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Getting To Yes: Bridging The Value Gap

Law360, New York (March 02, 2010) -- A key and difficult issue in many current merger and acquisition negotiations is the disparity between the seller’s view of what its business is worth and the buyer’s view of what it is willing to pay. The delta is often very wide.

Recent market volatility has made many buyers’ fear that not only will the acquisition appear ill–timed over the long term, but also that the markets may suddenly turn so that they will appear to have foolishly overpaid.

Sellers are still hopeful that the premia and EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) multiples available in control acquisitions as recently as 2007 will once again come to the fore and are concerned that they might be perceived as desperate for selling when prosperity is just around the corner.

Deal makers have always confronted the disparity between the prospective buyer’s bid and the seller’s ask, but never before has the gap been as wide or the parties as intractable. One weapon in the deal maker’s armory that can sometimes bridge what might otherwise be an impossible chasm is the earnout.

Earnouts, at the most basic level, are pricing mechanisms that permit a portion of the purchase price to be determined after the closing of the transaction depending on factors and formulae that seller and buyer have determined at the time the initial agreement is reached.

In the pharmaceutical industry, where many companies’ full potential value is tied directly to developmental stage drugs, the success of which may not be known for many years, use of earnouts and staged payments contingent on Food and Drug Administration approvals (even without any associated revenues), have been a typical element of acquisitions for a long time.

Earnouts are not the only form of contingent value mechanisms worth considering when structuring a “value bridge” in an acquisition. Recently there has been greater focus on contingent value rights or CVRs.

A contingent value right is a right granted to sellers of an acquired business that provides for an additional payment upon the happening of a specific event within a pre-agreed period of time.

While a CVR may be more suitable to a public company or a private one with numerous shareholders, it is essentially a traditional earnout wrapped in a form that permits the right to be transferred to multiple parties.

Whether a CVR or an earnout, they are essentially bespoke contractual provisions negotiated between buyer and seller. Earnouts tend to be used more frequently in connection with sales of private companies rather than the sale of public companies. This is for a variety of reasons.

--By Francis J. Aquila and George J. Sampas, Sullivan & Cromwell LLP

Frank Aquila and George Sampas are both partners with Sullivan & Cromwell in the �rm's New York o�ce.

The primary reason is that for public companies with broad ownership, issues associated with the initial registration of the securities evidencing the CVR and the ongoing disclosure requirements regarding developments that might change the amount or likelihood of the earnout payment, although not insurmountable, are still substantial.

Another very important reason is the difficulty in convincing the typical institutional shareholders, such as a pension or mutual fund, that there is meaningful value associated with the contingent rights at issue and, often just as importantly, shaping the contingent rights so that the rights will meet the investment criteria of the funds.

Unless the CVR meets the institutional shareholder’s criteria to be a permitted investment, the institutional shareholder will be forced to sell the CVR, presumably at a heavily discounted price.

Another reason for the limited use of earnouts, CVRs and other forms of contingent consideration in both public and private company transactions arise from the difficulty in designing an instrument where the interests of the holders of the instrument, the former shareholders of the company, will be assured that their rights and interests are adequately protected.

In the public context, this issue features most prominently because directors of a public company with fiduciary duties to thousands of shareholders may be less willing to accept great uncertainty on behalf of a broad range of shareholders with a myriad of interests and investing profiles.

The degree of difficulty in resolving these alignment issues depends in large part on the complexity of the trigger for the payment of the contingent consideration. Is the trigger based on receipt of a specific FDA approval for a particular pharmaceutical compound? If so, will the individuals who worked on the compound at earlier stages be leading the development and approval effort?

Have these employees already received so much compensation in the transaction, usually due to the value of their stock options and shares held in the seller, that they are unlikely to remain following the transaction?

Can you design new incentive measures for these individuals to insure their focus on the payment trigger or will the amounts involved create their own issues if disclosure of these arrangements are mandatory?

Even if the individuals best positioned to lead the compound’s development stay with the company following acquisition, will they have the appropriate resources to seek to resolve any FDA concerns that may develop over time — including the ability to conduct any studies that may allay concerns about potential side effects or insufficient demonstration of efficacy?

Will the buyer make so much money from the compound that even if you do not negotiate an instrument that perfectly aligns the interests of buyer and seller, you can be assured that the new owner is sufficiently incentivized to do all it can to cause the trigger event to occur? And these are just some of the issues that crop up when you have a fairly straightforward payment trigger.

One particular situation that accommodates resolution through the use of an earnout or another form of contingent value mechanisms is where on the one hand, a large portion of the target’s value is uncertain, for example as noted above, when a company has little operating history but is developing a potentially hig hly valuable new pharmaceutical compound, and on the other hand you can create a fairly straightforward auditable metric as the trigger for payment, such as a phase three approval or a revenue hurdle.

Other situations where the authors have assisted sellers and buyers in implementing a contingent value bridge to a

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successful deal are in highly volatile industries such as the mining and hospitality industries where the triggers

were based upon an independent consultant’s certification as to proven and probable reserves or the private equity buyer’s ultimate sale proceeds.

The key is matching the uncertainty related to the seller’s business to a payment trigger that appropriately demonstrates that the risk has largely, if not entirely, been avoided.

Earnouts and other contingent value mechanisms were particularly useful in solving disputes that arose during the recent market turmoil when buyers found that they no longer had access to the financing necessary to pay cash for the entire value while sellers recognized that their current alternatives were severely constrained.

As we have seen over the last two years, earnout or CVR payments permit the buyer to pay a lower initial cash price, while providing the seller with assurance that substantial additional value will be received if the payment trigger is ultimately reached.

Given this recent experience with contingent payment mechanisms, it is likely that we will see them used on a regular basis in the future. In the right circumstances, earnouts and CVRs can be the right horse for the course.

The opinions expressed are those of the authors and do not necessarily re�ect the views of Portfolio Media,

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