Corporate development and general counsel face a myriad of challenges in matching contractual language to deal intentions.  The structure of earnout provisions, the use of the locked box working capital mechanism, and the application of transactional insurance were discussed in detail during the M&A Conference at the University of Chicago.

Moderator Christen Morand, Partner in Ernst & Young’s Forensic & Integrity Services practice, whose practice deals with a broad range of post-close disputes, started the discussion with a look at innovative methods for structuring earnouts. 

Patrick Belville, who served as Associate General Counsel, M&A, of Cardinal Health (now in private practice as a Partner at Jones Day), expressed caution about earnouts, alluding to how today’s price dispute can lead to tomorrow’s litigation.  Belville did explain how the use of capped earnouts can be a deal incentive.

Aaron Friedman, Director of Corporate Development, Mergers & Acquisitions and Venture Investing at Walgreens Boots Alliance, said that his team tends to focus more on the working capital mechanism, but noted that they have had some success in short-term earnouts for smaller acquisitions.  “As you blend businesses together, earnouts are harder,” Friedman added.

Jason Lilly, Vice President of Strategy & Corporate Development at Neogen, said that his company defines earnouts in the Letter of Intent, adding that most are based purely on revenue. 

Furthermore, these earn-outs are derived from gross margins and defined clearly in spreadsheets, subject to audited financials.  “As long as the numbers are coming through there, the sellers are happy; money helps lubricate happiness,” Lilly noted.

Belville added that earnout considerations should start with integration considerations; what one will do with a business post-closing, which should include a careful assessment of cost structure and cost of product.

“Go as short as you can, capped, with as clear a set of benchmarks as you can get,” Belville advised, reminding that it is difficult to cover all contingencies in such agreements.

Morand also asked about the timing of earnouts. 

Lilly said two years is typical; three years the maximum, with the percentage payout declining over time. Friedman stressed maintaining flexibility and warned, “It’s not as much in the control of the seller as they might think.”

The panel also discussed intricacies of the locked box working capital mechanism and its calculation, including the value of doing sample calculations to show how cash, debt, and working capital are agreed to ensure the benefits of a fixed price deal.

While acknowledging the use of reps and warranties insurance, Belville suggested that “Everything you can get out through working capital the better.”