It is a classical situation in the M&A process: With a view to the possible expected purchase price, the potential buyer vehemently contradicts the corporate forecasts provided by the seller and instead forecasts a significantly "gloomier" image of the future development of the company for sale.

We are therefore in a phase of negotiating the purchase price, in which the value estimates put forward are to be subjected to estimates of the basic parameters for the future development of the company. And because, as you know, the future cannot be entirely planned, the different estimates are fertile ground for price negotiations.

In a best case scenario, both parties will find a common denominator in the form of a purchase price that they can mutually agree on. What happens, though, when the parties agree on the strategic fit of the transaction partners, but the possible purchaser is not willing to take future potential for value increase into account in the valuation to the expected degree?

We often find this situation in the M&A practice,

• if the business model of the company in question is strongly project-driven, i.e. the results can fluctuate a lot over time
• for companies with breaks in their track record, e.g. after reorganization phases or restructuring measures
• for young companies with strong growth, whose short history does not allow a sufficient statement to be made on medium-term development.

In these areas, earn-out clauses can provide a bridge to finding a purchase price. Earn-out clauses could also be referred to as an agreement on subsequent alteration of the purchase price depending on performance. We are therefore talking about a variable purchase price depending on the future performance of the company.

One example:

The contractual parties agree to a target purchase price of a total of € 25 million on the basis of the business plan submitted. The business plan forecasts revenue growth rates of > 15 % p.a. for the next few years. The transaction agreement now initially provides for a fixed purchase price of € 20 million for 100 % of the shares in the business, which will be payable upon conclusion of the transaction agreement. The difference of € 5 million is now the subject of an earn-out clause, which provides for a subsequent proportional increase in the purchase price depending on whether the aims documented in the business plan are reached (revenue, growth, result, etc.) within a certain period (e.g. 1 or 2 years). If, on the other hand, the aims documented in the business plan are not reached, no subsequent adjustment of the purchase price will take place or, if agreed, an adjustment will be made but it will be proportional depending on the extent to which the aims are reached.

It is not difficult to imagine that transaction agreements with earn-out clauses offer an immense range of organizational parameters. The following is a non-exhaustive list:

• Ratio of fixed to variable purchase price payment
  Theoretically, a 100 % variable purchase price arrangement is conceivable. In practice, however, transaction structures with a fixed purchase price portion of > 50 % are generally found. The agreed ratio of variable to fixed purchase price payment should also be dependent of the extent to which the seller can influence the achievement of the aim. This is more the case if the seller is also active in operational management after the transaction than if the company is integrated into the buyer's organisation and the key functions are occupied by an external management.
  
  
• Basis for measurement, target parameters
  The achieving of income goals (e.g. EBIT) is probably the most usual basis of measurement for earn-out clauses. Revenue targets, the achieving of market shares, strategic milestones (product development) or a combination of various aims may also, however, be the subject of earn-out clauses. The extent to which the subsequent purchase price adjustment is proportional to the extent to which the aims are achieved or consists of a fixed amount upon achievement of a threshold value depends on negotiations in the same way as the covering of the maximum purchase price or its general open organisation.
  
  In any case it should be (contractually) guaranteed that the agreed goals cannot be falsified or manipulated by the coincidental or wilful actions of third parties. Examples of key words in this area are reporting policies, cost allocation and transfer prices. Even if many manipulation risks can be minimized by means of provisions in the transaction agreement, a minimum level of faith in the sincere intentions of the contractual partner in question is still required.
  
  
• Measurement period
  A short measurement period (e.g. 1 year) is suitable for companies with continual business performance. For strongly project-driven companies, a longer period is generally recommended, which also means that effects from other periods are forced somewhat into the background.
  
  In the case of companies with strong growth, on the other hand, a longer earn-out period can be very desirable for the seller in order to possibly achieve an overall higher sale price. The same applies if positive synergy effects are expected on the part of the seller, e.g. by means of a wider range of products, new access to markets, etc. Here too, patience can pay off in the form of hard cash.
  
  
• Payout period / payment guarantee
  The determination and payout of the purchase price adjustment can take place in various steps depending on the measurement period. Depending on the extent of the earn-out volume, it may be in the interests of the seller to request sufficient collateralization of the purchase price volume that may subsequently be due at the time when the purchase agreement is concluded.

The extent to which earn-out clauses represent a sensible component of the corporate purchase agreement must be examined in each individual case. As stated at the beginning, an earn-out clause may act as the proverbial bridge in the transaction process that makes the difference between "deal or no deal" in individual cases. The psychological effect on the negotiation process of the willingness of the purchaser to assume risk for a defined period after the transaction can also not be underestimated.

A targeted and motivating earn-out clause should meet the requirement of the purchase price portion being at a healthy ratio to the risk position and possibility of the exertion of influence by the transaction partner in question. The overreached transaction partner can quickly develop into a dangerous "boomerang", while a balanced set-up can result in a true win-win situation. The difference between a blessing and a curse is indeed very slight.

Even at 70 or 80, top US M&A consultants are not thinking of making an exit, to the delight of their corporate customers, who pay them high rates.

They continue to work for fun, not because they have to. At over 60, or even over 70? For some top merger consultants from New York who are among the best in the world, there is no question of retirement. They often work 6 days a week, up to 90 hours. Some of our American, but also, for example, Dutch and Indian cooperation partners fall into this category. The older they get, the better they get - that's their reputation. A mania for youth is not an issue for them or their corporate clients. The top merger consultants mature like fine wines with a long shelf life. Experience is one of the most important factors in success in the consultancy business.

German and British consultants usually retire between 50 and 60. In these countries, the mania for youth is still going on. Consultancy companies that reduce their age limits too low, will, however, lose in competence and market share. In German consultancy companies, consultants are often driven into retirement simply because of their age. However: some insightful company managers are getting around the age requirements. Like today at a private equity company in Baden-Wuerttemberg: The previous managing director, age 64, is continuing to work for his company, no longer as managing director, but rather as senior advisor. A stroke of luck for the company and the clients.

The question of how to guarantee sufficient company liquidity through the inclusion of external capital has plagued businesses since time immemorial. Even if borrowed capital and credit financing tend to be linked to liquidity principles, a well-known side effect can also be that the profitability of the company’s own capital increases through a so-called leverage effect.

Another well-known form of financing is of course going public, although in light of the corresponding requirements (company size, publication procedures, administrative outlay, etc.), not to mention the contemporary stock market climate, this option is not available to every company.

Share capital as an external source of finance is another alternative, which presents a considerably wider spectrum to companies as is commonly assumed. In addition to the primary purpose of achieving liquidity, many investment companies offer valuable know-how, experience and (sector) contacts. Accordingly, share capital should certainly be included in long-term considerations concerning company financing.

The relevance of this form of financing is highlighted by the following figures: for many years now, an ever-growing current of investment capital has been flowing into the Polish economy. By the year 2007, this figure had reached 13 billion Euros. As a consequence, the increasing amount of private capital will doubtless serve to propel consolidation processes and competition in general.

In contrast to classic types of credit, investment capital is not orientated towards short-term business development. Here, external investors are willing to accept temporary solvency problems or supposedly risky capital structures for a specific period of time, providing that this lies within the context of a longer-term company strategy directed towards value creation. A long-standing partnership and a long-term planning horizon do not expose management to the constant pressure to deliver perfect quarterly results to dividend-hungry shareholders, and possibly having to follow short-lived strategies, with limited power to make lasting strategic decisions as a result.

The positive side effects of share financing include the intellectual assets presented by shareholders. Shareholding partners often include marketing or administrative experts, who can support the existing management team in specific areas. This can be especially useful when opening up new markets, introducing new products or improving production processes. Further attractions are posed by the range of potential international networks presented or the opportunity to access new markets and branches. A considerable degree of importance should also be given to the fact that external investors always have a differentiated viewpoint concerning the company, making them valuable sparring partners for the management team.

The involvement of an investor does not necessarily mean a loss of control over the company, as is all too often feared. Serious investment companies are dedicated to ensuring a long-term and trusting relationship with the management team, and do not generally attempt to involve themselves in the operation of the company. It is therefore no wonder that appreciating and getting to know the management team during the investment process is of upmost importance. The question as to whether shareholding leads to the emission of the majority of shares, or whether the investor merely gains a minority share, depends on the investment strategy of the investment company in question, and especially on which transactional structure makes most sense for the company itself.

JP Mergers & Finance has years of successful experience with companies on both sides of investment financing, in addition to searching for suitable partners.

Thomas Zimmer has a management experience of 27 years. He had leading positions in Finance&Administration in the IT and telecommunications sector. His last assignment was CFO of a mid-size enterprise for broadcast services. Furthermore Thomas Zimmer was responsible for purchasing and human resources.

Thomas Zimmer will focus his activities beside Germany on India, Russia and Romania, and additionally in branches like mechanical engineering and telecommunications.

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