What is an “Earnout”?

1. EARNOUTS IN BUSINESS ACQUISITIONS Presentation at the Sault Ste. Marie Innovation CentreSeptember 15, 2009

2. What is an “Earnout”? • A contingent payment made in the future related to the post-closing performance of an acquired business • Not a typical “purchase price adjustment” • A supplementary payment obligation • A good thing of a bad thing? • A useful tool or a recipe for litigation?

3. Why have an Earnout? • Bridge the gap between Seller’s and Buyer’s valuation estimates • The ability of one or the other to say “I told you so” • Motivate the Seller’s management who will stay on to run the business post-closing

4. Off the Shelf Examples? • NO STANDARD STRUCTURE!! • A simple concept, but difficult to implement • Tailored to meet the particular needs of the transaction • Complication is added if the business operations are to be integrated into the Buyer’s operations, and not kept separate • What happens if the acquired business makes further acquisitions? • As an aside: consider investment banker’s engagement letters and “success fee” calculation

5. What Business Variables are to be Measured? • Financial and/or Non-Financial? • Top Line vs. Bottom Line Measurement • Top Line is Generally Preferred by Seller • Bottom Line is Generally Preferred by Buyer • Revenue • Gross profit • Net income • Cash flow • Earnings before interest and taxes (“EBIT”) • Earnings before interest, taxes, depreciation and amortization (“EBITDA”) • Earnings per share • Number of units sold • Value of the business at a future time • Require consistency of practice/application • Deliverables/Milestones

6. Seller’s control over the outcome • An inevitable limitation on the Buyer’s ability to run the business • An artificial limitation on the Buyer’s ability to integrate the business into the Buyer’s operations • The business is to be run “in the ordinary course of business consistent with past practices” • How do you translate this into practice? • Particular restrictive covenants may be imposed upon the Buyer • Contractual commitment by the Buyer to particular goals

7. Seller’s control over the outcome • Need to ensure that the Buyer is not able to artificially depress the results which give rise to the payment • Need to balance the conflict between the Seller’s short-term focus, compared with the Buyer’s long-term focus • Seller may manage the business in the short-term to maximize the earnout at the expense of the long-term prospects of the business • “Routine” vs. “fundamental” changes

8. Seller’s control over the outcome • Ability of the Buyer to cry “uncle” and take over all controls • Payment of full earnout • Payment of partial earn-out if the takeover follows particular events (e.g. which the Seller equates to mismanagement) • Compare this to a “kick-out” provision which entitles the Buyer to take over control without penalty if the Seller has not met certain specified performance thresholds (which are materially below those which would entitle the Seller to the earnout)

9. Seller’s control over the outcome • Is the earnout measured only by existing services and goods that are being sold, or does it include new services and goods that are introduced throughout the period of the earnout? • Totally new services and products vs. those that are “related” to the Seller’s current services and products • How do you deal with “bundled” products or “bundled” operations?

10. Seller’s control over the outcome • Is it appropriate/inappropriate to include an express contractual statement that the parties are acting as fiduciaries in this regard to impose a fiduciary duty?

11. Considerations of Payment of the Earnout • Period of measurement • Quarterly • Semi-annually • Annually • Can periods of good performance (well above anticipated thresholds) in some periods be used to supplement a lesser performance during another part of the earnout period?

12. Criteria for Payment of the Earnout • Flat fee payment? • All or nothing vs. graduated payments? • A percentage of the amount by which the actual outcome/performance exceeds the pre-determined threshold

13. Duration of Earnout Period • A particular period post-closing • Typically 2-5 years, but will vary depending upon the nature of the milestones to be measured

14. Determination as to whether the threshold has been satisfied • The Buyer must maintain separate books and records for the business unit which is being measured • Do the results need to be audited? • This will impose an additional cost upon the Buyer • “GAAP” is not necessarily sufficient • define the particular accounting principles to be applied (e.g. based upon Seller’s existing accounting policies and records)

15. Determination as to whether the threshold has been satisfied (cont’d) • Particular expenses to be excluded • Buyer’s management fees, bonuses, etc. • Administrative and general overhead expenses • except to the extent that services are provided by Buyer that were previously undertaken (but no longer undertaken) by Seller • Normalize the business operations to those which were used by the Seller pre-closing • Cf. increased salaries and bonuses • Inter-company transactions to be considered

16. Determination as to whether the threshold has been satisfied (cont’d) • Particular expenses to be excluded • Add-backs • Goodwill amortization • Resulting from heightened depreciation caused by a write-up in assets acquired on the acquisition • Consider less advantageous tax treatment post-closing (e.g. no longer a CCPC or no longer entitled to small business exemption or research tax credits?) • How to deal with extraordinary losses/gains?

17. Maximum Potential Payment? • Is it capped or is the sky the limit?

18. Other Considerations • What happens if the acquired business is sold during the earnout period? • What happens if the acquired business makes further acquisitions? • What happens if a change of control or focus of the acquiror? • Will the Buyer secure the future payments? • Payment of the earnout depends on the future financial viability of the Buyer • Force Majeure: how is the earnout affected by temporary events (e.g. natural disaster, act of war, labour strike, etc.)?

19. Jay A. Lefton Ogilvy Renault LLP Suite 3800 – 200 Bay Street Royal Bank Plaza, South Tower Toronto, Ontario, Canada M5J 2Z4 416.216.4018 (o) 416.998.1818 (c) jlefton@ogilvyrenault.com