Interesting trends have popped up relative to the use of earn-outs and insurance against seller misrepresentations in acquisition practice. (Tip of the hat to the firm of SRS Acquiom which provides shareholder services in such transactions and periodically reports on M&A trends.)
Earn-outs: for the uninitiated, an earn-out defers payment of the purchase price for a company until a future time, and the amount (if any) of such deferral is based on the post-closing economic performance of the acquired company. As can be seen immediately, this can be dangerous for the seller; an acquirer can be tempted to down-play immediate success when good results means more has to be paid to the seller. These arrangements are more typical of larger deals but occur about a fifth of the time even at the lower end of reported transactions.
What can be written in a contract to provide realistic protection for the seller if there is an earn-out? Solutions include agreements by the purchaser: to act in good faith in running the acquired business (a vague standard); to run the business as in the past (not a likely result as the buyer will want to adapt the business to its own management style, or merge it into existing operations); to take no action with the intent to minimize future earnings (hard to prove what is in someone’s intentions); to operate to maximize profits (buyer’s independent business judgment might drive the opposite rational business goal, for example to revamp for long-term profitability or to integrate a business into internal product flow). In any event, proving any one of these fact patterns is, to say the least, not easy.
Without descending to great detail, in practice the percentage of potential earn-out dollars actually paid is very little. Possible take-away for many sellers, in my view: avoid pie-in-the-sky possible future windfalls and trade earn-out for as many dollars as you can negotiate up front.
Warranty and representation insurance: these are insurance policies to indemnify a purchaser for damages suffered when a business seller has misrepresented (willfully or not) as to salient facts about the business being sold. When I started practicing law, admittedly decades ago, this was not common and indeed if I recall correctly not even available in the dim dark past. Today, such insurance was purchased in 76% of reported acquisitions by venture capital firms and 34% of cases involving strategic buyers. I suspect this reflects the likelihood that a strategic buyer possesses greater knowledge of the details of a related business being acquired while capital investors are at greater risk by reason of not being in a similar business. Deal negotiations here revolve around whether insurance is purchased, who pays for it, and whether the seller remains on the hook for any damages arising from incorrect representations for amounts in excess of insurance limits. Note that in about 80% of all cases the sellers are left on that hook.
These deal realities lead to the practice of a hold-back of purchase price to cover, among other matters, any such misrepresentations. Part of the purchase price is placed in escrow, often covers mechanical costs of winding up the transaction, but also is held to cover misrepresentation injury to the buyer. Sellers often must decide whether they are better off buying insurance or suffering a holdback of funds in an escrow fund.
Each deal of course is different in substance and motivation. Particularly in strategic deals the final deal model is unpredictable. With private equity, not so much– when the buyer is not intimately knowledgeable about a given space, the buyer is much harder to deal with. Be ready to be asked: “Aren’t you sure of your representations? You are making me nervous about this deal if won’t stand behind the business you are asking me to purchase.”