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As the next installment in our continuing examination of the potential adverse effects of COVID-19 on M&A transactions, we discuss a post-closing risk arising from a customary contract provision–the earnout calculation. To recap, our first client alert discussed how COVID-19 may serve as a trigger for parties seeking to terminate a transaction under an MAE clause, and described four quantitative analyses companies should perform in preparing for potential litigation. In our second client alert, we examined the Subsequent Events timeline and the analytical tools to determine the impact of COIVD-19 on the post-closing true-up of a target company’s closing working capital and any associated purchase price adjustments.
Buyers and sellers in an M&A transaction often have potentially irreconcilable views regarding the value of the target. An earnout provision is often included in the negotiation of the purchase price to provide a mechanism to bridge this gap. The potential payment over time of additional consideration contingent upon the target’s achievement of specified financial targets is a common mechanism to resolve differing views on valuation. Earnouts are even more likely to be included in a purchase and sale agreement (PSA) in times of financial turmoil and economic uncertainty, and we expect that this will hold true in the worldwide economic downturn caused by COVID-19.
Many transactions executed in the COVID-19 era will involve considerable uncertainty about the target’s ability to return to pre-pandemic operating and profitability levels. Determining whether earnout thresholds or targets have been achieved can be a contentious process, even during stable economic times. However, we anticipate that in light of the global pandemic and associated commercial upheaval, there will likely be a significant increase in disputes between buyers and sellers about whether earnout targets have been attained, including the accounting treatment for certain revenue and expense elements.
An earnout is a contractual provision of an M&A PSA in which the seller agrees to accept, and the buyer agrees to pay, additional consideration contingent on the achievement of certain post-closing financial thresholds. Earnout provisions tend to be utilized more when there is an increase in perceived risk for the buyer attributable to factors such as the target’s limited operating history, the nature of the industry of the target company or a period of economic downturn, and the conditional payout provides a mechanism to bridge the associated valuation gap.
Earnouts can be advantageous to the buyer because the initial cash outlay for the purchase of a business is reduced to a level typically closer to the buyer’s valuation of the business, and any contingent additional payment is effectively financed by the operating results of the acquisition target. Similarly, an earnout can be beneficial to sellers who are often retained to manage the acquired business for a period of time and have the opportunity to earn additional proceeds contingent on the target’s performance during the post-closing period. For these reasons, while both the buyer and seller share in the risk and rewards of future performance of the business, their motivations post-closing can potentially diverge. The seller may be motivated to manage the business in the short-term to maximize the potential earnout payment, while the buyer may not be aligned with the seller management’s operating decisions given the long-term perspective of the buyer and accordingly, may not agree with the proposed increase in purchase price.
An earnout is typically a heavily negotiated PSA term. The earnout thresholds are generally quantitative in nature and measured against post-closing financial metrics or benchmarks. Common earnout performance metrics include a target level of gross revenue, net income, earnings per share or EBITDA over a specified time period or as of a specified date. While these are customary accounting terms, they may be interpreted differently by the buyer and seller in light of their respective internal reporting practices and methodologies. Accordingly, the PSA will often specify the standards upon which the underlying financial statements must be prepared, such as U.S. GAAP or a nonstandard basis of accounting that may be unique to the industry or is customary to the transacting parties.
Despite the presence of an executed PSA that provides the earnout benchmarks along with the accounting standards for calculation, earnout agreements are sometimes characterized as a mere postponement of tomorrow’s litigation through a disagreement in today’s purchase price valuation. In the context of the 2020 economic fallout from COVID-19, the standards and definitions of earnout benchmarks will be critical to determining whether an earnout that is subject to the results of the 2020 (or possibly 2021) calendar year has been achieved.
In particular, an often present but seldom relevant concept captured by the phrase “extraordinary, unusual and non-recurring” (EUNR) will be of greater importance for buyers and sellers who enter into earnout agreements that span the 2020 calendar year, and likely beyond. In 2015, the Financial Accounting Standards Board (FASB) attempted to simplify GAAP financial reporting by releasing ASC 220, which eliminated the separate reporting income statement classification of extraordinary items.1 While this was a sensible financial reporting amendment that reduced the inconsistency surrounding the identification of EUNR, many PSAs continue to stipulate the EUNR concept within the definition of the earnout metric in an effort to comport with the valuation concept of normalization adjustments. For example, EBITDA may be defined for earnout purposes as the consolidated net income of the corporation determined in accordance with GAAP, plus all interest, taxes, depreciation and amortization expenses, exclusive of extraordinary, unusual or non-recurring charges, gains and losses. This clearly presents an inconsistency between GAAP and non-GAAP guidance.
This EBITDA definition could significantly affect an M&A transaction post COVID-19. For example, assume a transaction in which a U.S. widget retailer was purchased on June 30, 2019 with two 12-month earnout measurement periods ending on June 30, 2020 and 2021, respectively. After the transaction closing date, local law required the business to eliminate in-person retail shopping for approximately 10 weeks between March and May 2020. Upon reopening the target’s retail stores, the buyer invested in mandatory personal protective equipment for all employees and doubled its in-store personnel to permit shopping in a socially distant compliant manner. Accordingly, the income statement used to derive the EBITDA calculation for the period ending June 30, 2020 would be expected to reflect a potential increase in both labor and in-store supplies expense. At the end of the first 12-month earnout period, the buyer prepares the required EBITDA calculation.
In a case where the facts and circumstances result in an EBITDA target that is either materially over- or under-achieved, the treatment of certain operating expenses will likely not have a significant impact at the margin. However, in our hypothetical, we will assume that the magnitude of the incremental expenses for additional labor and in-store supplies makes the difference between whether the earnout is achieved or not. It is easy to see how the buyer would likely seek to characterize these expenses as ordinary business expenses required for operating the reopened stores in a compliant manner, thus increasing expenses for the year and missing the EBITDA earnout benchmark. Similarly, one would expect the seller to object to such characterization, and to interpret the additional expenses as a reaction to the post-pandemic environment and therefore, as extraordinary or non-recurring, which would be added back to calculate EBITDA under the definition in the purchase price agreement.
Continuing with our hypothetical into the second earnout measurement period ending June 30, 2021, we assume that in May 2020, the target applied for and received a loan under the Paycheck Protection Program (PPP loan) as part of the CARES Act. The funds were intended to cover payroll expenses at the retail locations, although their potential forgiveness is in doubt as they were also used to compensate additional hired employees and to pay for PPE at the stores. Let’s also assume that the PPP loan amount was material in relation to the achievement of the 2021 earnout threshold and further, that in May 2021, the PPP loan was forgiven.
FASB’s ASC 405-20, Extinguishment of Liabilities and ASC 470-50, Debt Modifications and Extinguishments provide guidance on when debt is considered to be extinguished and how to recognize a gain or loss on it. At the end of the second and final 12-month earnout period, one might expect the buyer-prepared EBITDA calculation to classify the recognized gain on the forgiven PPP loan as extraordinary or non-recurring. Conversely, the seller would likely object and seek to recharacterize the gain as ordinary income, increasing EBITDA and the likelihood of achieving the earnout benchmark. In the absence of a precisely worded earnout provision, the potential for a dispute regarding the seller’s entitlement to all or a portion of the earnout payment becomes abundantly clear.
Similar to the interpretation of terms or concepts such as the EUNR exceptions discussed above, another potential post-closing issue that might be made more complex by COVID-19 is the determination of consistency in regard to the application of agreed-upon accounting standards in the preparation of post-closing financial statements. This concept can be illustrated through another hypothetical example.
Presume that, historically, the target business estimated bad debt reserves and the associated expense based on their historical collections experience. However, with the end of an earnout period quickly approaching on June 30, 2020, the buyer recognizes some of the challenges in collecting outstanding receivables and elects to increase their bad debt reserves for the anticipated exposure presented by the economic upheaval caused by COVID-19. In addition to a required analysis of the PSA’s earnout provision regarding the underlying basis of preparation (i.e., U.S. GAAP, IFRS or other), the parties must consider additional provisions such as a potential requirement that the target company’s post-closing practices and methodologies be consistent with those in effect pre-closing. In this simplified example, the buyer appears to have changed the methodology of their reserve policy from a historical method to a forward-looking approach. If material, this type of inconsistent application of accounting standards could diminish the seller’s ability to meet the earnout EBITDA target.
In our hypothetical, the target is likely generating short-term receivables from certain in-store retail customers who have a retail branded credit card. However, if we assume the target also engages in wholesale activity and extends liberal payment terms through long-term receivable arrangements, the buyer’s approach could affect operating results when compared to the target’s practice and methodology for recording loss contingencies.
FASB’s ASC 450, Contingencies, guides users to recognize and disclose losses if the amount is probable and can be reasonably estimated. Based on past recognized losses, the target’s recording of loss contingencies in accordance with that historical experience would ordinarily be expected to withstand scrutiny if the conditions of both “probable” and “estimable” were met.
However, in 2016 FASB issued Accounting Standard Update (ASU) 2016-13, Measurement of Credit Losses on Financial Instruments (Topic 326), an update to ASC 326, Current Expected Credit Loss Standard (CECL). ASU 2016-13 introduces the “current expected credit loss concept” and requires a revised methodology for recognizing certain credit losses. While this guidance is currently required for public companies, private companies may choose to early adopt or wait until the effective date of the update in 2022. In contrast to the previous guidance for long-term receivables, which based losses on historically experienced rates, under the CECL methodology a business is required to incorporate forward-looking and projected loss contingencies into their loss reserves. The appropriate accounting methodology is case specific and requires analysis of the respective financial statement line items being accounted for. Again, if the buyer in our hypothetical chose to make the change from a GAAP-compliant historical approach for the recognition of loss reserves to a different GAAP-compliant approach utilizing the new CECL forward-looking method, this would violate any PSA-specified requirement for the “consistent” application of accepted accounting guidance. If material, this could impact the seller’s ability to meet the earnout EBITDA target.
These are just a few hypothetical examples of how earnout agreements can result in disagreements between buyers and sellers, especially in times of economic hardship and uncertainty, such as the current COVID-19 crisis. Buyers and sellers will often have competing motivations even under more ordinary circumstances, and therefore an understanding of both the contract provisions and the appropriate accounting standards is critical to support companies in post-closing earnout disputes.
Duff & Phelps is a leading provider of accounting, valuation consulting, neutral arbitration and expert testifying services to companies facing post-closing purchase price disputes. Our forensic accounting, transactions and valuation professionals provide analytical support in both pre-closing M&A negotiations as well as during post-closing earnout
For more information on this and other M&A-related questions facing your business, please reach out directly to our M&A Post Acquisition Disputes team.
1.Financial Accounting Standards Board Accounting Standards Codification 220, Income Statement- Reporting Comprehensive Income.
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