Earn-out agreements in M&A deals by Dutch SMEs

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Earn-out agreements in

M&A deals by Dutch

SMEs

Henrieke Hoftijzer (1386891)

Supervisor: dr. Westerman

MSc MBA Finance thesis

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Msc MBA Finance thesis | Introduction 2

Earn-out agreements in M&A deals by Dutch SMEs

Abstract

This thesis deals with earn-out structures in Dutch SME acquisitions; the motives to include an earn-out, the design of the contingent payment and the ex post evaluation of

this payment structure. The interrelatedness of these aspects will be developed on the basis of the leading literature in the field, five cases and interviews with the involved advisors and entrepreneurs. The motivation of the parties for including an earn-out should

have a large influence on the design of the earn-out, a decision tree is developed to show this interrelatedness. Next, best practices are given for each step in the decision tree,

which may provide guidance to practitioners and scholars. Keywords: SME, M&A, payment structure, earn-out

JEL codes: C93, G32, G34

Author: Henrieke Hoftijzer Student number: 1386891 Date: 27th of March 2009

E-mail: henriekehoftijzer@hotmail.com MSc Business Administration - Finance University of Groningen

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Table of Content

1. Introduction ... 6 2. Methodology ... 8 2.1 Case Study ... 9 2.2 Research design ... 9 2.2.1 Case selection ... 10 2.2.2 Data collection ... 11 3. Literature Review ... 11 3.1 SMEs... 11

3.2 Mergers and Acquisitions and SMEs ... 12

3.3 Earn-outs ... 13

3.3.1 Earn-outs: the case for SMEs ... 13

3.4 Motivation for the use of earn-outs ... 14

3.4.1 Emotion ... 15

3.4.2 Information asymmetry ... 15

3.4.3 Uncertainty future... 16

3.4.4 Equity Gap ... 16

3.4.5 Retention of valuable human capital ... 17

3.5 Design of earn-out deals ... 17

3.5.1 Earn-out amount ... 18

3.5.2 Earn-out period ... 18

3.5.3 Performance goals ... 19

3.5.4 Payment schedule / formula ... 19

3.5.5 Performance measurement ... 20

3.5.6 Contracting ... 20

3.6 Evaluations of the advantages and disadvantages of earn-outs ... 21

3.7 Alternatives of earn-outs ... 24 3.8 Framework ... 25 3.9 Summary ... 26 4. Cases ... 26 4.1 Case 1 “Parquet B.V.” ... 26 4.2 Case 2 “Print B.V.” ... 26 4.3 Case 3 “Trailer B.V.” ... 27

4.4 Case 4 “Truck SA” ... 28

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4.6 Overview of deal characteristics ... 29

5. Analysis of the cases ... 29

5.1 Deal characteristics ... 29

5.2 Motives ... 30

5.3 Design ... 34

5.4 Assessment ... 38

5.5 Alternatives to earn-outs ... 39

5.6 Interrelatedness of motivators and design elements: a decision tree ... 40

5.7 Summary ... 41

6. Conclusions and recommendations ... 42

6.1 Recommendations ... 43

7. Bibliography ... 44

8. Appendices ... 48

Appendix 1 Definition SME ... 48

Appendix 2 Dutch M&A market 2004-2008 ... 49

Appendix 3 Research Questions ... 50

Appendix 4 Relation Earn-out period and DGA retention ... 51

Appendix 5 Contracting versus trust ... 52

Appendix 6 Interview Questions (in Dutch) ... 53

Appendix 7 The equity gap pyramid (translated from Dutch) ... 55

Appendix 8 Overview of responses of the interviews with the advisors ... 56

Appendix 9 Overview of responses of the interviews with the buyers ... 62

Appendix 10 Overview of motivation of including an earn-out ... 68

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List of figures

Figure 1 Preliminary framework of the process of earn-outs in Dutch SMEs ... 10

Figure 2 Collection method according to Yin (1994) ... 11

Figure 3 Motivation for the use of earn-outs ... 14

Figure 4 Design of the earn-out process ... 18

Figure 5 Framework of the process of earn-outs in Dutch SMEs ... 25

Figure 6 Motivations for the use of earn-outs ... 33

Figure 7 Integrated decision-model concerning the interrelatedness of motivators and design of earn-out constructions ... 41

List of tables

Table 1 Pros and cons of earn-outs for the acquiring firm... 23

Table 2 Pros and cons of earn-outs for the selling firm ... 24

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1. Introduction

It is expected that approximately 100,000 Dutch firms are up to be taken over in the upcoming years (Ministry of Economic Affairs, 2003). This is strongly associated with the ageing society in the Netherlands (MKB ING Bank, 2005). Currently, there is a decline in the number of takeovers in the Netherlands due to the international credit-crunch and a downturn of the economic tide. During the current international banking crisis the market of takeovers has collapsed in the Netherlands, since buyers cannot attract funds for their acquisitions and market prospects have deteriorated. This makes the earn-out even more contemporarily. During the first two quarters of 2008, 236 acquisitions were recorded, compared to 421 during the first six months of 20071 (overfusies.nl, 2008). The vast majority of these companies comprise of Small and Medium Enterprises (SMEs). This is not remarkable considering the fact that the Dutch economy consists of 786.000 SMEs, which make up for 99,7% of Dutch businesses (www.mkb.nl). Moreover, recent research found that 43% of young entrepreneurs intend to take over a business in order to grow within the next two years (Grand Thorton International Ltd., 2008). Clearly, the characteristics of the acquisition process of these companies are worth paying attention to.

During my internship at AenF Partners, an acquisition and finance advisory business, I was confronted with the differences between takeover processes concerning SMEs and large firms. The two are very dissimilar; larger corporations often have complete departments dedicated to the strategic positioning of the firm, while for SMEs the process is often solely executed by the owner / manager. Moreover, larger corporations have more discretion with respect to monetary resources. However, the more ‘soft’ differences may be of most importance. Often, emotion plays a substantial role in the takeover process of SMEs (MKB ING Bank, 2005).Entrepreneurs feel usually closely connected to their business; they often have either set-up or inherited their own business. In addition, the scale of operations makes that entrepreneurs often feel closely related to their employees. These last two issues may also be part of the reason why entrepreneurs frequently overvalue their own corporation; they look upon its value too subjectively. Conversely, potential buyers may undervalue the business due to information asymmetries, which may exist between the seller and the potential buyer (Schrijnemaekers, 2004). Moreover, the potential buyer may be forced to place a low bid, due to a financing gap (McNally, 1997). The existence of a financing gap is a substantial problem for SMEs and will be discussed in more detail further on.

The value of a company is almost without exemption one of the major points of discussion in the negotiation process between the potential buyer and a seller. Many acquisition processes reach a deadlock due to unconquerable valuation differences. A possible avoidance of or solution to deadlock in the negotiation process, is the introduction of earn-out contracts. This type of contingent payment may be used to close the “bid-ask spread” between buyer and seller (Frankel, 2005). The use of an earn-out as a method of payment in

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acquisitions has increased in popularity during the last decade (Dahl and Richmond, 2008). An earn-out is an arrangement between the buyer and the target of acquisition, whereby the buyer does not pay the entire deal value upfront, but agrees to pay a certain amount now and more at a later moment, contingent on how well the business performs (Craig and Smith, 2003). Often earn-out payments are made contingent on specific prospective performance targets such as future profits, sales or EBIT (earnings before income and taxes) for a specified period; i.e. if future profits turn out to be lower than expected, the total acquisition price will be lower as well, whereas if profits turn out to be higher, the total acquisition price will be as well. Hereby, the selling party has to put his money where its mouth is with respect to his valuation of his corporation. “[He] allow[s] the buyer to say: “If you show me that your valuation turns out to be correct, I’ll be pay you the price you want.” (Henderson, 2008, p. 1) If the seller believes in his own estimates of substantial sales, EBIT or profit growth, he should not oppose making part of the transaction price contingent upon these prognoses.

There are several motives for including an earn-out clause in takeover agreements. It is often used, as hinted at above, to resolve valuation disagreements. In this case valuation risks are shared by multiple parties and referring to Bazerman and Gillespie (1999, p. 195) “Betting isn’t always risky, it actually reduces risk by sharing it among two or more parties.” However earn-outs may also be used to foster cooperation between the seller and the acquirer. The former owner / manager will also feel more responsible for the future wellbeing of the business as well. Finally, an earn-out may be used to close an equity gap often experienced by SMEs and especially in current market conditions, where financial institutions seek security (risk avoidance) and are reluctant to supply funds. There are also other kinds of contingent payment structures which can be employed to include incentive payments in an acquisition agreement. These payment structures include: escrows, holdback allowances and stock option plans. (Bruner, 2001 and Fabregat, 2005). An escrow is a legal arrangement by which an asset is deposited pending satisfaction of contractual contingency or condition. A holdback allowance is comparable to an escrow in that it requires the buyer to hold a particular percentage of the payment for a stipulated length of time, without putting the monetary funds in deposit. The right to acquire a number of shares in the corporation in the future is yet another way to align incentives (Bruner, 2001 and Fabregat, 2005). The possible alternatives of earn-outs will be discussed in further detail in chapter 3.7.

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Msc MBA Finance thesis | Methodology 8

employment period of the owner / manager. However, the actual incidences of these ties are yet to be explored. As potential buyer of a firm, how should you overcome price perception differences, an equity gap or motivate the retaining manager? Is an earn-out suitable for solving all these issues and what will be the consequences for the selling party? More insights into the process of earn-outs can offer guidance to practitioners and may be a valuable extension of the stance of current research.

This thesis will focus on earn-outs as a method of payment in the acquisition of Dutch SMEs, and more specifically on the motives of entrepreneurs for including an earn-out and the ex ante and ex post earn-out structures of acquisitions. First, the research questions and the methodology used are presented in the next paragraph. Subsequently, in the literature review the acquisition process of SMEs and the specific characteristics of SMEs with respect to acquisitions are put forward. Additionally, earn-out provisions are discussed in detail, including the pros and cons of including an earn-out for both the seller and the buyer. Then the cases explored in this research are discussed. Next, the results of the case study conducted will be presented and analyzed. Finally, some concluding remarks will be given and suggestions for further research will be discussed.

2. Methodology

Due to the lack of data of earn-out clauses by SMEs, no prior research is conducted, as far as undersigned is aware of, researching the process of earn-out clauses for this type of business. In order to understand and investigate this topic better in the future, more information should be available concerning the process of these earn-out clauses. A conceptualization of the process of earn-outs in Dutch SMEs in the Netherlands may offer guidance to practitioners and entrepreneurs who consider either selling or buying a business.

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Research Questions

Considering the issues discussed the following research questions can be composed: 1. What are the main motives for including earn-outs agreements?

2. How are earn-out agreements structured?

3. How are earn-out agreements evaluated by the entrepreneurs and advisors involved? 4. How are these issues interrelated?

A number of specific research questions are formulated in order to answer in detail the research questions (Cooper and Schindler, 2003). The specific research questions can be found in appendix 3.

2.1 Case Study

In order to scrutinize the structuring of earn-out structures, a number of cases, which included earn-outs, will be selected in order to dig further into the process earn-out deal structures. The selected cases are very diverse with respect to the type of earn-out structure (see table 3).

First, the deal negotiation process of the deal is scrutinized, based on the available data, correspondence and contracts. Issues studied include in which part of the negotiation process the use of earn-outs is firstly mentioned, who initiated the earn-out, how the negotiation with respect to the level of the earn-out proceeded and which agreements are laid down in the LOI (letter of intent) and in the closing contracts (SPA). Subsequently, the buyer party as well as their M&A advisor are questioned about their opinion concerning the earn-out agreements. Only the buyer’s side will be interviewed, since they usually propose the earn-out which serves to align the interests of the seller to the interests of the buyer or to close the pricing gap. Moreover, specialists in the field of acquisition processes are asked for their opinion regarding the best way to structure an earn-out deal.

Contact with the executives, and their advisors, of these businesses will be established by the cooperation of two partners of AenF partners B.V., the acquisition and finance company where I did my internship. Only already completed deals (minimal t-2) have been selected as cases. All the cases examined and the interviews conducted are treated confidentially, as a result, no company names or names of executives will be made public and codenames will be used to refer to specific cases.

2.2 Research design

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The assessment of the earn-out deal is scrutinized both on objective as on subjective grounds; the actual payments are discussed, as well as the post-deal assessment of the dealmakers. Possible motives extracted from prior research will be discussed in the subsequent chapter and eventually depicted in the boxes in the graph below (see figure 1). Furthermore, the characteristics of the structure are given in the box below. The validity of these arguments are tested during this research (qualitatively) and possibly be replenished by additional arguments originating from the case study. Below, a preliminary framework is set up, based upon prior research (to be discussed in the literature review). This model is evaluated during the case study. The aim is to gain more understanding of the use of earn-outs in the negotiation process of Dutch SMEs.

Figure 1 Preliminary framework of the process of earn-outs in Dutch SMEs

2.2.1 Case selection

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Msc MBA Finance thesis | Literature Review 11

Optimal coverage is impossible due to practical considerations, however optimal coverage given the confronted limitations is attempted.

2.2.2 Data collection

The collecting method as put forward by Yin (1994) will be employed (see figure 2 below). Multiple sources of evidence will be used in order to gain sufficient knowledge of the cases and the corresponding earn-out agreements and payments. First, the legal documents of the cases are scrutinized, in between others the LOI, the SPA, employment contracts with former owner / manager and specific earn-out agreements. Next, the correspondence between parties will be inspected, to recover the negotiation process and the reveil possible ex post conflicts concerning the earn-out agreements.

The interviews with the key persons involved in the process should shed more light upon the matter. A questionaire is constructed in order to structure the interviews according to the main elements under investigation, namely motives, design and assessment. These elements are divided into subquestions concerning the specific case. Moreover, a number of general questions will be posed concerning specific SME factors, general pitfalls of earn-outs and further remarks. Besides the structured questions, the interviewees will be asked to give their opinion on and analysis of earn-out agreements. The appendix shows the questionaire used (see appendix 6).

Figure 2 Collection method according to Yin (1994)

3. Literature Review

3.1 SMEs

SMEs are of vital importance to the European economy. Research showed that there is a significant positive correlation between entrepreneurship and employment, productivity, innovation and sustainable economic growth (Audretsch, Carree and Thurik, 2001 and Ministerie van Economische Zaken, 2003). The 23 million SMEs in the European Union2 provide approximately 75 million jobs and represent 99% of all enterprises (European Commission, 2003). SMEs are worldwide recognized as “[…] a source of innovation, dynamism and flexibility […]” (OECD, 2006, p. 9). Nevertheless, research concerning SMEs is relatively scarce. This is mainly due to a lack of information available to researchers. Data

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concerning listed corporations is better accessible and available due to state regulation postulating openness of annual accounts (Davies, 2002). Furthermore, small limited liability corporations are allowed to publish only limited financial information.3

There is no consensus in economic literature concerning the definition of SMEs. Therefore, the European definition, as laid down by the European Commission in Recommendation 2003/361/EC (European Commission, 2003), will be used in this paper. This directive of the European Union, which replaced Recommendation 96/280/EC as from the first of January 2005, gives the legal definition of the economic thresholds of SME corporations. SMEs are firms employing less than 250 people and have an annual turnover of less than EUR 50 million or total assets less than EUR 43 million (see appendix 1 for an overview).

3.2 Mergers and Acquisitions and SMEs

The market for corporate control is perhaps the most controversial field in corporate finance. Especially, in Rhineland countries Merger and Acquisitions (M&A) practices are often perceived as the culminating point of Saxon capitalism (Tirole, 2006). In Anglo-Saxon countries on the contrary, M&A practices are perceived as an efficient and effective way of natural selection. Nevertheless, in the light of recent developments, major shifts in these views towards a mere Rhineland-model may be expected.

M&A practices are pursued in order to obtain an economic gain. Brealey and Myers (1988, p. 2) have described the motivation for M&A practices as “the total value of the new company after M&A should exceed the total value of the two former separate companies.”

The paucity of research concerning SME takeovers is striking, especially when considering the fact that SMEs make up for the vast majority of takeovers in the Netherlands, Europe as well as worldwide. Exceptions to this are the efforts of Chang (1998) and Ang and Kohers (2001) to uncover key aspects of the M&A market of SMEs / non-listed corporations. Lu (2006) lists a number of problems that SMEs come across when pursuing M&A activities, namely: capital shortage and weak financial structure, shortage of accounting professionals, insufficient security, high private loan ratios and the inability to gain complete information concerning loan opportunities. Moreover, he also points out problems SMEs may face with respect to financial institutions, such as the conservative attitude of banks towards SMEs due to high risks of bad debt, limitations associated with financial policy (they cannot raise capital through the capital market) and high costs of credit and numerous loan items. These problems explicitly prone to SMEs may induce financial constrainment.

Another important and popular aspect within the field of M&A deals with the issue: Do acquisitions add or destroy value to firms and to the economy as such? (Fabregat, 2005) Scholars have not reached any consensus regarding this point. While it is a popular assertion that M&A create substantial losses for firms (Bruner, 2002, Renneboog and Goergen, 2004 and Bradley, Desai and Kim, 1988), Moeller, Schlingemann and Stulz (2005) find that the

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large aggregate losses associated with acquisitions are due to the increased size of the losses in the left tail of the distribution of dollar acquisition returns. So, a few large deals account for the majority of the wealth losses in acquisitions. Chang (1998) examines the performance of M&A practices for a sample of larger unlisted corporations. He finds that bidders experience positive abnormal results in stock offers while in cash offers they do not experience significant abnormal results. Kohers and Ang (2001) find that acquisitions of privately held firms yield substantial gains for both the target as well as the buyer, in spite of the method of payment used (shares or cash). Vijh and Yang (2007) compare the acquisition performance of S&P 500 firms to unlisted firms. Their findings suggest that S&P 500 firms outperform their unlisted peers with respect to pre- and post-acquisition performance. These findings are consistent with the efficiency hypothesis, which poses that S&P 500 firms are superior acquirers and are more efficiently managed. Overall, we might carefully conclude that M&A destroys value for the acquirer, especially in case of public takeovers (Bruner, 2002, Bradley, Desai and Kim, 1988 and Chang, 1998).

The findings above suggest that there should be some specific characteristics of SMEs which make up for the diverging conclusions concerning M&A performance (Officer et al., 2007). Moreover, the issues already mentioned in the introduction may partly explain the differences between takeovers of listed corporations and SMEs.

3.3 Earn-outs

An acquisitions’ transaction price can consist of two components, namely a payment made upon completion of the deal and one or more subsequent contingent payments (Spillman, 2004). The latter are contingent upon some measure of future performance of a firm; this may be EBIT, turnover or net profit. However, earn-outs may also be made contingent upon non-monetary proxies, such as retention of one or more key customers, FDA (Federal Drug Administration) approval or oil price development (Jongkind, 2005). For example, the deal of Giant-BP PLC included payments contingent upon the development of the oil price (Cain et al., 2006). Many earn-out contracts are designed to align the incentives of the new shareholder(s) and the former shareholder who remains in office. The use of an earn-out structure makes sure that he will be appraised for his efforts in the business (Datar et al., 2001, Kohers and Ang, 2000, Cain et al., 2006 and Evans, 2008).

3.3.1 Earn-outs: the case for SMEs

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cash flow.” (Bruner, 2001, p. 3) This is often the case for corporations operating in emerging industries or start-up businesses. Consistent with this, Cain et al. (2006) find from their United Kingdom sample that 33% of the targets belong to five industries, which represent only 23% of the sample size. Dahl and Richmond (2008) explain why earn-outs are often used in high-tech industries. The value of these corporations lies to a large extent in their great potential. The value of such a firm will be substantially larger than a simple multiple of past EBIT or EBITDA levels (earnings before interest, taxes, depreciation and amortization). However, buyers are reluctant to pay for intangible value and value potential alone. In this case, an earn-out contract may be a solution to the pricing gap between the buyer and the seller.

How often earn-outs are employed in acquisitions remains an ambiguous point, since the outcomes are strongly dependent on the sample researcher’s use, moreover it is very difficult to construct a sample consisting of solely SMEs. For example, Cain et al. (2006) identify that 3.9% of firms include an earn-out, while Datar et al. (2001) observed 4.1% and Kohers and Ang (2001) found an earn-out percentage of 5.6%. However, the results mentioned before all referred to samples which consisted not only of SMEs. So it can be expected, in line with Bruner (2001) and Sudarsanam (2003), that the percentage of deals including an earn-out will be even more pronounced for a strict SME sample, since the stockholdings of managers of larger corporations are usually just a fraction of total shares of the company. An inquiry of CFO magazine found that nearly 10% of all US deals with deal values below $ 250 million included earn-outs (Harris, 2002). Additionally, he found that there is an upward trend in the use of earn-outs, from 3.7% to 9.7% in the period 1995 - 2002.

3.4 Motivation for the use of earn-outs

Earn-out transactions in case of SMEs differ on several points with respect to other firms. These differences can best be explained by the following aspects: emotion, information asymmetry, insecurity future, equity gap and retention of valuable human capital (see figure 3).

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3.4.1 Emotion

As mentioned in the introduction of this paper, entrepreneurs of SMEs usually feel closely attached to their corporation, due to the fact that they have often set-up / inherited their business and the scale of operations makes that they often feel closely related (MKB ING BANK, 2003). On the one hand, this may lead to the tendency of entrepreneurs to overvalue their own business, which in turn may lead to deadlock in the negotiation process (Bazerman and Gillespie, 1999). Earn-outs may prove a solution to this deadlock. On the other hand, as argued by Ang and Kohers (2001) managerial hubris may play less of a role in the takeover process of privately owned firms as opposed to listed corporations. The lack of media coverage and disclosure of information will decrease the likelihood that managers embark on hubris-motivated M&A. It is not clear which one of the two views prevails.

3.4.2 Information asymmetry

The issue of information asymmetry plays a role of importance for SMEs, especially in case of acquisitions (Officer et al., 2007). As mentioned above, information disclosure obligations are less strict for small and medium enterprises. Due to the fact that none of these companies are listed, the valuation of their shares is a more burdensome task since there are no fair market prices readily available. Moreover, SMEs are often characterized by inadequate financial accounting (Schrijnemaeckers, 2004). In addition, knowledge is often tacit in SMEs and concentrated in a few key officers or the manager / owner (Schrijnemaeckers, 2004). Large information asymmetries, leading to valuation differences, between the target and the acquirer may especially arise when the target firm operates in an industry characterized by high growth opportunities like the high-tech industry. Moreover, they may arise when the firm has a relatively large portion of intangible assets, like in the service industry, or when information disclosure is low, as is the case for most private companies (Kohers and Ang, 2000). If the prospective buyer perceives relatively large information asymmetries, he will be willing to be pay less for the business (MKB ING Bank, 2003). Here, an earn-out agreement may offer a solution.

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It resembles a kind of lemon market, whereby a buyer cannot accurately assess the value of the corporation before the actual sale takes place while the seller can do this more accurately (Akerhof, 1970). The market for corporate control of SMEs satisfies several other requirements of a lemon market; the seller has no credible disclosure technology (maybe, due diligence) and there exists an incentive for the seller to pretend as if the value of his business is higher than it actually is. Moreover, due diligence investigations are costly, in particular for small-sized SMEs (MKB ING Bank, 2003). Furthermore, the average seller quality may be perceived to be low by the market, due to the fact that managerial hubris, emotion and subjectivity blur the image of the entrepreneur. Due to guarantees, government regulation and legal enforcement the no-trade equilibrium will fail to appear. Earn-outs may be used as a signaling device by the seller, to signal his superiority over the average seller.

3.4.3 Uncertainty future

Since earn-out constructions involve contingent payments based on prognoses of the corporation, which lie in the future, it may be used as a method to share the uncertainty risks among parties. These prognoses are based on multifold factors, among which market circumstances, industry prospects and the conduct of business. Both the buyer and the seller cannot perfectly predict the actual future state of the firm. An earn-out may divide these risks between the two parties. The seller may disclose very prosperitious future predictions of the firm, which the buyer believes are unattainable. In reaction, the buyer may introduce an earn-out agreement, whereby the seller will be forced to put his money where his mouth is (Henderson, 2008). The buyer and the seller may have a conflicting perspective upon the future based upon diverse experiences (inside and outside the firm), a different attitude towards risk and the seller may behold tacit knowledge concerning the performance of the firm. Moreover, the seller tends to perceive the future prospects as more prosperitious, since his opinion is colored by emotion too. This motivation differs from information asymmetry in that here both parties do not own the information concerning the future and may have differing images of the future state of the business, whereas information asymmetry deals with non-disclosure of information by one side towards the other party.

3.4.4 Equity Gap

If a MBI / MBO candidate or SME business wishes to collect funds in order to acquire a business he can turn to several possible capital providers. For funds amounting to approximately EUR 300,000 he can turn to the famous 3Fs; friends, fools and family or opt for a credit facility at his bank (European Commission, 2006). For funds over EUR 5 million he can turn to the larger participation companies or the banks (MKB ING Bank, 2003).4 They may be willing to invest in the business in return for an equity share. However, for funds in the range from EUR 300,000 up to EUR 5 million, it is very difficult to obtain funding. This is the so-called ‘equity gap’ experienced by many medium and small businesses (Folkeringa, 2008). Yet another possibility is that the selling party remains participating in the business,

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by providing funds to the acquiring party, often by granting a subordinated loan (OECD, 2006).

The equity gap experienced by SMEs and entrepreneurs can also be closed by the use of earn-outs. In this way the acquirer has to pay less money upfront and can use the firms’ cash flows of the upcoming years to meet his earn-out obligations (Jongkind, 2005). Therefore, the use of earn-out provisions may be related to the creditworthiness of the acquirer (Berger and Udell, 2006). 5 In the face of the current global credit crisis, earn-outs may be used to overcome the reluctance of bank to finance deals, by decreasing the portion of risk capital necessary from financial institutions.

3.4.5 Retention of valuable human capital

SMEs often rely heavily upon one or more key managers, who is in many cases the major shareholder as well. Especially in services or more professional sectors firm value may be highly dependent upon personal goodwill. Without the key manager / owner, the firm may lose valuable tacit knowledge and human capital (Schrijnemaeckers, 2004). The acquirer does not want to lose this value to his acquired firm and therefore attempts to retain the former CEO. One way to secure this is to sign an employment contract between the former CEO and the acquiring party; however the former CEO may not be fully committed to the acquirers’ goals and targets; the well-known moral hazard problem arises (Jensen and Meckling, 1976, Evans, 2008 and Tirole, 2006). The relationship between the new owners and the retaining manager / owner resembles a traditional principal-agent relationship, whereby the interests of the Agent (the retaining manager / owner) should be aligned to the interests of the Principal (the buyer) (Jensen and Meckling, 1976 and Ross, 1973). Based on the pay for performance approach, derived from agency theory discussed inter alia by Core, Guay and Larcker (2003) and Bebchuk and Fried (2003 and 2004) one should construct an optimal contract for the agent defined by Core, Guay and Larcker (2003, p. 1) as “ […] a contract that maximizes the net expected economic value to shareholders after transaction costs (such as contracting costs) and payments to employees.” Therefore, an earn-out can align the incentives of the former CEO to the new owners of the firm. It may be advisable to match the length of the earn-out period to the retention period of the former CEO (Cain et al., 2008). Another solution to the above problem may be to appoint the former manager / owner as business advisor, however in this case the problem of commitment and incentive alignment can remain troubling.

3.5 Design of earn-out deals

The negotiation process can be divided into two rounds, namely the initial negotiations, leading to the Letter of Intent (LOI) and a second round of negotiations directing to the signing of an eventual transaction agreement; the SPA (Share / Sale Purchase Agreement). The SPA expresses a convergence of will between the parties. The specific earn-out structure

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will be laid down in the SPA. It depends on the process and motivation of including earn-out provisions in which stage of negotiation the earn-out will enter the discussion.

Next the design of an earn-out deal will be discussed. A classification of factors as used by Fabregat (2005) and Bruner (2001) will be loosely pursued in this paragraph, only in a slightly different order (see figure 4). One will commence with the amount of the earn-out, which represents the pricing gap between parties (Reum and Steele, 1970). Next, the inputs of the formula should be determined, mainly consisting of the period and the performance goals of the earn-out. Than the earn-out should be structured into a formula, which stipulates the goals to meet in order to pay out the earn-out. Consequently, agreements should be made concerning the measurement and control of the conditions stated in the earn-out formula. Finally, the agreements should be carefully written down in the LOI and SPA.

Figure 4Design of the earn-out process

3.5.1 Earn-out amount

The earn-out amount reflects the divergence of the value perspective of the buyer and the seller. As explained by Bruner (2001, p. 1), “The earn-out percentage is usually a function of the negotiation price gap.” The buyer attempts to expand the amount of the earn-out during negotiations, while the seller attempts to increase the amount received upon completion (Fabregat, 2005). Bruner (2001) claims that practitioner’s think that the earn-out ratio6

should lay between 20% and 70%. Moreover, his results show that earn-outs range from 15% to 88% of total transaction price in 1999 in the United States. Cain et al. (2006) find that the maximum earn-out that could be paid per acquisition from their sample constituted of 33% (median 28%) of total transaction value.

3.5.2 Earn-out period

The earn-out period is an outcome of the negotiation process between both parties as well. The buyer attempts to lengthen this period to decrease the net present value of the contingent payment in line with the time preference of money, whereas the seller tries to scale down this period (Bruner, 2001). However, according to option price theory (Black and Scholes, 1973, Fabregat, 2005 and Bruner, 2001) the buyer will attempt to lengthen this

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period to reduce the likelihood of granting the contingent payment. Bruner (2001) claims that earn-outs with the time-preference of money may be mistakenly viewed as a “sure thing”, whereas the contingent payment rather strongly resembles an option. The earn-out period typically ranges between one and five years (Bruner, 2001). An earn-out period exceeding five years is exceptional; Cain et al. (2006) found an average period of 2.57 years. This finding is consistent with the one of Kohers and Ang (2000).

3.5.3 Performance goals

Contingent payments should be based upon a measure of performance of the business. This may be revenues, gross margin, EBIT, cash flows EBITDA or other performance milestones (Bruner, 2001). Payments may also be made dependent upon multiple goals, such as a combination of revenues and EBIT (Bruner, 2001 and Jongkind, 2005). Performance goals (EBIT, sales, profits) may be measured at different time intervals either annually, semiannually or quarterly. The buyer has more discretion to manipulate earn-out payments the further the performance measure moves down the income statement, since he can speed up investments and costs and increase managerial withdrawals to lower profits (Jongkind, 2005). On the other hand, the further you move up the income statement, the less representative the goals will be. For instance, a manager may increase turnover by selling not-profitable products, in order to reach his performance targets.

Cain et al. (2006) find that in 90% of earn-out deals included in their sample, payments are made contingent upon performance of the target firm, while the remainder is made contingent on the target and the acquiring business together. Kohers and Ang (2000) find that for the larger part earn-out performance goals are based on internal performance goals; in their sample only one in 79 deals was based on external performance benchmarks. They also found that in 91% of the cases the target shareholders received full payment or partial payment of the agreed contingent payment (46% received full payment, 20% received on average 43% of the earn-out).

3.5.4 Payment schedule / formula

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calculate the number of shares the seller is entitled to.7 The moving standard differs from the former type by the fact that here an excess over the highest previous performance during the contract period is charged. Within the first year after the deal the threshold is determined by the performance level of the year preceding the acquisition. Subsequently, the highest performance over any of the contract years is used as threshold. Finally, the cumulative standard focuses on aggregate performance, in order to ignore fluctuations of performance during the out period. Bruner (2001) introduces just another type of earn-out formula; the sliding scale. Alternatively, one may consider a reverse earn-earn-out agreement whereby the seller agrees to pay the buyer a certain amount contingent upon a performance goal of the company (Evans, 2008). If the performance of the target company falls short of agreed projections, the seller has to comply to pay the agreed contingent payments.

Cain et al. (2006) find that in 42% of the cases the contingent payments are linear function subject to a maximum and in 40% of the cases it is a stepwise function of the target’s performance (with a maximum). Nine percent of the contracts stipulated a concave function, a convex function or a function without a maximum. Bruner (2001), Jongkind (2005) and Betton, Eckbo and Thorburn (2007) argue that one should cap an earn-out payment, due to the unpredictability of the future.

3.5.5 Performance measurement

Both parties should agree upon the use of certain accounting rules, especially with respect to normalizations due to exceptional or not-periodically reoccurring costs (Henderson, 2008). These agreements are especially important when the buyer intends to merge the acquired corporation with other activities. The buyer may allocate overhead costs in such a way that profitability of the acquired business declines, which in turn may affect the earn-out payments. On the contrary, the retaining manager may use his discretion to artificially increase turn-over or EBIT for his own interest. Henderson (2008) also touches upon the issue of revenue recognition; both parties should agree upon which accounting principles will be used. Reum and Steele (1970) discuss issues as capitalizing expenses when direct write-offs are more appropriate, depreciation policies of assets, level of executives’ salaries, amounts charged for corporate overhead and services, minimum level of discretionary expenditures (R&D, advertising) and amounts charged for intra company loans.

3.5.6 Contracting

The parties involved will have the choice to either apply a one-size-fits-all general deal structure or a customized contract, tailored for that specific deal. In case of a one-size-fits-all contract the earn-out will represent the average (standard) earn-out that the advisor of one the parties often uses and the contract may be standardized as well. If operations are relatively small, the legal and financial advisory costs to construct a personalized contract may form a substantial part of the deal size. Therefore, in this case the cost advantages may

7_{In formula; Number of shares = (I x C)/ M. Where I equals the excess, C the capitalization factor and M the market value of one share in}

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outweigh the gains of a personalized contract. Moreover, an optimal construction of an earn-out exploits all opportunities to extract rents from the corporation. These two issues just mentioned can be explained by the complete contracting view, the costly contracting view and one-size-fits-all contracting. Complete contracting is a concept from contract theory; it assumes a contract to be complete if it specifies the respective rights and duties for all possible future states of the world. Of course, this extreme point would be extremely expensive and time-consuming to construct, therefore complete contracting is a merely theoretical concept (Tirole, 2006). The costly contracting view poses that the terms of the contract are determined by a tradeoff of the relative costs and benefits. This contract will be optimal in the sense that it optimizes the transaction value while taking into account the costs of creating such a contract (Cain et al., 2006). Cain et al. (2006) found that earn-out contracts are rather heterogeneous, which supports the costly contracting view. It may be expected that contracts are rather homogeneous for SMEs due to monetary constraints. However, the feasibility of writing a contract may be higher for SMEs since they have a private character and are often managed and owned by one single person.8

The SPA should at least include the earn-out amount, the earn-out formula and agreements concerning the measurement of the contingent payment. Additionally, one should include provisions covering the incidence of post closing acquisition disagreements concerning the earn-out (Frankel, 2005 and Straus, 2008). It is advisable to include dispute settlement provisions in the SPA, for example by appointing a mediator (Jongkind, 2005). Frankel (2005) detects two main drivers over which disputes concerning earn-outs may evolve, namely uncertainty concerning the terms and metrics and disputes concerning the responsibility for performance; who is to blame (seller or buyer) if performance is disappointing.

3.6 Evaluations of the advantages and disadvantages of earn-outs

There are numerous reasons to include an earn-out component in an acquisition deal as discussed in the preceding paragraphs. However, there are also a number of negative effects of earn-outs which should be considered as well. One should attempt to design the earn-out in such a way that the effects of the disadvantages are minimized and the advantages are optimized. Here, a summary of the pros and cons of earn-outs will be given. An overview of these pros and cons are listed in the tables below (see table 1 and 2).

Pros of earn-outs to the acquiring firm

The use of an earn-out constuction leads to several possible avantages for the acquiring firm (see table 1 for an schematic overview of advantages). First, an earn-out construction motivates a staying-on manager / owner to put his best efforts in the company. As Kohers and Ang (2000, p. 448) put it “tying the timing of the deferred payment to the duration of the target’s owner / manager employment with the bidder serves as a bonding mechanism to induce the manager to stay.” Moreover, the incentives of the staying-on manager / owner

8_{See Wade, J.H. and Honeyman, C. ,,Negotiating beyond agreement to commitment: Why contracts are breached and how to make them}

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will align with the incentives of the acquirer (Jensen and Meckling, 1976). Next, it may reduce the valuation risk of the acquirer. In most negotiation processes, the valuation of the target is a point of fierce discussion. One of the reasons for this may be the information assymmetry between the buyer and the seller. The seller knows the company from within and has the possession of superior information over the buyer. The due diligence may diminish this advantage, although some assymmetry will remain.

Moreover, it reduces the financing need. The extention of payment offered by an earn-out contract provides the buyer with a form of acquisition finance. Adjacent to it, it will lower the interest costs to third party financing (Bonenfant, 2005). Reum and Steele (1970, p. 88) refer to an interview they conducted with the Group vice president of a multimarket company who stated: “Any time that I can borrow money from a seller at advanteous prices, I’ll do it.” This will especially be the case for corporations with a relative large proportion of goodwill on their balance sheet, since intangibles are assets which cannot be used as collateral to obtain funding and for firms facing high interest costs (low credit ratings). In addition, it may avoid deadlock in the negotiation; parties decide to “agree to disagree” (Kohers and Ang, 2000, p. 1 and title). Differing valuation perspectives may lead to deadlock in negotiations. The introduction of an earn-out may avoid this. It also allows a “grace period” for the buyer (Reum and Steele, 1970). The inclusion of an earn-out in combination with the retention of the former owner / manager offers the seller an opportunity to get to know one’s business and decide in that period if he wants to retain managers or find / prepare a new management team (Bonenfant, 2005). Another advantage for the buyer may be according to Bonenfant (2005), that earn-out provisions permit the buyer to offset possible future indemnification claims. This lowers the financial risk in case of non-compliance with the payments stemming from guarantees, representation and warrantees laid down in the SPA. At last, it may give the buyer an advantage over other acquisition candidates if the owner / manager wishes to remain involved in the business. The manager / owner may wish to remain involved in the corporation and wants to remain responsible for earnings. If a potential buyer offers him a contingent payment in combination with the retention of the manager / owner, the seller may have a preference for that candidate (Reum and Steele, 1970).

Cons for acquiring firm

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the acquired business and will consequently not reap synergy benefits (Bonenfant, 2005, Bazerman and Gillespie, 1999, Bruner, 2001 and Reum and Steele, 1970).

Next, it may limit the upside gains of the buyer. If the contract stipulates that all earnings exceeding a certain level of EBIT / sales / EBITDA accrue to the former owner, the buyer will reap lesser up-side gains of the business (Fabregat, 2005). In addition, in order to motivate the former owner / manager, the buyer must grant him some discretion with respect to authority (Reum and Steele, 1970). Consequently, the buyer will have less discretion with respect to his acquired business (Dahl and Richmond, 2008). Finally, the contracting of earn-out provision requires more complex contracting. Incomplete contracting creates the possibility of disputes and litigation concerning the interpretation of the earn-out clauses (Reum and Steele, 1970 and Bonenfant, 2005). This will come at considerable legal costs and possible loss of focus on the business.

Acquiring Firm

Pros Cons

• Motivate staying-on manager / owner • Short-termism

• Reduce valuation risk • Delayed integration

• Reduce financing need • Lesser upside gains

• Avoid deadlock in negotiations • Loss of control

• Introduce “Grace” period • Complex contacting, high contract / negotiation costs

• Offset indemnification claims

• Advantage over possible other acquisition candidates Table 1 Pros and cons of earn-outs for the acquiring firm

Pros for the selling firm

Earn-out constructions also pose a number of possible advantages for the selling firm. First, it may be used to maximize the transaction value. If the business should perform as prognosed by the seller, an earn-out clause will be a way to structure the process in order to the receive the intrinsic value of the corporation. This is, as discussed, especially the case for businesses in high-tech or innovative industries and businesses in early stages of the lifecycle (Dahl and Richmond, 2008). Moreover, it may give firms typified by fluctuating sales / profits, in non-stable environments or with high growth potential the possibility to sell their business for a (to them) acceptable price, which in absense of an earn-out clause would not be possible (Fabregat, 2005).

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Finally, the owner / manager may feel rewarded if the buyer(s) of his business offer him a (advisory) position in the acquired business. He may view his position as irreplaceable and in this way his self image may inprove or be ratified.

Cons for selling firm

The most important disadvantage for the seller of an earn-out construction is the delay of received cash and the fact that cash receipts are made dependent on future performance of the firm. The seller will not receive full payment upon completion, which leads to the fact that he can not take advantage of the time value of money. Furthermore, he cannot invest his proceeds in funds earning a higher yield.

Additionally, the actual payments depend upon the future financial health of the business (Fabregat, 2005). However, depending on the contractual agreements the actual payments may be dependent upon the industry and economy as a whole as well. Moreover, in case of retention of the seller, he will have yield ground with respect to control over his business to the buyer of the business. He may therefore not have enough autonomy to assure that he satifies the performance goals in order to receive the contingent payment (Bonenfant, 2005 and Fabregat, 2005).

As a final point, in order to meet the short-term objectives, the former owner / manager may face a high pressure to substantiate the future prognoses of the business. The manager may feel forced to pursue short-term goals even if it is not in the long-term interest of the business (Fabregat, 2005).

Selling firm

Pros Cons

• Maximize transaction value • Delay of received cash and dependent on future financial health

• Capture gains future profits & buyer funds future growth opportunities

• Loss of control

• Advisory / managerial function accrues to “pride” of owner / manager

• High pressure to meet short term results

Table 2 Pros and cons of earn-outs for the selling firm

Yet another possible advantage for both parties may be the possibility of tax defference / avoidance due to earn-out construction. However, discussion of this issue goes beyond the scope of this research.

3.7 Alternatives of earn-outs

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which may, under certain conditions, be better suitable to overcome some obstacles. The escrow may be used for information assymmetry or insececurity from the side of the Buyer concerning the completion of a certain task or terms. If the buyer of a firm faces an equity gap, he will need to collect funds or to structure the deal price in such a way that he can pay part of the transaction price out of the future cash flows of the firm. The use of an subordinated loan or a deferred, however fixed, transaction price can be a good solution.

3.8 Framework

We should be able to fill in part of the framework now, based on the foregoing discussed literature (see figure 5). In the next paragraph, a number of cases are discussed to focus more in depth on the earn-out process. After the discussion of the cases and interviews with the key persons involved in the acquisition process, the framework can be amended to these outcomes. Moreover, it is attempted to uncover the underlying relations between the motivation, the design and the assessment of the earn-out agreement.

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Msc MBA Finance thesis | Cases 26

3.9 Summary

Prior research, although scarce in number, has paved the way for the future. Thanks to the efforts of Cain et al. (2006), Datar et al. (2001) and Kohers and Ang (2001) much more is known concerning the characteristics and occurrence of earn-out agreements in acquisition deals. However, many aspects are still left untouched. The aim of this paper is to shed more light upon the post-acquisition period for acquisition deals that include an earn-out. Moreover, the qualitative aspects of earn-out deals will be further explored. As argued above, emotion plays a large role in SME takeovers, since entrepreneurs feel often closely related to their company. Therefore, the experiences and views of entrepreneurs, who have experienced earn-out deals, concerning the deal structure and the post-acquisition payments, can prove to be very intuitive.

4. Cases

First, the cases will be introduced; an overview of the main events of the negotiation and assessment will be given and the main elements of the earn-out deal will be discussed. Table 4 gives an overview of the deal characteristics of the specific cases.

4.1 Case 1 “Parquet B.V.”

The target company Parquet B.V. (Target) is a Dutch firm that produces parquet floors. The Buyer already owned a conglomerate of businesses. The main motivation for introducing an earn-out was strategic negotiation and insecurity concerning the future prospects of the firm. Moreover, information asymmetries played also a role as motivator. The earn-out is proposed by the Buyer who sought to reduce the upfront payment of the acquisition. Moreover, the Buyer argued that as a financial party, he is not faced with an equity gap, however did seek to maximize the leverage on acquisitions to receive a good return on equity. Earn-outs postpone the eventual payment into the future, often without interest obligations, which makes it a cheap way of financing a deal. One advisor motivated the earn-out as: ,,The deal sum paid for Parquet B.V. was relatively high, especially when taking into account that we [The Buyer] paid a badwill of € 1.6 million. In return we thought that it would be fair to demand an earn-out.” The former owner / manager did wish to remain employed by the Target, however the deal is not motivated by this. The Buyer indicated that “I do not believe that an earn-out can be used to motivate the management, by the time that he has received for instance 80% of the deal sum, he will not work his ass off to earn an additional 20%. I rather believe that he may be incentivized by the risk of losing face when the projections are not met.” The performance is set on gross margin. According to advisor C: ,,The minimum threshold in the formula is determined by the expected gross margin plus a margin of error.” The contingent payments are being paid to the Seller, and all the targets are met.

4.2 Case 2 “Print B.V.”

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attempt to lower the upfront payment. Advisor C: “We told the Seller: ‘It will be difficult to pay this amount up front, but don’t you believe in the future prospects which you have composed yourself? If you don’t, then your offer is obviously too high and if you do, then you will not have any problem with an earn-out.’ After which he agreed!” The former manager (Seller) also wished to remain involved in the business (the involved advisor rated this motivator as relevant whereas the Buyer rated it as irrelevant). The Buyer did not oppose an earn-out, since he bought the corporation as a financial investment and did not wish to integrate the business. The performance goal is set on EBIT and a stratified payment schedule with a very low minimum threshold is constructed. The reason for introducing such a schedule is that the Seller perceives the earn-out as more “definite”, since he nearly always receives some payment. Moreover, the formula carried forward up to considerable levels. However, the Buyer knew that the Target could not live up to such levels, although it motivated the Seller to do the utmost to attain the highest proceeds possible. The deal turned out positively for both the Seller and the Buyer: the Seller crossed the threshold in both years and received an additional 2/3 of the upfront payment and the Buyer paid a low upfront payment and paid eventually not even five times net profit for the corporation. Both parties lived up to their agreements and no discussions concerning the earn-out emerged. The advisor argues that this owed by the high level of contractual specification, the specific construction of the payment formula and the fact that both parties perceived the eventual purchasing as fair.

4.3 Case 3 “Trailer B.V.”

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obligations of the bank loan first. The earn-out formula was not capped, since that did not seem fair to the Buyer. The level of contractual specification is low (see appendix 5). They based their agreement largely on trust. The post acquisition profits, and the consequent earn-out proceeds, turned out to be considerably higher than anticipated.

4.4 Case 4 “Truck SA”

The parties in this acquisition are a middle-sized corporation (Target) and a large multinational organization (Buyer) which operate in the logistics industry. The deal is primarily strategically focused. The Buyer did not wish to integrate the target into his own corporation during the first few years. The Buyer proposed to include an earn-out in the initial stage of negotiations, to warrant consistency of profits. Moreover, the projections consisted of many normalizations, some of which were indefinable. The earn-out target was based on an historical average of EBIT for two consecutive years. The realizations the consecutive years fell short of the prospects; therefore the acquisition price had to be adjusted negatively for this shortfall in EBIT. Next to the earn-out, a subordinated loan gave the Buyer an increased level of confidence in the Seller’s future business prospects. Both parties assessed the earn-out positively, since the Seller introduced the earn-out for the right motivation in retrospect and the Seller perceived any possible earn-out proceeds as a premium over the transaction price, since he already received a relatively high upfront payment.

4.5 Case 5 “Parking B.V.”

Parking B.V. (Target) is a company which is specialized in parking systems. The management of the firm (MBO team) acquired the Target from the already distant shareholder (Seller). The MBO team received full control over the corporation upon juridical conveyance which took place at the end of 2006. The initial non-binding offer of the Seller contained a purchasing price unacceptably high for the MBO team. Consequently, the Seller suggested the use of an earn-out in order to overcome the equity gap of the MBO team and to take advantage of the potential future return of the Target. The MBO team positively assesses the agreed earn-out provision, since this posed the only opportunity to close the deal. However, they regret that the payment formula did not include a cap on possible earn-out proceeds (actual profits turned out to be much higher than anticipated). Nevertheless, the advisor claimed that they waived the capping as a trade-off against the proposed performance goals and formula. The MBO team considers buying off the earn-out obligation as of next year.

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Msc MBA Finance thesis | Analysis of the cases 29

4.6 Overview of deal characteristics

The table below (table 3) gives an overview of the deal characteristics of the discussed cases.

Case Closing date Earn-out period Deal category Deal size* Earn-out** Performance goals Payment Schedule Earn-out formula Parquet B.V. 2007 2008, 2009 Strategic/ Financial

1-2 9% Gross margin Fixed amount

plus % over set standard Lumpsum [if gross margin > x] + 0.1(gross margin -threshold) Print B.V. 2006 2006, 2007 Strategic/ Financial

0-0,5 16% EBIT Stratified n/a

Trailer B.V. 2007 2007-2009 MBI 0,5-1 0% Net earnings % over set

standard (uncapped)

0.5 (net profit – threshold)

Truck SA 2005 2005, 2006 Strategic 5-7,5 20% Average EBIT

(historical)

Deviation from 2 (target EBIT – actual EBIT)°

Parking B.V. 2006 2006-2008# _MBO _1-2 _15% _{Net earnings} _{% over set}

standard (uncapped)

0.5 (net profit – threshold)

* total fixed deal size in million EUR

** earn-out as % of total deal size (including earn-out). The amount of the earn-out represents the amount of the earn-out if target is achieved, the excess is not reported.

° for subsequent year EUR 1.20

#

(10/12)th of the net profit over 2006 accrues to the seller. (current accounting year)

Table 3 Overview of deal characteristics

5. Analysis of the cases

During the research and the interviews with both the executives and the advisors, several trends and guidelines became clear. These findings will be discussed in this chapter. First, the distinct features and their influence upon the earn-out will be discussed. Second, general trends and guidelines are extracted from the analyses and summarized in appendix 11. Eventually we will work towards an integrated decision model for earn-out clauses (see figure 7).

5.1 Deal characteristics

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the Buyer sought geographical expansion of his activities, without integrating the target in the near future, since he believed in gradual transition to the main label. Nevertheless, they did relocate the Finance and Administration services in their headquarters and charged market prices for these services and segregated any possible inter-firm turnovers. Parking B.V. involves a MBO, one advisor claims that earn-outs are less used with MBOs, since the information asymmetry tends to be lower than in other takeovers. Advisor C asserts that: “the higher the “granting factor”, the lower the incidence of an earn-out, and the lower the “granting factor” the higher the incidence of an earn-out.” The management often has a good relationship with the former owners of the firm, therefore the former owner may trust the management more and is willing to back up the MBO team financially. A subordinated loan would be a more obvious choice, since the main problem of the MBO team will be to arrange lines of credit (see discussion section 5.5). Trailer B.V. was acquired by a MBI candidate, who are normally also characterized by limited financial resources. However this did not play a role of importance in this case; the buyer rather used it as an argument to strengthen his negotiation position (opinion Buyer Trailer B.V.). An advantage of an earn-out arrangement by a MBO team or MBI candidate is that he will only acquire that business, so no integration with other business units will take place, which simplifies the performance measurement.

5.2 Motives

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Information asymmetry: In the case of Truck SA, the many normalizations in the projections of the firm gave rise to information asymmetry, since the buyer was not able to accurately assess the correctness of these accounts. The buyers of Truck SA therefore decided to introduce a combination of a ‘normal’ earn-out and a reverse earn-out. Hereby it could safeguard itself against fluctuations in performance caused by incorrect normalizations. Moreover, the buyer of Print B.V. and Parquet B.V. indicated that the administration of both targets, as many SMEs, was not consistently done and as a consequence did not provide a clear and accurate image of the position and possibilities of the firm. He argued that, although the manager knows everything that happens in his business, most of that knowledge remains tacit and rather unattainable for the buyer. Advisor C indicated that information asymmetries will be limited to the negative information asymmetries. If the seller knows anything that may increase the portion of upfront payment he will not hesitate to mention this to the buyer. A thorough due diligence should diminish information asymmetries between parties, according to Advisor B.

Insecurity future: In all of the cases, the insecurity concerning the future prospects of the firm played a role of importance. No one can accurately predict the actual future state of a business and the economy as a whole. As a consequence, most disagreements concern this issue. Moreover, the seller believes in his company and tends to overestimate the value of it (see above the paragraph on emotion). Besides, the buyer has a future oriented view, since there he will earn his profit. This makes insecurity concerning the future probably the most prominent motivator for including an earn-out. In most cases the buyer just wished that the seller’s predictions were obtained or crossed. As mentioned above, the earn-out of Truck SA is designed in order to affirm performance stability.

Strategic negotiation: Strategic negotiation is a motivator not anticipated for in the literature review, however appeared to be the main motivator in two of the cases, namely Parquet B.V. and Print B.V. There was no justification to introduce an earn-out based solely upon the motivation factors described in the literature review. In Parking B.V. relative power of the buyer was limited as opposed to the power of the seller, negotiations reached a deadlock where the buyer had to give in and had to accept an uncapped earn-out formula, in return of a deferred payment of part of the purchasing price. The source of the confined negotiation power at Parking B.V. may be traced back to the fact that the seller knows that the MBO team wishes to buy that particular company even at a premium and that the MBO team depended upon the seller to participate in the funding of the purchasing price. On the contrary, in the case of Parquet B.V. and Print B.V. the buyer is an experienced and strategic negotiator, who was, through strategic negotiation, able to almost half the upfront payment by introducing a fairly friendly earn-out which appeared to the seller as a semi-fixed payment.