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Earn-outs and Acquisitions of Foreign Companies: Small and Middle Market Firms Can Participate Too Despite the generally low value of the dollar against major foreign currencies, US acquisitions of foreign companies are likely to accelerate at least in the near term… According to The Association for Corporate Growth*, there were 1,098 US acquisitions of overseas companies in 2004 for a total value of $117.2 billion representing 16% of all reported M&A activity for that year. Volume is up from 913 deals with total value of $88.3 billion in 2003 but down from 1,660 deals and a total value of $154.5 billion in 1998, the peak year for US acquisitions of overseas targets in the past decade. Despite the generally low value of the dollar against major foreign currencies, US acquisitions of foreign companies are likely to accelerate at least in the near term. Can middle market firms participate in this activity or acquisitions of foreign companies reserved just for the Fortune 500? Of the 3,047 deals done outside the US that disclosed terms in 2004 (includes non-US buyers and sellers), 2,150 deals or 71% were valued between $5 million and $100 million (1,205 were valued between $10 and $50 million). Clearly, there are plenty of entrepreneurs growing their small and medium size companies in international markets through acquisitions. Foreign acquisitions have all the risks and then some of other international growth strategies. To name just a few with a uniquely international flavor, there is political risk, currency risk, and the biggest risk of all, the cultural, operating risk. But of course with greater risk comes greater return. One way to mitigate the risk is to structure a deal with a contingent payment or an "earn-out". An earn-out is simply a performance-based component of the final purchase price in a merger or acquisition. Earn-outs accomplish numerous objectives - the most common being to bridge the gap between the seller's and the buyer's projections of future performance - but in small and middle market transactions earn-outs have one particularly attractive advantage. They preserve cash. Instead of paying the entire purchase price in cash immediately, a buyer can structure a deal paying a portion in cash at the closing and the balance paid over time. Earn-outs also spread the risk of future performance, particularly helpful when the buyer seeks to introduce a product or service into an unfamiliar culture, and creates a framework of incentives for performance minded management teams. The key elements of an earn-out, which have many combinations and permutations, are (i) the earn-out metrics or indicators, (ii) the exchange of value, and (iii) termination. (One obvious but important caveat: An earn-out can only be used when the seller's management stays on to operate the company. In an international acquisition this is not much of an issue, since a principal objective of the deal is almost always to acquire and develop a relationship with a team who can operate successfully in the foreign culture.) The most common earn-out indicator for triggering the future payment is usually one or more financial metrics. Buyers, particularly public companies, like to use EBITDA or net earnings because these metrics drive their stock price. Sellers sometimes prefer total revenue or gross earnings because there is less room for adjustments (for instance, imputed operating expenses as a result of synergies generated by combining the companies) that can work against the management team when striving to meet the earn-out objectives. More creative earn-out indicators could be launching a new product, achieving certain market share, or opening up a new sales channel depending on the buyer's strategy to penetrate the foreign market. The exchange of value ties the earn-out objectives with compensation, which can be cash, stock or a combination of both. Sounds simple enough? Generate $20 million of total revenue, for example, or $500,000 of EBITDA in a financial year and receive $1,000,000 in cash or stock as a contingent payment to the sale of the company. What if the seller falls short of the earn-out target by a few points? Are they entitled to any compensation? This can be terribly de-moralizing - the direct opposite of what the earn-out is supposed to do - creating disincentives for management teams in follow on years, or even once a few months of projections are missed. There are many solutions to this. Earn-out floors or minimum hurdles can be structured into the deal as well as capping compensation payouts. Perhaps the earn-out compensation is pro-rated. The key here, as is the case with all the other elements of the earn-out, is to negotiate and define the terms during the deal stage and not during the integration of the companies. Usually earn-outs terminate based either on the completion of a specified time frame or upon meeting the earn-out milestone. Typical time frames are two to three years. Less than two years may tempt management to focus on short-term performance to the detriment of long-term planning and investment. Too long of a period opens the door for wide fluctuations in external events (e.g. political risk). Issues abound here too. What happens if the acquiring company is, in turn, bought out and new management has different priorities for international divisions? Do the earn-out payments accelerate or terminate? One solution is to structure an option to purchase the remaining term of the earn-out (sort of a buy-out of the buy-out). There are other issues to consider, some of which are critically pertinent to foreign acquisitions. One glaring example is using GAAP accounting to measure financial earn-out indicators. GAAP is not the perfect measurement stick in US deals not to mention in countries that have their own accounting rules. Notwithstanding the risks and possible complexities, structuring acquisitions using earn-outs can be a strategic and cost effective tool for US small and middle market companies to penetrate foreign markets. The key is to carefully think through the issues and clearly define the terms. If you would like assistance with the development or implementation of your global growth strategy, or if you would like to explore this topic further, contact Brad Fleisher at Focus Enterprises. Focus Enterprises is a middle market investment bank. Mr. Fleisher, a lawyer and a Principal at Focus Enterprises. He will be speaking on the subject of earn-outs at the VALET Quarterly Meeting in Williamsburg, VA on October 8. Mr. Fleisher can be contacted at Brad.Fleisher@focusenterprises.com. Brad Fleisher ESQ, Principal Focus Enterprises Brad.Fleisher@focusenterprises.com www.focusenterprises.com * Source: Mergers & Acquisitions The Deal Maker's Journal, February 2005, published by the Association of Corporate Growth.