Family Equity Partners: What will 2010 bring for family-owned companies?

In light of today's economic climate, earnouts are being used more frequently to bridge the valuation gap between buyers' and sellers' expectations. In addition, when the former owners are retained to help run the business after the sale (as is often the case with financial rather than strategic buyers), earnouts are a useful tool to provide incentives to sellers and managers in transition.

Clearly the biggest challenge in negotiating and drafting an earnout is to structure it in a way that provides management with incentives and compensation for growth as a result of fulfilling their business plan. At the same time, the buyer does not want to over-compensate sellers due to growth attributable to future acquisitions or significant changes in the post-acquisition business plan.

In structuring an earnout, among the key areas that a buyer should consider are the following:

If the buyer intends to integrate the target into its existing business, carefully craft the earnout so that it will not restrict the buyer's ability to accomplish the integration.
Resist seller's attempts to retain control over the operations of the company after the sale, as this can restrict the buyer's ability to react to alter the business plan and growth strategy in case of changes in market conditions.
Base the earnout on simple triggers rather than upon a complicated matrix of variables. This will allow management to focus more on growing the business rather than managing it with an eye towards meeting a number of targets. It will also reduce the chances for dispute, which can cause acrimony between buyers and sellers, and can divert attention away from running the business.
To align incentives, consider having the earnout comprise a significant percentage of the purchase price. If the seller receives a significant portion of the purchase price up front, human nature reasons that he/she will be less committed to future growth.
Limit the earnout period to no more than three years since it becomes extremely difficult to accurately project results beyond that time frame. Growth beyond that time frame will be increasingly the result of the strategic decisions and capital expenditures of the buyer rather than the actions of the seller.
Provide for caps on earnout payments, so that the seller is not unjustly rewarded for un-projected growth, which is often a result of changes in the business plan implemented by the buyer after the acquisition rather than the result of actions of the seller.
In the event that the seller retains operational control, provide for a call or buy-out of any remaining earnout payments to allow the buyer an "escape hatch" in case the existing provisions turn-out to be too restrictive on the buyer's ability to operate the business or execute on its growth strategy.
Provide a mechanism for resolution of dispute, such as binding arbitration, so that disputes don't linger.

Be sure to retain qualified accounting, legal and tax professionals. They have been there before and have the experience to recognize pitfalls and ensure that there are precise definitions. This will, in turn, increase the likelihood that the earnout to be paid is fair and transparent. Also, since "time is money," make sure that the seller has experienced M&A professionals, as nothing can slow down a transaction as much as having unsophisticated counsel, accountants and other experts.

Michael D. Schwamm, Partner at Duane Morris LLP
Michael D. Schwamm practices in the areas of corporate, mergers and acquisitions, securities and technology law. Mr. Schwamm has represented companies of all sizes, including startups and venture-backed companies, privately held family businesses and both large and small public companies in all aspects of their business affairs, as well as providing services to angel investors, venture capital and private equity funds, and other institutional investors. In addition to providing general corporate counseling to a diverse number of clients, Mr. Schwamm has worked on a wide variety of transactions, including public offerings, private placements, mergers, acquisitions, reverse mergers into public shells, joint ventures and licensing arrangements involving a number of industries such as biotechnology, e-commerce, entertainment, manufacturing, sports and telecommunications.

Mr. Schwamm is a former vice president and general counsel of FiberCity Networks, Inc., a telecommunications service provider. In 2006, he was selected as a Super Lawyer in Securities and Corporate Finance in New York.

Mr. Schwamm is a 1983 magna cum laude graduate of Georgetown University Law Center, where he was editor of the Journal of Law and Policy in International Business and a cum laude graduate of the University of Pennsylvania.

Michael D. Schwamm, Partner
Duane Morris LLP
1540 Broadway New York, NY 11036-4086
Phone: (212) 692 1054, email: mdschwamm@duanemorris.com