MIDDLE MARKET FIRMS CAN SUCCESSFULLY STRUCTURE FOREIGN ACQUISITIONS: Despite the generally low value of the dollar against major foreign currencies, US acquisitions of foreign companies are likely to accelerate, at least in the near term.

In the article below, " Earn-Outs and Acquisitions of Foreign Companies: Middle Market Firms Can Participate,” FOCUS Principal Brad Fleisher draws upon his expertise in cross-border European transactions. Brad is an experienced entrepreneur and attorney with over twelve years of international corporate and business development experience. He was in-house Counsel for Eastbrokers International (Nasdaq: EAST), a Central European Investment Bank, and also co-founded and served as Executive Vice President of Spectrum Europe, an Eastbrokers spin-off that invested in radio stations located in Western and Central Europe. Prior to joining FOCUS, Brad founded and served as President of Adlego Solutions, a healthcare consulting firm.

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Earn-Outs and Acquisitions of Foreign Companies: Middle Market Firms Can Participate

By Brad Fleisher, FOCUS Principal

According to The Association for Corporate Growth,* there were 1,098 US acquisitions of overseas companies in 2004 for a total value of $117.2 billion. This represented 16 percent of all reported M&A activity for that year. Volume was up from 913 deals with total value of $88.3 billion in 2003 but down from 1,660 deals and a total value of $154.5 billion in 1998, the peak year for US acquisitions of overseas targets in the past decade. Despite the generally low value of the dollar against major foreign currencies, US acquisitions of foreign companies are likely to accelerate at least in the near term.

Middle Market Firms Can Grow Successfully Through International Acquisitions

Can middle market firms participate in this activity or acquisitions of foreign companies reserved just for the Fortune 500? Of the 3,047 deals done outside the US that disclosed terms in 2004 (includes non- US buyers and sellers), 2,150 deals or 71 percent were valued between $5 million and $100 million (1,205 were valued between $10 and $50 million). Clearly, there are plenty of entrepreneurs growing their small and medium size companies in international markets through acquisitions.

Foreign acquisitions have all the risks, and then some, of other international growth strategies. To name just a few with a uniquely international flavor, there is political risk, currency risk, and the biggest risk of all, the cultural, operating risk. But of course with greater risk comes greater return. One way to mitigate the risk is to structure a deal with a contingent payment or an “earn-out”.

Contingent Payments or “Earn-Outs” Can Mitigate Risk

An earn-out is simply a performance-based component of the final purchase price in a merger or acquisition. Earn-outs accomplish numerous objectives – the most common being to bridge the gap between the seller’s and the buyer’s projections of future performance – but in small and middle market transactions earn-outs have one particularly attractive advantage. They preserve cash.

Instead of paying the entire purchase price in cash immediately, a buyer can structure a deal paying a portion in cash at the closing and the balance paid over time. Earn-outs also spread the risk of future performance, particularly helpful when the buyer seeks to introduce a product or service into an unfamiliar culture, and creates a framework of incentives for performance minded management teams.

The three key elements of an earn-out, which have many combinations and permutations, are:
• Earn-out metrics or indicators,
• Exchange of value,
• Termination.

One obvious but important caveat: An earn-out can only be used when the seller’s owner/manager stays on to operate the company. In an international acquisition this is not much of an issue, since a principal objective of the deal is almost always to acquire and develop a relationship with a team who can operate successfully in the foreign culture.

Earn-Out Metrics for Triggering Future Payments

The most common earn-out indicator for triggering the future payment is usually one or more financial metrics. Buyers, particularly public companies, like to use EBITDA or net earnings because these metrics drive their stock price. Sellers sometimes prefer total revenue or gross earnings because there is less room for adjustments (for instance, imputed operating expenses as a result of synergies generated by combining the companies) that can work against the management team when striving to meet the earn-out objectives. More creative earn-out indicators could be launching a new product, achieving certain market share, or opening up a new sales channel depending on the buyer’s strategy to penetrate the foreign market.

Exchange of Value Ties Objectives With Compensation

The exchange of value ties the earn-out objectives with compensation, which can be cash, stock or a combination of both. Sounds simple enough? Assume that a firm generates $500,000 of EBITDA in a financial year and is scheduled to receive $2,500,000 in cash or stock as a contingent payment to the sale of the company. What if the seller falls short of the earn-out target by a few points? Are they entitled to any compensation? This can be terribly de-moralizing – the direct opposite of what the earn-out is supposed to do – creating disincentives for management teams in follow on years, or even once a few months of projections are missed.

There are many solutions to this. Earn-out floors or minimum hurdles can be structured into the deal as well as capping compensation payouts. Perhaps the earn-out compensation is pro-rated. The key here, as is the case with all the other elements of the earn-out, is to negotiate and define the terms during the deal stage and not during the integration of the companies.

Termination of Earn-Outs

Usually earn-outs terminate based either on the completion of a time frame or upon meeting the earn-out milestone. Typical time frames are two to three years. Less than two years may tempt management to focus on short-term performance to the detriment of long-term planning and investment. Lengthy periods open the door for wide fluctuations in external events (e.g. political risk). Issues abound here too. What happens if the acquiring company is, in turn, bought out and new management has different priorities for international divisions? Do the earn-out payments accelerate or terminate? One solution is to structure an option to purchase the remaining term of the earn-out (sort of a buy-out of the buy-out).

Structuring Foreign Acquisitions Using Earn-Outs Can Be a Cost-Effective Tool

There are other issues to consider, some of which are critically pertinent to foreign acquisitions. One glaring example is using GAAP accounting to measure financial earn-out indicators. GAAP is not the perfect measurement stick in US deals not to mention in countries that have their own accounting rules.

Notwithstanding the risks and possible complexities, structuring acquisitions using earn-outs can be a strategic and cost effective tool for US small and middle market companies to penetrate foreign markets. The key is to carefully think through the issues and clearly define the terms.
*Source: Mergers & Acquisitions The Deal Maker’s Journal, February 200,5 published by the Association of Corporate Growth.
DISCLAIMER – The contents of this article are intended to provide pertinent information for FOCUS Newsletter readers interested or already involved in international trade. While every effort is made to convey accurate and timely information, the contents of this article are not intended as specific advice to its readers. Our intent is solely to convey information.

*Source: Mergers & Acquisitions The Deal Maker’s Journal, February 200,5 published by the Association of Corporate Growth.
DISCLAIMER – The contents of this article are intended to provide pertinent information for FOCUS Newsletter readers interested or already involved in international trade. While every effort is made to convey accurate and timely information, the contents of this article are not intended as specific advice to its readers. Our intent is solely to convey information.

This article originally appeared in the September 21, 2005 issue of “Beyond Virginia,” the newsletter for the state of Virginia’s Economic Development Partnership, Division of International Trade.If you would like assistance with the development or implementation of your global growth strategy, or if you would like to explore this topic further, contact Brad at brad.fleisher@focusbankers.com or at 202.470.1965.

RECOMMENDED READING: New Mergers & Acquisitions Article Examines Sarbanes-Oxley Act (SOX) Compliance for Private Companies

The October 2005 issue of Mergers & Acquisitions includes an article entitled “Private Companies Toe the SOX Line.” The article notes that demands for SOX compliance fall across a broad front and suggests that applying SOX internally in advance of a transaction can make a company a more attractive target and help the seller secure the best purchase price. Here are brief excerpts from the article:

“A ‘SOX-ready’ private target will make for an attractive candidate and even may fetch a premium, if the buyer is spared post-deal cost and trouble and faces reduced risk of SOX liability…A ‘SOX-ready’ private target, conversely, will make for an attractive candidate and even may fetch a premium, if the acquirer is spared post-deal cost and trouble and faces reduced risk of SOX liability…As a result, acquirers are incorporating SOX compliance into their due diligence processes and requiring targets to fully document internal controls and correct deficiencies as a condition of closing the deal.

…private companies should look to SOX as a ‘best practices’ guide and implement provisions that and applicable and cost-effective. Many of the law’s corporate governance measures, such as establishing board committees and developing a code of ethics for senior officers, make sense because they can be accomplished at reasonable costs that are significantly out-weighted by the benefits provided. Good corporate governance provides legitimacy to corporate records and actions, provides for the standardization of processes to improve efficiency and accuracy, and results in more accurate financial reporting for internal management to evaluate.

SOX requirements and other ‘best practices’ that private companies may consider adopting include:
• Recruiting independent directors for boards and board committees;…
• Ensuring proper registration of an outside auditing firm;
• Evaluating and documenting internal controls and procedures and improving them if necessary;…”

The complete article appears on pages 34-36 of the October issue of Mergers & Acquisitions: The Dealmaker’s Journal.

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About FOCUS Enterprises, Inc.

Headquartered in Washington DC, with offices in Atlanta, Chicago, and San Francisco, FOCUS provides a range of investment banking services tailored to the needs of middle market companies. FOCUS specializes in transactions for entities with $5 to $100 million in revenues, serving entrepreneurs, corporate owners, public companies, private companies or operating units, and various types of investors.

For 23 years, FOCUS has successfully integrated corporate development consulting and transactional expertise with its extensive research capability. The firm has long standing experience in completing mergers, acquisitions, divestitures, capital formation assignments, corporate development consulting projects, and financial advisory engagements.

Over twenty FOCUS Partners and Principals provide over two centuries of C-level operating experience in a variety of industries.

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