Until now, the general approach has been that a company cannot claim privilege against its own...
Earn outs in the time of Covid-19
Coronavirus has already caused economic carnage in the UK and the after effects are inevitably going to raise problems for parties who have recently completed corporate transactions or are part way through negotiating a transaction.
An earn out deal is one where part of the purchase price is deferred and paid out over a period of time after completion, on a performance related basis. Earn-out clauses can operate to overcome a difference in price expectations between the seller and the buyer, where the seller is asking for more than the buyer is willing to pay, and to avoid overpricing and undervaluation. Paying a seller over several years post completion allows a buyer to reflect the true value of the business in the price paid whilst retaining key managers. Equally, a seller can benefit from realising the true value of a business, with continued positive contribution by the seller and target’s management.
In periods of market uncertainty like current times, as deals are negotiated buyer’s will be keen to defer part of the purchase price and make the price payable contingent upon performance. That said, it is also possible that high levels of uncertainty may mean those sellers that have a choice (and some may not) are not willing to accept an earn-out structure.
One of the most immediate problems buyers and sellers are likely to face is if their completed transaction included earn-out provisions. Deals including an earn-out period which for example ended on 31 December 2019, may now mean that buyers are facing the prospect of having to make a substantial cash payment which it is unable to satisfy as result of its own reduced cash flow. Similarly, sellers may lose out as they may not have the ability to “earn” as much if the earn out period included part of 2020, and if a significant chunk of the consideration was conditional on future performance then they may not receive the eventual value they were expecting.
(Re)negotiation
Confronted with these uncertainties, parties who have already completed deals could consider a variation to their agreed earn-out clauses to include specific arrangements that deal with the consequences of coronavirus. For example, by extending the term of the earn-out period to possibly outlast the outbreak and wait for markets and economies to stabilise again. Any variation to the terms of a share purchase agreement will require all parties to agree to it and for the variation to be recorded in writing. So, any attempt by a buyer to try and impose new terms on a seller without the seller’s agreement is likely to constitute a breach of contract.
It may be that a business has performed well in 2019, but any earn-out period which takes account of any part of 2020 will be hit hard. Sellers in this position may therefore be prepared to agree to a request for an extension of time to make an earn-out payment in respect of 2019, provided the buyer agrees to vary the earn-out calculation in respect of 2020, to take into account the effect of coronavirus.
Sellers whose final earn-out period ended on 31 December 2019 may take a harder line versus those who are part-way through a deal who may be more sympathetic. Sellers that have negotiated an earn-out with a buyer who has now been severely financially impacted, may be advised to seek some sort of security from the buyer as a condition of accepting the variation, if security does not already exist.
Explore Alternatives
The parties may wish to consider alternative forms of consideration, such as issuing shares or loan notes. This could be where they need to vary the terms of an existing cash-based earn-out and also for any new deals being negotiated. Buyer’s may want to pay some or all of the purchase price in shares, in and in doing so may incentivise owner-managers to remain with the target following completion, by linking their financial reward with the buyer’s performance. Note however, the commercial viability of offering shares as consideration will of course depend on the impact the coronavirus has had on the value of the shares being offered.
The process of offering shares can be a complex exercise, and if sellers are willing to accept shares in a company it is likely to result in them holding a minority stake. In these circumstances it will be important to obtain certain protection (such as anti-dilution protection and perhaps “veto rights” in respect of key decisions). This may require new articles of association and a new shareholders’ agreement (or amendments to existing documents) and so the buyer will need to take proper advice as it will want to ensure it retains majority control.
Another alternative to cash is a buyer loan note. Loan notes are flexible and can be issued for a specific amount at a fixed interest rate, to provide a guaranteed return. As with issuing shares there will be a range of issues to consider, for example whether the loan notes should be freely transferable and whether they should be capable of early repayment/redemption. Generally speaking, however, they may be simpler to deal with than issuing shares.
MAC clauses
A material adverse change or “MAC” clause is not widely used in corporate transactions but provides some protection where a transaction involves a split exchange and completion. Usually drafted as a condition to completion, a MAC clause provides a buyer with a right to withdraw in the event that anything happens which has affected (or which may affect) the value of the business being acquired. We may now see more of these feature in deals going forward given the global impact of coronavirus.
A variation to the standard type of MAC clause may be considered whereby a buyer could have the option to further defer a payment which would otherwise be due in the event that a MAC event has occurred and/or is continuing.
This would be a significant risk to the sellers and so likely to be heavily resisted by sellers. But it may be an option where a buyer is in a particularly strong negotiating position and/or the deal horizon is flat and it is a buyer’s market.
Conclusion
The coronavirus outbreak has already introduced great uncertainty for many business sectors and therefore impacted the expected results of existing earn-out clauses. Sellers and buyers who have entered an earn-out based deal before the outbreak are advised to consider their position and likely outcome under the earn-out arrangements and seek to re-negotiate and adjust the earn-out if necessary. If parties negotiating deals, notwithstanding the current economic climate, decide that an earn-out is an appropriate pricing structure, they should include provisions which anticipate any coronavirus related uncertainties. It is impossible to try and provide for every conceivable eventuality in legal documents. However, parties may wish to consider whether they can include any additional protection in their transactional documents.
Contact
If you would like any further information or advice on this subject please do not hesitate to contact Kam Johal (corporate partner) on kjohal@georgegreen.co.uk or telephone on 07815 490432.