1. Deferred Compensation in M&A Transactions ABA Business Law Section Spring Meeting Hermann J. Knott Partner, Luther, Köln, Germany Diane Holt Frankle Partner, Kaye Scholer LLP, Palo Alto, CA
San Francisco, 18 April, 2015

2. Agenda Context in which Earnout provisions are appropriate 3
Issues arising in negotiating Earnout provisions 4
Differences Between US and EU Earnout provisions 5
Examples – sample clauses 6
Post-Closing Dispute Resolution – Issues
San Francisco, April 18, 2015

3. Earnouts Context in which Earnouts provisions are appropriate
Valuation gap between vendor and purchaser – portion of the purchase price depending on short term revenue goals
Uncertain event expected to materialize within a short term – if it occurs it will have an impact on the present valuation of the target business
Intervening events potential ground for dispute
Incentive for vendor to stay on with the target business for a defined period
Earnouts work best when there is close alignment between buyer and seller as to the value produced by milestone event. Retention bonuses can be tied to same event.
Often used in tech and life sciences deals because these are growing businesses with significant upside potential, but capital constrained
San Francisco, April 18, 2015

4. Issues Arising in Negotiating Earnouts
Examples of milestones include obtaining government (eg. FDA) approval, or revenue targets for identified products or the business, or gross margin, EBIT or EBITDA targets.
Are the milestones objectively determinable?   Are the triggers too complex? How are derivative products handled?
Are there reporting obligations? Is there any right of setoff?
What is the dispute resolution process?
Is obligation to act in good faith express or implied, or disclaimed? Are commercially reasonable efforts required, and if so, is this term defined?
What is the impact of an acquisition of buyer or seller’s business? Other changes?
Earnouts often result in post-closing disputes.

5. We Observed Some Differences Between US and EU Earnouts
Use of gross margin, EBIT or EBITDA targets.
Standard for buyer behavior post-closing during the earnout period (eg, good faith, commercially reasonable) or disclaimer of standard.
Implied covenant of good faith and fair dealing (eg. DE case law (Winshall, American Capital, Fortis Advisors).
Reporting requirements, obligations to retain records.
Changes to the business.
Right to setoff.
Dispute resolution procedures.

6. Examples
Disclaimer of obligation as to conduct of business post- closing
Each Seller Party acknowledges and agrees that (i) from and after the Closing and except as expressly provided to the contrary in this Agreement, Acquiror and its Affiliates have the right to operate, sell or market the Purchased Assets, including the Earnout Products, in any way that they deem appropriate in their sole discretion, and (ii) Acquiror and its Affiliates owe no fiduciary duties or other express or implied duty to any Seller Party, including an implied duty of good faith and fair dealing.
San Francisco, April 18, 2015

7. Examples Covenant regarding conduct of business
The Seller acknowledges and agrees that from and after the Effective Time the Purchaser may operate the Surviving Corporation in any manner deemed by the Purchaser, acting in good faith, to be appropriate; provided, however, that the Purchaser and the Surviving Corporation shall use Commercially Reasonable Efforts to obtain the Pre-Market Approval. The Purchaser expressly disclaims, and shall not be subject to, any express or implied obligation to take, or omit to take, any action to obtain the Pre-Market Approval or to maximize Net Sales of US Company Products.
San Francisco, April 18, 2015

8. Examples Deemed completion
The Integration shall be deemed completed for purposes of this Section 4.7 if the Integration cannot be achieved for reasons not caused by the Seller or by Mr. W, in his capacity as managing director of the Company, provided the milestone plans pursuant to Exhibit 4.7 have been followed by Mr. W in his capacity as managing director of the Company to the extent reasonably possible and Mr. W. in his capacity as managing director of the Company has used his reasonable best efforts to complete the Integration.

9. Examples Impact of post-closing events
Notwithstanding any provisions herein to the contrary, in the event that either (A) all or substantially all assets related to the Products or (B) all or substantially all of the capital stock of the Surviving Corporation (provided that the Surviving Corporation continues to own all or substantially all of the assets related to the Products), is sold to, transferred to, merged or otherwise combined or reorganized with or into a Third Party, then the maximum possible amount of the Earnout then payable pursuant to this Agreement (excluding amounts previously paid with respect thereto) shall become immediately due and payable by the Purchaser to the Holders, unless such Third Party expressly, or by operation of law, assumes the obligations of the Purchaser with respect to the payment of such Earnout.
San Francisco, April 18, 2015

10. Earnouts – Post Closing
Dispute resolution
Fulfillment of financial criteria
Ascertain whether triggering event has occurred
Legal issues: courts or arbitration
Upon written notice, parties to seek to resolve differences in good faith
Public accountants; possible to use new DGCL Code provision – statutory binding arbitration
Fees of the dispute resolution process – arbitrators – borne equally or by the complaining party if change insignificant in their favor, or by the purchaser
Access to books, records and personnel/confidentiality agreement
Binding, nonappealable, conclusive
Expert arbitrator
San Francisco, April 18, 2015