expectations of both parties by identifying the variables that match the underlying goals.

Control is always an issue. After the deal closes, the buyer generally exercises complete control over the acquisition. This leaves the seller dependent on the new management to determine performance, and it raises a potential for conflict. Sellers must be aware of the buyer’s adverse incentive bias, the author urges. While this bias should be offset by the desire to achieve successful performance, an especially large payment can certainly tempt the buyer to hinder the company’s performance, thereby reducing or eliminating the payout. Another possibility is that the buyer might weight the financials away from the payout metrics. Avoid potential issues of control by permitting the seller either to retain some control over the business or to establish parameters for operation. Examples are requirements for minimum expenditures in marketing or adherence to the existing business model, until the payout is complete.

Abstracted from Journal of Corporate Accounting & Finance, published by John Wiley & Sons, 111 River Street, Hoboken, NJ 07030. To subscribe, call (888) 378-2537; or visit www.wiley.com/cda/product/0,,JCAF,00.html.