Part Two of our Sustainable ESOP Series
In the last post in our sustainable ESOP series, we explained that it is important to consider debt capacity when determining fair market value. Doing so, puts the company in the best position to ensure that the seller gets paid and the company continues as a going concern. In some circumstances, however, the Sponsor may be more conservative and the Sellers may feel that they are not being offered fair market value. While it is important to structure the transaction so that the Sponsor can service the debt, it is also important that the Sellers receive full fair market value for their shares. The structure of the transaction may be adapted to bridge any potential “gap” between what the seller believes the purchase price should be based on the seller’s assessment of “fair market value” and what the buyer believes the purchase price should be based on the amount of debt the Sponsor can service.
Consideration of debt capacity and cash flow of the Sponsor almost always play a role in how a transaction is structured. For example, available cash will determine what portion of the transaction will be cash and what portion will be financed with seller financing (i.e. “Sellers Notes”). Debt capacity then will determine how the financing is structured, both in terms of interest rate and loan duration. For example, the Seller Notes may provide for a delay in payment until either any external third-party financing is repaid or the principal amount of the external third-party financing is reduced to a certain level. In most instances, these steps are enough to ensure that the Sponsor can service the debt associated with the transaction.
While basic transaction terms such as cash paid and Seller Notes are helpful in easing the strain of the transaction indebtedness, other structures may also be used to address perceived differences in value. In third party transactions, where a third party purchases the target company rather than an ESOP, parties that differ on value of the target company may use earn-outs to help bridge the “value gap.” An earn-out provides for additional consideration to be paid by the buyer to the seller if certain revenue or net income targets are met. Earn-outs are used in approximately 15%-25% of third party private transactions. In the ESOP transaction context, the DOL has suggested (in the Settlement) that a trustee should consider whether a clawback provision is needed. A clawback provision is the inverse of an earn-out. Rather than the buyer paying more to the sellers, the clawback requires the sellers to return some of the purchase price if certain projections of revenue or net income are not met. In the context of a partial ESOP transaction, the sellers may be asked to transfer more shares to the ESOP based on the perceived reduced value of the stock due to a failure to meet projections. Clawbacks are not prevalent in third-party private merger and acquisition transactions. Out of 1,542 private acquisition transactions closed between 2011 and 2014, clawbacks were utilized only in five of them. And of those five clawbacks, only one operated like an inverse earn-out relating to an earnings target. The clawback in the other four reported transactions was triggered only in the event of fraud by the sellers.
The problem with a clawback often is that it leaves the parties with a sour taste in their mouth. First, the sellers may be upset because they have to forego (or repay) monies already received. The company often is disappointed because, if it is not meeting expected targets, the participants will see the fair market value of the Sponsor stock diminish on their statements. In short, everyone will be disappointed if the clawback is triggered. The earn-out, on the other hand, is an excellent carrot, especially if the selling shareholders are continuing in the business. Even if only psychological, an earn-out simply “plays” better to all constituencies. For example, the sellers may receive less in the initial transaction, but will receive more consideration for their shares if the earn-out kicks in. From the Sponsor’s perspective, though the company has to pay more for the shares, the Sponsor has the benefit of being successful and surpassing targets. The participants see growth in the fair market value of Sponsor stock notwithstanding that more money is being paid to the sellers. For these reasons, the use of an earn-out is a much better alternative to a clawback (even though ultimately they achieve the same goal).
An alternative to an earn-out may be to utilize warrants in a transaction. Warrants provide the parties providing the transaction financing (including the selling shareholder who receive Seller Notes) a right to purchase stock from the Sponsor at a point certain in the future at a set price (the “Strike Price”). Warrants often are issued in conjunction with the Seller Notes as a mechanism to give the selling shareholder the benefit of the upside of the growth of the Sponsor while payment under the Seller Notes remains at-risk. These warrants are generally not exercised by the selling shareholder for the issuance of shares but rather the Sponsor pays cash in lieu of Sponsor stock based on the difference between the fair market value of the stock at the time of the exercise of the warrant and the Strike Price. The greater the growth of the value of the Sponsor’s stock post-transaction, the greater the consideration paid to the selling shareholders. Conversely, if the Sponsor’s stock does not grow commensurate with expectations, the selling shareholders receives less upon exercise of the warrants.
Either an earn-out or warrants can be used to address Sponsor debt capacity and concerns that the selling shareholders receive “true” fair market value. The key is not only to consider “fair market value,” but also to consider debt capacity from the outset and, if necessary, to provide mechanisms in the original transaction that will allow for uncertainty and allocate uncertainty fairly among the parties.