"The rearview mirror is always clearer than the windshield." This observation by Warren Buffet holds especially true when it comes to valuations in private M&A transactions. Information asymmetries, a multiplicity of possible valuation standards and differing opinions about future success can create a pricing gap between buyer and seller large enough to threaten a transaction's viability. As discussed in the three previous posts in this series, an earnout can be an effective tool for hedging against the inherent commercial challenge of "unclear windshields", ensuring that the price ultimately paid for the business is acceptable to both sides, no matter where the road ahead leads. In this final installment of our earnout series, we look at the use of equity securities, rather than cash, as all or part of the earnout payment. We focus on the following key issues:
- When this structure is appropriate;
- Tax reasons for using convertible shares; and
- The characteristics of the securities that are used.
When is a share-based earnout structure appropriate? At first glance, the tactic of employing an earnout comprised of common shares appears contrary to a vendor's primary objective, which is typically to sell and exit the business. With a share-based earnout, the vendor is actually earning itself back into the company that it has just finished exiting. Where a vendor really wants out, a share-based earnout is obviously not going to be an attractive option. However, in a significant subset of cases vendors may be more than willing to participate in potential gains from the synergies of a combined business or from the advancement of the business to a new level (e.g., through a successful IPO following capital investments that it was unable to make). From the purchaser's perspective, a share-based earnout can have three major benefits: it preserves cash, bridges any valuation gap and incentivizes the vendor where it remains part of management.
Tax reasons for using convertible shares
When determining the share-based earnout structure that best suits their objectives, parties should consider the matter of rollover benefits—that is, how to transfer the securities while minimizing or deferring the tax consequences of the disposition. Where a vendor will receive shares of a Canadian company under an earnout, it should generally be possible to structure the earnout in such a way that the vendor is not subject to tax on the value of the shares received under the earnout until the vendor ultimately sells those shares. For rollover benefits to be realized, the agreement must provide for the conveyance of the earnout shares at the time of closing rather than deferring the issuance of these securities until the performance targets are hit. If the share issuance is deferred until performance targets are hit, the vendor would generally be subject to tax on receipt of the shares or earlier. On its face, however, this strategy raises an apparent difficulty: If the earnout shares are issued at the time of closing, the vendor would own the securities before it has earned them. To get around this, parties can consider creating and issuing convertible shares (instead of common shares) at closing. These convertible shares would be exchangeable for common shares under certain circumstances—specifically, if the agreed-upon targets that trigger an earnout are achieved (it should be possible to implement this share exchange on a tax-deferred basis). If the company fails to meet these earnout targets, the convertible shares would be redeemable for nominal consideration. Prior to implementing such an earnout arrangement, there should be confirmation that issuance of convertible securities is permitted by the company's articles. If not, the approval of directors and shareholders must be obtained to amend the company's constating documents to allow for the creation and issuance of a new class of shares.
The business terms of the transaction and, in particular, the earnout arrangement, are the key drivers in determining the terms of the convertible shares. Parties should graft these economic objectives onto the share terms that govern the conversion of the new securities into common shares. Some matters to be considered include:
- Multiple Series: It is not uncommon for there to be several valuation points during the term of an earnout, with each valuation point potentially entitling the vendor to certain payments—in effect breaking up the earnout into multiple smaller earnouts (assuming, that is, that catch-up payments are not included in the earnout provision). To provide for this segmented disbursement structure, a party may create several series of convertible shares that each convert (or are redeemable by the company) at times corresponding to the various valuation points and/or upon the acquired business' attainment (or non-attainment) of its given earnout objectives.
- Redemption, Conversion and
- What happens if the earnout target is not achieved? The convertible shares will no longer be eligible for conversion to equity securities. Establishing a nominal redemption price permits a redemption of the convertible shares at minimal cost to the company and eliminates such shares as outstanding shares (see "Shareholder Rights" below). Indeed, anything above nominal consideration for redemption by the company of the convertible shares would constitute an "unearned" gain on behalf of the vendor. Assuming that the redemption price is a nominal amount, the redemption should not result in any negative tax consequences to the vendor or the purchaser.
- What happens if the earnout target is achieved? The vendor would then be entitled to an earnout payment. The mechanics of conversion from convertible securities to equitable securities, such as the setting of a conversion price or ratio, should be reflective of the economic terms agreed to by the parties, including the value of the earnout amount. For example, equity securities that have a low conversion cost (whether expressed by way of a conversion price, a conversion ratio or otherwise) would have a higher value than those with a high conversion cost.
- What if something happens before the earnout can be achieved? Vendors may also wish to include acceleration rights whereby conversion into equity securities would be triggered by intervening events that could affect whether the earnout target is achieved (e.g. if there is a change of control of the company or some type of transformative transaction). Whether such rights are included should be driven by the economic terms agreed to by the parties.
- Dividend Entitlement: Unless the purchaser is feeling particularly generous, holders of the convertible shares should not be entitled to dividends.
- Shareholder Rights:
There are certain rights a shareholder has that a purchaser would
want to consider in setting the terms of convertible securities.
The most important of these is voting rights.
- It is prudent to ensure that the vendor does not have voting rights before it is entitled to the common shares. Therefore, the convertible shares issued to the vendor should be created as non-voting securities. It is important to keep in mind that, even though the earnout shares are non-voting securities, there are occasions where the vendor, simply by virtue of holding shares in the acquired business (and regardless of whether those shares possess a stated voting right according to their terms), is entitled to a vote pursuant to Canadian company law (e.g., in a sale of all or substantially all of the assets of the company or certain changes to the authorized capital of the company).1 To achieve additional comfort that statutory voting rights attached to the earnout shares will not be exercised by the vendor, the purchaser may request that the vendor enter into a voting trust, which would provide the purchaser with control over how the earnout shares are voted prior to their conversion or redemption. The vendor would have very little basis for objecting to such a mechanism, since it has not yet "earned" the associated share compensation and should not be entitled to any rights of such compensation prior to the achievement of the earnout targets.
- Beyond voting rights, shareholders also have certain information rights such as the right to inspect corporate records and to be sent financial statements. A purchaser may wish to give some consideration to the appropriateness of these information rights for a vendor that may no longer be involved in the business of the company.
These mechanisms are designed, in large part, to fashion the earnout shares into convertible shares that are, in essence, bare securities whose sole worth lies in their contingent convertibility. By stripping the securities of any inherent value, parties can comfortably issue them prior to the earnout targets being attained, take advantage of the rollover benefits discussed earlier in this post and avoid being subject to many of the liabilities and obligations associated with having outstanding securities. A purchaser should also be aware that by conveying earnout shares at the time of signing, it provides the vendor with certain statutory remedies (e.g., oppression remedy) intended to protect a shareholder against actions that are oppressive, unfair or prejudicial to the shareholder. Accordingly, the purchaser must remember to be mindful of its conduct (and by extension the conduct of the company) during the term of the earnout or risk exposure to potential statutory penalties.
Share-based earnouts, though not applicable in every situation, can be a vital part of one's toolkit when the appropriate circumstances arise. This post has highlighted some of the main considerations in the use of share based earnouts but parties should be aware that there are additional challenges that have not been considered here. As long as parties are cognizant of the full range of challenges that come with offering shares as deferred compensation, this tool can be flexibly adapted to help achieve parties' commercial objectives, close deals that would not have otherwise succeeded and minimize the effects of "unclear windshields" in creative and effective ways.
1 The nuances of the interaction of share terms and Canadian business corporations statutes are not explored in this post.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.