Overview
As we reach the mid-point of 2015, commodity prices remain depressed - as of mid-June 2015 the price of a barrel of crude oil is roughly 60% of its price at this time in 2014 (http://www.nasdaq.com/markets/crude-oil.aspx?timeframe=1y) and the North American rig count is down by over 1,000 rigs since June of 2014 (http://phx.corporate-ir.net/phoenix.zhtml?c=79687&p=irol-reportsother). The resulting slow-down in the energy markets has affected various industries, and in particular the energy services industry, as customers of energy service companies batten down the hatches to contain their costs as best they can.
It can be anticipated that energy service companies with sufficient liquidity or access to capital, as well as energy focused private equity investors, may see this as an opportunity to pursue undervalued assets. While a number of transaction terms may be impacted as the negotiating leverage shifts to the acquiror in this space, there are a handful of deal terms that we may anticipate will become more prevalent or at least more heavily negotiated in the current climate: earn-outs; and material adverse effect conditions to closing.
This article will discuss each of the above-mentioned transaction terms at a high-level with a view to how buyers and sellers/targets are likely to view and negotiate these terms.
Earn-outs
Earn-outs come in various forms, but in general an earn-out is a mechanism whereby a portion of the purchase consideration is deferred to be paid after closing upon the achievement of pre-determined targets or goals that are typically financial in nature. A common formulation of an earn-out provides that the seller is entitled to receive a percentage of the amount by which the target business' earnings after the closing exceed a prescribed hurdle. In this type of earn-out mechanism, the buyer and seller share the risk that the earnings of the target business may not exceed the prescribed hurdle. Thus, earn-outs are often utilized as a way to bridge the valuation "gap" that may exist where the parties' expectations about the intrinsic value of the target are substantially different, for example in an industry that is in upheaval due to a significant correction in commodity prices.
To illustrate a typical scenario, take Party A, an energy service company that is interested in acquiring its competitor, Party B. Based on the historical earnings of Party B and Party A's forecast of Party B's future earnings, Party A has valued Party B at $90,000,000. Party B's owners, however, are more optimistic about the recovery of commodity prices and Party B's ability to compete for business and believe the real value of Party B is not less than $100,000,000. There are three things that could happen in this scenario. The parties could part ways, believing that the $10,000,000 valuation gap is simply too significant to overcome. The parties could find a compromise position somewhere in the middle. Last, the parties could agree to an acquisition structure that would pay the owners of Party B $90,000,000 at closing, plus provide them the opportunity to gain up to an additional $10,000,000 in deferred payments after the closing contingent on Party B exceeding earnings targets that would be based on Party B's projections.
While the earn-out presents a distinct advantage in that it can help make a transaction come together that might not otherwise occur, it is not without its drawbacks.
As anyone who has negotiated an earn-out will know, these provisions can be difficult to negotiate. While at a high level they sound straight-forward, there is a natural tension that is likely to surface when the details of the earn-out are drafted. Specifically, it is the conflict between the buyer's view that it should have full discretion in making decisions concerning the conduct of the acquired business, and the seller's desire to retain some level of control over the conduct of the business to the extent that such conduct can directly and significantly impact the seller's ability to earn its deferred payments. A few examples of questions that may be addressed in the earn-out mechanism are:
- The buyer's duty to operate the business in a manner consistent with the pre-closing operation. The buyer's level of efforts to achieve the earn-out targets. The impact of add-on acquisitions. Should the seller benefit from the potentially enhanced earning ability of the target, or should the earnings for purposes of the earn-out calculations disregard that? Note that his highlights a separate issue, which is the sometimes difficult exercise of tracking the target's earnings. Rules concerning buyer's allocation of overhead to the target. If the buyer has other businesses that are in the same competitive space as the target, does the buyer have any obligation to direct business opportunities to the target as opposed to its other businesses? Absent a contractual obligation, a buyer may conclude that it will direct opportunities to its other business, where it does not have to share in the earnings with the seller. The impact of post-closing reductions in force or termination of key personnel. A seller that is counting on key management to drive the earnings post-closing could see it as problematic if the buyer terminated a member of key management during the earn-out period.
Thus, the earn-out negotiation can quickly turn into a discussion concerning various covenants related to the post-closing conduct of the business, and the impact of not performing in accordance with those covenants. In certain cases, the seller may demand acceleration of the full (or a significant percentage of) earn-out consideration as its remedy for the buyer's non-performance.
Perhaps because of the difficulty in negotiating them, successfully negotiated earn-outs carry a greater risk of dispute. In addition to the matters described above, the parties may disagree on the determination of the target's performance. A buyer who is considering an earn-out structure should be aware that in certain cases courts have recognized an implied duty to use reasonable efforts to operate the business to maximize the earn-out, in particular when a substantial portion of the total consideration is contingent upon achievement of the earn-out targets (see, for example, Sonoran Scanners Inc. v. PerkinElmer, Inc., 585 F.3d 535 (1st Cir. 2009) (http://cases.justia.com/federal/appellate-courts/ca1/09-1089/09-1089p-01a-2011-02-25.pdf?ts=1410909040) and O'Tool v. Genmar Holdings, Inc., 387 F.3d 1188 (10th Cir. 2004) (http://openjurist.org/387/f3d/1188/otool).
Material Adverse Effect
A common provision that may become more heavily negotiated is the "material adverse effect" condition to closing, and in particular the way in which the parties define what does and does not constitute a "material adverse effect" for that purpose. However, a review of several cases that have addressed the subject suggests that buyers should not rely on this term to provide an escape route if the target company's business trends downward during the interim period in between signing and closing.
A customary material adverse effect definition might read as follows:
- "Material Adverse Effect" or "Material Adverse Change" means any change, effect, event, occurrence, state of facts or development that, individually or in the aggregate, is materially adverse to the financial condition or results of operations of the Company and its Subsidiaries taken as a whole; provided, however, that none of the following shall be deemed in itself, or in any combination, to constitute, and none of the following shall constitute, or be taken into account in determining whether there has been or will be, a Material Adverse Effect or Material Adverse Change: (a) any adverse change, effect, event, occurrence, state of facts or development arising from or relating to (i) the announcement or pendency of the transactions contemplated by this Agreement or the identity of the Buyer; (ii) conditions affecting the industry in which the Company and its Subsidiaries participate, the United States economy as a whole or the capital markets in general or the markets in which the Company and its Subsidiaries operate; (iii) changes in GAAP; (iv) changes in Law, rules, regulations, orders, or other binding directives issued by any Governmental Authority; (v) performance of compliance with the terms of, or the taking of any action required by, this Agreement; or (vi) national or international political or social conditions, including, the commencement, continuation or escalation of a war, armed hostilities or other international or national calamity or act of terrorism directly or indirectly involving the United States of America; (b) any existing event, occurrence or circumstance with respect to which the Buyer has knowledge as of the date hereof; and (c) any adverse change in or effect on the Business of the Acquired Companies that is cured before the earlier of (1) the Closing Date and (2) the date on which this Agreement is terminated pursuant to Section 12.1 hereof.
Several cases have adopted the position that in order for an effect to constitute a material adverse effect, the event must threaten the target's earning potential in a manner that is of significant duration. In the case of In Re: IBP, Inc. Shareholders Litigation, 789 A2d 14 (Del. Ch. 2001) (https://www.courtlistener.com/opinion/2109097/in-re-ibp-inc-shareholders-litigation/), the Delaware Chancery Court suggested that the relevant period should be measured in years rather than months. Two later cases, Frontier Oil Corp. v. Holly Corp., C.A. No. 20502, 2005 WL 1039027 (Del. Ch. Apr. 29, 2005) (http://courts.delaware.gov/opinions/download.aspx?ID=61090) (quoting with approval the IBP case that a material adverse effect provision "is best read as a backstop protecting the acquiror from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner") and Hexion Specialty Chemicals v. Huntsman Corp., 965 A.2d 715 (Del. Ch. Sept. 29, 2008) https://www.courtlistener.com/opinion/2370774/hexion-spec-chemicals-inc-v-huntsman-corp/) (following IBP in holding that the material adverse effect must be assessed over "a commercially reasonable period, which one would expect to be measured in years rather than months"), have reinforced this principle. While another court outside of Delaware, in Genesco Inc. v. The Finish Line, Inc., Case No. 07-2137-II(II), http://www.deallawyers.com/member/Litigation/12_27_07_Genesco.pdf, 2007 WL 4698244 (Tenn. Ch. 2007), ( has indicated that under certain circumstances a material adverse effect could be deemed to occur in a period of three to four months (in that case the court relied on a provision in the merger agreement that contemplated a material adverse effect could be cured before the drop dead date). In light of court interpretations of what may constitute a material adverse effect, buyers would be well advised to view the necessary impact of a material adverse effect as a long-term impact to the target's business and thus a difficult hurdle to overcome.
Additionally, the Delaware cases cited above have advanced the proposition that the burden of proof for establishing whether a material adverse effect has occurred rests with the buyer. Thus, a buyer that wants to have the burden allocated differently should expressly provide for it in the acquisition agreement. In the absence of such an express allocation it appears that a court would most likely find that the buyer has the burden.
Related to the various carve-outs that are often drafted into the material adverse effect definition (refer to clauses (a) through (c) of the sample definition provided above), the Huntsman court indicated that unless there has been a finding of material adverse effect there is no need to consider whether the carve-outs are applicable. Consequently, given the already difficult standards applicable towards the finding of a material adverse effect, if the Huntsman standard regarding carve-outs is followed it will be a unique case where a court is in the position of analyzing the applicability of the carve-outs.
In light of the current state of the case law, buyers would be well advised not to place much reliance on a material adverse effect condition in order to protect against having to close in a situation where the target has suffered even significant negative effects. Instead, buyers may consider identifying specific negative events or occurrences that might be applicable to the target and negotiating conditions based on the non-existence of such events or occurrences.
Conclusion
In conclusion, buyers intending to bridge the valuation gap by agreeing to an earn-out should be aware that these provisions can be difficult to negotiate and are generally going to be subject to later interpretation, which is relevant because of the risk of later dispute concerning the interpretation of the provision.
Buyers looking for protection against post-signing negative impacts should not rely on the standard material adverse effect condition to closing. Instead, when feasible, buyers should attempt to negotiate specific conditions to closing that address anticipated negative effects that might impact the target.
About the Author
You may also be interested in