Bridging the Gap in the Post-COVID-19 World: Use of Contingent, Deferred and Non-Cash Consideration in M&A Transactions—A Practical Checklist

In the post-COVID-19 world, potential obstacles to using straight cash consideration in M&A deals may become more pronounced. Valuation of a potential target may be more difficult, leading to a greater chance that there is a significant difference between buyers’ and sellers’ respective valuations of a prospective target.

In addition to the valuation hurdles, external financing may be difficult to obtain or may have terms and interest rates that are not acceptable to a buyer. Even when buyers have the cash on hand to pay the acquisition price, liquidity concerns generally may make alternative forms of consideration more attractive.

Even in more prosperous times, these concerns exist. However, they have become more acute in the face of the economic downturn resulting from COVID-19.

This practical checklist is intended to cover some of the alternative forms of consideration that buyers and sellers may look to in the post-COVID-19 world to bridge these concerns, along with the certain pros and cons from both a buyer and seller perspective. These various alternative consideration forms can be used separately or they can be mixed and matched to suit the particular deal.

Earn-Outs

• Earn-outs are a popular mechanism to bridge the differences between the perceived value of a target from the buyer’s and the seller’s perspective.
• Earn-outs require the seller to accept a lower initial purchase price based on the theory that the seller will share in the upside of the target business prospering in the hands of the buyer.
• This mechanism is generally easy to understand at a high level. It is also considered intrinsically fair, because it gives the seller the opportunity to “prove” the promising projections it has provided to the buyer. The buyer is also benefitted by the acquired business meeting from milestones.
• Although earn-outs are easy to understand conceptually, in practice there are a number of concerns to keep in mind when considering this form of consideration, since disputes over whether earn-out targets have been met are common.
• Choosing a Metric for the Earn-Out
• A key element of any earn-out, which is often the subject to extensive discussions between the parties, is the target metric(s) that must be met.
• Targets are typically financial targets, such as revenue or EBITDA, but they can also be based on other metrics or milestones tailored to a particular industry; such as number of new subscriptions if it is a subscription business or regulatory approvals within a certain timeframe for heavily regulated industries such as the medical industry.
• The choice of metric can be contentious, as both the buyer and seller will want to limit the ability of the other party to manipulate any data used to calculate whether the target has been met. For example, the seller may attempt to push for a straight gross revenue target to prevent the buyer from moving costs to the target business in an inequitable manner, whereas the buyer often wishes to use a metric that includes costs in order to provide a more holistic representation of the success of the target business.
• In general, the more objective and straightforward the metric used, the better, as vaguely defined metrics and targets may lead to disputes or litigation.
• Timing of the Earn-Out
• Another potential area of contention is the timing of payments and length of the earn-out period.
• Sellers will generally prefer shorter periods, although the length of an earn-out period will also depend on the industry and the goals agreed upon by the parties.
• If there are disagreements about the length of the earn-out period, interim targets may help bridge the gap by allowing partial payment of the earn-out at set intervals so long as interim targets are met.
• Control of the Target Business
• A frequent concern with respect to earn-outs is the extent of the buyer’s obligations to run the acquired business in a way that makes the earn-out achievable.
• Sellers will want to restrict the ability of the buyer to take actions that make the achievement of the earn-out targets more difficult and bind the buyer to agree to make investments in the acquired business to help it thrive.
• Buyers do not want an express obligation to take specific actions with regard to the acquired business, as they will want maximum flexibility to operate the acquired business in a way that is best for the entire company, not just the acquired business. In fact, buyers usually push to include disclaimers of any obligation to operate the acquire business in any particular manner.
• In order to make calculations of whether the earn-out target has been met more straightforward, sellers may request (and some sellers may insist) that the acquired business be kept separate from the rest of the company, with separate bookkeeping for the acquired business.
• Aligning the economic interest of the buyer and the seller in achieving an earn-out will be key and often times can provide more practical protection than detailed operating covenants.

Stock Consideration

• If a buyer is having trouble accessing credit markets at acceptable rates, another option may be to pay all or a portion of the consideration in stock of the buyer.
• Stock consideration can also bridge the gap in valuation of the target business between the seller and buyer by offering a way to share in the upside of the combined business.
• Stock consideration offers the seller a chance to share in the upside of the acquired business going forward, similar to an earn-out provision, but instead of having its upside tied to the success of the acquired business alone (as is typical in an earn-out scenario), the seller shares in the success of the entire combined business. This helps reduce the friction over control of the acquired business that is often present in an earn-out scenario, as sellers are invested in the success of the entire combined business and not just one portion to the potential detriment of the remainder.
• Depending on the specifics, the use of stock consideration can qualify the transaction as a tax-free reorganization (although the specifics of what is required for such treatment is beyond the scope of this checklist).
• Potential Issues at Signing and Closing

While stock consideration may be a good choice for a particular deal, there are a few things to keep in mind:

• In addition to the potential difficulty of valuing a target business in the wake of COVID-19, there is the additional burden of valuing the buyer company as well. If the seller and buyer operate similar businesses, this may be mitigated by using the same method of valuation for both, but it may not always be appropriate or possible to use the same valuation methodology;
• Valuation can either be fixed (each share of buyer’s stock is worth $X) or variable based on a formula. If a long time is anticipated between signing and closing, a variable valuation may help assure the parties that the consideration will ultimately be fair, but it adds complexity and increases the difficulty for both sides to understand ahead of time just how much of the combined company will be held by the seller; and
• Because the seller will be acquiring stock from the buyer, the seller will usually require more extensive buyer representations than in the all-cash context. While this should not prove a major obstacle, it will add to the negotiation time and costs.
• Potential Issues Post-Closing

Even after the closing of the acquisition, the seller will now own a portion of the combined company, and the acquisition documents will need to account for how the equity held by the seller is treated.

• Sellers will want to have some minority protections over decision making at the combined company. These could be as limited as board observation or as extensive as specific veto rights over certain decisions;
• Exit rights should also be determined ahead of time. Sellers will want maximum flexibility to dispose of its equity in the combined company, and buyers will want to control to whom and when equity in the company may be transferred. Both parties should think about what sort of put and call rights are most appropriate and how equity should be valued upon exit; and
• A balance must be made between protecting the value of the seller’s shares and maintaining flexibility for the company going forward.

Employee/Equity Compensation

• When the seller, in some manner, continues on at the acquired business or the combined enterprise after the acquisition is closed, post-closing employee compensation based on buyer stock may help bridge difference in valuation between the seller and buyer and is intended to incentivize the continuing employees to maximize the value of the continuing business.
• Restricted stock is the most common form of employee compensation that is delivered in connection with a transaction.
• Offering restricted stock to seller employees in an M&A transaction can be most effective in cases where the buyer:
• Hopes to establish particular performance targets that would justify the company’s purchase price;
• Would like to incentivize and retain the senior management of the company after an acquisition; or
• Is looking for a competitive edge among competing bids.
• Taking an offer with restricted stock employee compensation in an M&A transaction can be most effective in cases where:
• The target company has been valued by sellers with an estimated purchase price that is higher than the buyer is willing to pay; or
• The seller is not interested in a lump sum payment that adversely affects tax considerations and is concerned about a taxable earn-out.
• Typically a target company that is privately owned with few majority shareholders who will continue to work for the acquired or combined business after the close of the acquisition will be the best fit for the use of restricted stock.
• If the buyer already has in place an equity compensation plan that provides for restricted stock grants, it may be relatively easy to make grants of restricted stock under that plan to the seller employees without the need for additional buyer shareholder approval (depending on the terms of the existing plan).
• This alternative combines some of the features of the earn-out and stock acquisition forms of consideration, in that certain targets must be met for the equity to vest, and in that it allows the seller employees to share in the upside of the company going forward as a whole.
• A “rollover” of existing equity may also provide beneficial tax benefits to the employees.
• The discussions over control and minority protection rights that are present to different degrees in both the earn-out and stock consideration scenarios are also present with restricted stock grants but may be lessened if there is an existing seller equity plan under which restricted stock awards can be made. The terms of the equity granted under these plans tend to be more favorable to the company than equity used as consideration in a heavily negotiated acquisition agreement, and a buyer can make a good faith argument to a seller that these more limited rights are fair by pointing to existing senior management who hold restricted compensation pursuant to their existing plan.

Seller Notes

• A seller note, which is a form of deferred purchase price, is the final option discussed in this checklist for financing a transaction. By issuing debt through a seller note, a buyer may make a partial payment of the purchase price, with the seller taking on the role of a lender. However, unlike the earn-out and stock forms of consideration, a seller note may be less useful in bridging disputes over the valuation of the target business.
• The use of a seller note defers the payment of the full purchase price and is useful in assisting buyers having difficulty accessing credit markets.
• As debt, a seller note will have a claim on the company’s assets before the equity owned by the shareholders and, if the combined business fails, the seller note will be paid before equity. A seller note is also usually subordinated to bank loans, or other senior debt, which helps buyers obtain debt for other aspects of the business at more favorable rates than if the financing for the transaction came from a third party and was not subordinated.
• Seller notes are very customizable. Seller notes earn interest, often at a very favorable interest rate, given that they are deeply subordinated in a company’s capital structure. The interest can be paid on a regular schedule but can be deferred. Seller notes can take many forms, from a fairly simple and straightforward note to fairly elaborate forms with negative covenants and other lender protections.
• Considerations for Buyers
• A seller note is typically less expensive capital than stock consideration and does not usually come with the same types of control and dilution issues that accompany stock consideration. Further, seller notes often have fairly high interest rates (e.g., up to 10% or sometimes higher), which serves as a deductible business expense for the buyer.
• Through use of a seller note, a buyer has the potential to receive a higher return on its investment than using stock consideration, and there is not a dilution of the equity of the buyers’ company.
• Buyers may also receive lower interest rates on other loans because the seller note will likely be junior to any bank debt. This is in contrast to a case where a buyer seeks third-party financing where the debt incurred to purchase the target company may be rated equally with the bank debt.
• Considerations for Sellers
• Generally, sellers will seek to re-invest the profits they receive in a transaction. In the aftermath of COVID-19 and the downturn in the markets, sellers may find fixed income investments (i.e., government bonds) more attractive in order to reduce volatility. A seller note, given its relatively high interest rate, will typically yield higher returns, compared to other forms of fixed income investments. These returns may drive a significant increase in the seller’s personal valuation of the transaction.
  • On the other hand, because seller notes are typically deeply subordinated, the seller will have very little recourse if the cash flows of the company are not sufficient to repay all debt. The seller will be an unsecured creditor, likely just one step above equity. 
• A seller note can also be a convenient way of dealing with indemnification claims (which may be offset against the principal amount of the note) and can replace the standard escrow required by buyers in many transactions. Finally, a transaction involving a seller note may be able to be structured as an installment sale for tax purposes, allowing payment of the related capital gains taxes to be delayed until the seller receives payment of the principal on the seller note.
• A seller note may potentially add value and increase the purchase price in a transaction, given that buyers typically consider return on investment (ROI) in agreeing on a purchase price. When buyers are able to replace a percentage of the capital required for a transaction with a seller note, the amount of equity the buyers will need to invest decreases, while the ROI increases.
• Finally, buyers may have more confidence in the prospects of a target where the sellers are willing to accept a seller note and essentially allow a portion of the purchase price to remain invested in the company, without the same potential control issue present in the case of an earn-out or stock consideration, as described above.

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And for any legal questions related to this pandemic, please contact the authors of this Legal Update or Mayer Brown’s COVID-19 Core Response Team at FW-SIG-COVID-19-Core-Response-Team@mayerbrown.com.