Arguments postponed

Dealmakers facing tough obstacles often reach for the more complicated tools in the kit. One of them is the earnout, which makes a portion of the purchase price contingent on the seller hitting some target (sales, say, or Ebitda or customer retention) perhaps 18 or 24 months after the close. Earnouts are notoriously knotty and susceptible to blowing up later on, but they can bridge a disagreement over valuation and bring a deal to closing.

The current recession is shaping up as a heyday for valuation gaps, what with sellers still looking back to the boom years and buyers peering into a hazy future. So folks determined to move ahead with deals increasingly turn to earnouts to get them done.

How many of these earnouts will work as intended? Too few, some advisers warn. They look at the volatile environment that's producing this crop of provisions and predict plenty of litigation ahead. "The amounts are larger, there's more at stake, there's more risk of companies missing the target," says Hendrik Jordaan, who works on middle-market M&A deals as a partner at Holme Roberts & Owen LLP. "And as a consequence, I think there's going to be more disputes."

It makes sense. What earnouts often amount to, after all, are disagreements postponed and embedded in a contractual web of covenants, conditions and metrics. That's not a formula for happily ever after in M&A any more than it is in a prenuptial agreement.

Take, for example, the best-known earnout provision in recent years. That would be the one that helped seal the deal in 2005 when eBay Inc., then led by CEO Meg Whitman, bought Skype Technologies SA, for $2.6 billion plus more than $1 billion in potential earnouts. As it turned out, the provision at least had the benefit of keeping eBay off the hook for about $1 billion worth of those payments in 2007. But in retrospect, the earnout agreement -- which ran to 15 pages and tied the payments to Skype hitting targets for revenue, gross profits and active users over time -- was emblematic of a deal long on vision and complexity and short on execution. Now led by CEO John Donahoe, eBay plans to spin off Skype in an IPO next year.

Of course, nobody's done an earnout on this scale lately. Nor is anyone likely to for a good while. Investors disliked the Skype deal from the outset, and the complicated earnout structure wasn't exactly a confidence builder.

Instead, a search of The Deal Pipeline shows earnouts employed in smaller deals in a range of industries. In mid-May, for example, IT security company McAfee Inc. bought venture capital-backed Solidcore Systems Inc. for $33 million in cash up front, with an earnout of up to $14 million. No details on the performance target for Solidcore were available.

And in April, the U.K.'s Filtrona plc sold its Filtrona Extrusion Inc. subsidiary to private equity firm Saw Mill Capital Partners LLC. The price is a potential $115 million, with $30 million of the total contingent on the unit's 2009 and 2010 Ebitda.

Some earnouts work out just fine. Maybe these will too; the companies will find out in a few years. Meanwhile, other dealmakers who might be thinking about including an earnout would do well to dust off some of the good advice that transaction services consultants and lawyers have compiled.

To be sure, with so many variables in metrics and timing and with plenty of case law on the topic, the advice gets complicated too. That's one of the caveats about this useful but tricky tool. If you're a buyer, you want to keep it as simple as possible. You want a clear target for your new business unit to hit. If you integrate aggressively, be aware of the disputes that arise when managers argue they weren't given free rein to deliver on their promises. Remember that change-of-control provisions and employment contracts can come back to bite you.

And 18 months from now, when your new business unit has cleared the hurdles you set for it, pay the rest of the money happily. Along with completing a successful deal, you will have also avoided the headaches now besetting several of your peers.