Return of the earn out in the technology, media & communications industries
May 2015 | SPOTLIGHT | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
In mid-March, the acquisition of Talpa Media by ITV plc went live. One of the remarkable aspects of this transaction is the fact that it includes an earn-out arrangement. And not a straightforward earn-out, but a package pursuant to which founder John de Mol has agreed on an earn-out arrangement with a term of eight years. ITV will pay an initial cash consideration of €500m for 100 percent of Talpa’s fully diluted share capital with further payments dependent on Talpa’s future performance. The total maximum consideration, including the initial payment, is up to €1.1bn. This total is contingent on Talpa continuing to deliver significant profit growth over an eight year period as well as John de Mol’s continued commitment to the business during this time.
What’s the rationale for an earn-out?
An earn-out is often used to bridge valuation gaps between the buyer and the seller. Reasons for such valuation gaps can be various, such as overly optimistic sellers or uncertainty about the future (which can be both about the target’s future or the overall economic climate) or in the case of start-ups, a lack of historic industry benchmarks. Also, due to the post 2008 credit crisis, buyers often lack the ability to attract debt for acquisition finance and thus are not able to pay the purchase price wanted by the seller, which has been a good reason for postponing part of the purchase price payment through earn-outs. If the parties fail to agree on the valuation of the target company, they may choose to structure post-closing performance-related targets which may result in additional value for the seller. The Talpa earn-out appears to be a typical example. The earn-out agreement presumes that Talpa will continue to deliver significant profit growth over an eight year period and that John de Mol’s will remain committed to the business during these eight years. As such, an earn-out can means a contractual obligation between seller and buyer pursuant to which the purchase price paid for a target will be increased if certain milestones are met.
What are the challenges for getting a solid earn-out in place?
In practice, disagreements between buyer and seller often arise in the implementation of earn-out arrangements. These differences may, for example, arise from the degree of control exercised by the buyer of the seller’s post-closing activities. Typical problems to be tackled are the interpretation of the accounting policies and the imposition of corporate overhead expenses by the buyer on the target, so that the possibility for the seller to achieve the earn-out milestones is reduced. Properly defining such milestones is of the essence; milestones can be financial, such as achieving certain levels of revenue, or net income or EBITDA. Non-financial milestones are often used when there is a lack of historic financial information, a situation which often occurs with technology or media start-up companies. In this context, a non-financial milestone can, for example, be the launch of a new product (technology companies) or obtaining patent approval for a medicine (life sciences start-ups).
The buyer’s perspective
From a buyer’s perspective, earn-outs provide protection for overpayment. This is particularly relevant in industries where there is no or limited history to benchmark valuations; obviously this is often the case with companies that bring disruptive technologies to the market. Typically, a buyer will wish to avoid a situation post-closing whereby the seller is only incentivised to focus on short term goals to meet the earn-out milestones. On the other hand, a buyer should avoid getting into a situation whereby it cannot achieve synergy effects due to the fact that the buyer cannot restructure the target because of the earn-out arrangements.
Tips for sellers
In order for sellers to achieve the earn-out targets and thus maximise the earn-out, below are some topics to be addressed in the transaction documents:
Performance indicators. Aim for a performance indicator that is related to revenue growth, not so much to profit. This prevents or restricts issues of cost and passing on corporate overheads by the buyer to the target.
Accounting policy. The buyer will normally apply its own accounting standards on the target. The seller and buyer must agree on the differences in applied accounting policies and principles prior to the earn-out period starting to run.
Earn-out period. From a seller’s perspective, it is advisable to limit the period of the earn-out, for example, up to a maximum of a year after closing. With the passage of time after closing, the probability that the seller has control over the feasibility of an earn-out diminishes, as well as the ability to influence the profit and loss account of the target.
Dispute resolution mechanism. It is important to include a clear dispute settlement procedure in the acquisition agreement pursuant to which objective, reliable third parties will help the buyer and seller to resolve any specific disputes relating to the earn-out calculation and payment. Typically there are two types of disputes regarding earn-outs: disputes where parties disagree on whether the earn-out milestones were met, and disputes over the reasons why the earn-out milestones were not met.
Interest on cash. Many companies being sold will continue to generate substantial cash after the acquisition. In this context, it may be in the interests of a seller to include an earn-out formula that provides a pre-agreed interest rate on cash generated by the target. This interest rate will be payable by the buyer to the seller during the earn-out period.
The ITV/Talpa deal is a great example of an earn-out, both because of its extraordinary length and because of the industry, the media sector. It shows that: (i) duration (eight years) of an earn-out is a key element; (ii) performance criteria (Talpa is to deliver continuing profit growth) which, no doubt, will be measured against pre-agreed milestones, financial or non-financial; (iii) keeping Mr de Mol on board seems to have been a key; (iv) management consideration for ITV to which the earn-out has been tied, in particular with such a lengthy earn-out, a well balanced and thorough dispute resolution mechanism is of the essence; (v) in this context, mandatory mediation should be considered to be part of the mechanism; and (vi) the payment method of the earn-out should be specified as well, including the calculation mechanism, the tax treatment and the applicable accounting standards.
Earn-outs are a welcome technique in closing the valuation gap which often arises in M&A transactions in the technology, media & communications industries. Parties should address each of the issues summarised above. No doubt the ITV and Talpa dealmakers have assessed these at length. And by agreeing on an earn-out with a duration of eight years, they have set a new duration standard for aligning buyer’s and seller’s interests.
Louis Bouchez is a partner at Kennedy van der Laan. He can be contacted on +31 20 5506 692 or by email: firstname.lastname@example.org.
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