Key Considerations in Negotiating Earnouts when Selling a Company

March 6th, 2010

Last week the WSJ ran an article saying that Google is moving away from earnouts when it acquires companies.  Earnouts are a tricky thing whether you are a buyer or seller in an M&A deal.  The article gives a glimpse into some of the issues.  Here is a rundown on some of the background considerations.

Definition of an Earnout
An earnout means that if you are a key employee in a company being acquired, some of the total purchase price in the deal gets paid to you over time based on your continued work on the product post-acquisition.  The premise is that some people are passive shareholders who put in cash and don’t have a key role going forward, so they just get paid out at closing.  On the other hand, some team members may be necessary after closing to keep development moving on the product, so their compensation in the deal is linked to continued success of the selling company’s product post-closing.

Keeping the Product Going
Implicit in this formula is the idea that the buyer will keep the seller’s product alive post-closing so that both sides can measure success and the sellers have confidence in their ability to achieve the earnout.  The WSJ gives Disney’s purchase of Club Penguin as an example of this- Disney bought Club Penguin and has kept it as an independent product.  This makes it easy(ier) to measure Club Penguin’s future results and calculate whether earnout metrics have been met.

Compare this with Google’s acquisition of Grand Central.  The product essentially went dark for about two years and then re-emerged as the largely free Google Voice.  I don’t know if the Grand Central acquisition involved an earnout.  If it did, it would certainly be much more difficult to work out success metrics than in the Club Penguin situation.  Google buys a lot of companies for the teams or for product sets that can be worked into larger Google suites, so I can see why they would have trouble measuring earnouts.

Key Considerations
When an earnout is involved in a deal there are several important factors that buyers and sellers need to consider.

-The first is the most objective metrics the deal will permit.  Product revenue is ideal.  It is a pretty easy number to track and works well if the product will be independent post-closing.  If the product will be rolled into a suite of buyer’s products post-closing, or if the seller’s product is free then this metric doesn’t work as well.  On top of that, even if revenue is the main goal we need to think about what would happen if the buyer decides to close down the product line.  Would the earnout accelerate in that situation? Partially accelerate?

-Second is freedom to manage the business.  This usually comes down to “best efforts” language so that the seller has something in writing to say the buyer will put enough resources behind the product to allow the earnout to be met.  It is very hard to make an ironclad promise out of this, since the buyer usually wants freedom to change its business plans and goals as the market requires.

-The third factor is flexibility.  It is impossible to predict what will happen to a product or business, so an ideal earnout will provide enough wiggle room so that if the buyer’s business plans change, the seller can still claim right to payment of some or all of the earnout.

-The last factor is trust.  When a big part of the deal hinges on future performance, buyer and seller both need to have faith that everyone will behave going forward.  The buyer wants to know that the seller personnel won’t make decisions that guarantee their earnout at the expense of the larger business, and the seller needs to believe that the buyer will keep the product alive and manage it in a way that lets the seller achieve the earnout.

Earnouts are usually the most contentious part of M&A deals.  We always do our best to understand the other side’s needs and objectives in the deal, but there is inevitably a leap of faith on both sides that the deal will work out to everyone’s benefit.

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What Happens to Preferred Stock When Your Company is Sold

November 11th, 2008

The phrase in the title of this blog showed up recently in my Lijit search results and it is a great question.  The way preferred stock clauses play out is not totally obvious, either, so here is my summary of the basic principles.  For simplicity, let’s assume these basic facts:

*1M shares of common stock have been issued to founders; and
*A $1M investment at $1.00 per share, meaning 1M new shares are sold and investors own 50% of the company.

Liquidation Preference
Preferred stock has rights that stand ahead of common stock.  The most basic of these (and the only one I will focus on) is the liquidation preference, meaning the amount of money each share of preferred stock will receive if a company is sold or liquidated. This amount is paid to the preferred stock holders before the common stock (founders and employees) gets any money.

The amount of the preference can be negotiated.  At a minimum the preference will be the amount paid, $1 in our example, so that investors know they will get their money back before anything goes to holders of common stock.  I.e. if the company is sold for only $1M the investors get their money back (ignoring any debt, attorney fees, etc.) and common stock holders get nothing.

If investors think the deal is risky they may demand more than a 1x preference.  Liquidation multiples of 2x or more are more common when times are tough and money scarce.  With a 2x liquidation preference our investors would get paid $2.00 for every $1.00 they invested before any money goes to the common stock.  This means the company needs to sell for over $2M before the common stock gets anything out of it.

Participating Preferred
The next question is what happens after the preference amount is paid.  In our 1x preference scenario with a $2M sale the preferred stock gets the first $1M.  What happens to the other $1M?

It depends whether the preferred stock is “participating” or “non-participating”.  Participating preferred splits the remaining $1M with the common stock and non-participating lets the common stock take the full amount.  Clearly, common stock holders would rather see the preferred not participate, while participation is a better deal for the investors.

But What Happens if the Company Sells for a Lot of Money?
These scenarios all assume our company is sold for a relatively small amount of money and show how investors would get their money back when the total payout is small.  What happens if a company hits a home run, e.g. if our company sells for $50M?

Following the rules above, here are some possible outcomes:

$1 preference, non-participating:  $1M to investors, $49M to common
$2 preference, non-participating:  $2M to investors, $48M to common
$1 preference, participating:  $1M preference + 1/2 of remainder = $25.5M investors, $24.5M common

The participation right makes a big difference, as we can see. (and note that the amount of participation can be limited as well, e.g. so that preferred stock gets its preference, $10M based on participation, and then the rest goes to common)

Conversion to Common Stock
The last thing to keep in mind is that preferred stock holders can always convert to common.  So for example, in the two non-participating examples just above the preferred stock would lose out if they only got paid their preference amounts.  Instead, they could forgo the preference, convert to common and share in the sale proceeds based on their percentage ownership of the company.  This would net the investors 50% of the sale proceeds in our example.

Which Leads to Percentage Ownership
The last (obvious) point is that percentage ownership matters.  A 10% owner nets a much lower return than a 50% owner.  This basic fact goes a long way toward explaining why valuations plummet in down markets- investors value the company lower so they can get a bigger percentage for the same amount of cash, and this lets them still make a decent return even if the company sells for a low price.

Wrapping Up
The bottom line is that in almost every situation there is a company sale amount below which the investors are better off staying as preferred stock (this is generally downside protection against low-sale price outcomes) and above which the investors are better off converting to common.  The main variables are the total sale price, amount of the preference, participation/non-participation (and any caps on participation) and the percentage of the company investors would own after conversion.  You can be sure your investors will be doing this math, so you should learn how to work through it as well.

And that’s what happens to preferred stock when a company is sold.

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Unusual Forced Merger Decision by Tennessee Court – Now THIS is Why Companies Elect Delaware Law

January 31st, 2008

Clients ask me all the time whether they should form their businesses as Delaware corporations, and what the benefits of Delaware are generally. My advice is that for early-stage businesses Delaware is an added, unnecessary expense, but as companies mature, spread out nation-wide and go public, Delaware has a volume of law and litigation history- and a degree of consistency in its decision-making- such that the outcome of a variety of disputes can be predicted with a decent amount of accuracy.

I don’t get to cite many great examples of this, though. Here is one where litigation in a Tennessee court seems likely to end badly. I can’t imagine a Delaware Chancery Court reaching a similar decision.

Clothing retailer Finish Line, Inc., backed by UBS financing, made an offer to buy Genesco, Inc. in a deal valued at $1.5B. Finish Line and UBS then tried to back out of the deal, saying that Genesco had failed to disclose material information that would have made the deal less attractive had it been provided up front.

The Tennessee Chancery Court held that although the merger agreement allowed for termination based on “material adverse events”, the reasons for Genesco’s declining performance were general economic conditions that fell within an exception to the termination right.

The Chancellor went on to hold that the appropriate resolution of the case is to require Finish Line to complete the merger.

This can’t end well for Finish Line, whose market capitalization, at $110M, is about 10% of what it was when the deal was announced in June 2007. That means the purchase price is close to 15x Finish Line’s current value. Ouch.

I can’t say for sure that Delaware would have reached a different decision, but I would be amazed to see it force a merger to go through under circumstances like this.

The other point worth mentioning here is that choice of law provisions are hard to negotiate in contracts. Each party usually wants its home state law to govern, the business principals never want to get involved in that level of detail and the lawyers seldom have enough specific data to make a convincing argument that ___ state will work out badly. In probably 99% of cases *not* arguing the point is probably the right result as well, since so few disputes actually go to litigation.

Sometimes, though, it matters. When I negotiate deals there is a handful of states whose laws I am comfortable with and I try not to let choice of law slow done completion of a transaction. The Finish Line case is a good piece of ammunition for compromising on Delaware when asked to provide for choice of law of a state with which I am not familiar.

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You Got Your Plaxo in my Facebook!

January 15th, 2008

VentureBeat reported that Facebook is set to buy Plaxo and speculates that the latter company’s huge database of email addresses and its technology for syncing contacts across platforms could be driving factors. That sounds like a reasonable idea, and it might be just as likely that any acquisition is a preemptive one to keep Plaxo’s technology from being snapped up by another social network.

Whatever the reasons, and assuming there is any truth to the rumor it sounds like a great idea. I have accounts on Plaxo and Facebook and check them both almost daily. I’ve realized they are nearly complete opposites: Facebook has a wealth of “stuff” happening with all the various applications my friends use, but it’s a roach motel- data goes in but has a hard time getting out.

Plaxo, on the other hand, is a completely open list of many more of my contacts, but with nothing much happening. I get news feed updates showing my friends’ Twitter and blog posts, updated contact information and birthdays, but that’s about it. Nothing original.

A merger that combined Plaxo’s openness with Facebook’s usefulness could be interesting somewhere down the line. I (along with probably just about everyone else) would love to check out new social websites from time to time without having to re-invent my social graph on every one just to make it useful. If Facebook could Plaxo-sync-invite my friends into applications that live outside of Facebook (I gave up on Tumblr after about 15 minutes because I didn’t know anyone else on it)- now that would be neat.

P.S.   I’d be pleased if Plaxo’s current or future management made it a little more difficult to send “connect with me” invitations. I realized recently that I accidentally spammed every single person in my address book- including all the people I met once and don’t really know- with an invitation.  Sorry about that.

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