Price Negotiation

Case: Printicomm’s Proposed Acquisition of

Digitech: Negotiating Price and Form of Payment
 Consideration Shares
• Consideration shares may be offered as non-cash consideration by a buyer in a transaction. The shares offered may be
common voting shares, non-voting shares, or preferred shares with the right to preferential dividends. The issuance of
consideration shares is common by public company buyers, since the value of the shares can easily be determined.
However, private companies also issue consideration shares, which requires the seller to conduct additional due diligence
on how the value of the shares is determined.
• Cash is the best consideration since there is no risk associated. With any other form of consideration, there is additional
risk which the seller needs to be compensated for in the form of future return. 

When consideration shares form part of a transaction structure, the key questions are:

• How is the value of the consideration shares determined, and are the assumptions in this valuation reasonable?
• What is the future value of the shares when they get monetized, and will the eventual return compensate the seller for
the associated risk of holding them?
• How easy will it be to monetize the consideration shares in the future?
• These are difficult questions to answer during seller due diligence. At a minimum, the valuation methodology should be
assessed - is it an EBITDA multiple that is being used? If so, trailing 12 months or an average of 3 years EBITDA? Is the
multiple reasonable against other comparables? 

The seller should also review the buyer's previous history of creating value for its shareholders. While the past is not
indicative of the future, a history of success goes a long way in generating confidence that the shares received may
actually be worth more when they are sold in the future. 
 Contingent Consideration
• Contingent consideration is the amount paid by the acquirer of a target company to the former owners of said
company in case of the occurrence of certain future events. The exact events and their terms are outlined in the
acquisition agreement entered into by both parties at the time of signing.
• Contingent consideration, commonly known as earn-outs, is a common practice in mergers and acquisitions
(M&A) deals as it helps to get the buyer and seller on the same page when it comes to valuation. The contingent
consideration is paid over single or multiple periods and is often calculated based on many financial metrics such
as revenue; gross profit; earnings before interest, taxes, depreciation and amortization (EBITDA); and profit before
tax (PBT). In some specific industries, like pharmaceuticals, non-financial metrics are also used for calculating
contingent consideration and these metrics include clinical trials, employee and customer retention targets, and
development of software or other research and development (R&D) strategies.
• The stipulated contingent consideration is paid either by cash or equity shares. However, a general rule is that
contingent considerations that are settled by equity have more complex valuation when compared to contingent
considerations that are paid by cash. In both cases, though, it is calculated based on the fair value and this value
depends on the share price prevalent on the date of acquisition. 
• Many methods are used to calculate the value of contingent consideration: some of the more popular ones are
discounted cash flow (DCF) and, the more complex, Monte Carlo simulation. The exact type of valuation will
depend on the payout structure and the financial arrangements to make these payments. Besides the valuation
method, contingent consideration also depends on the approach taken by both the buyer and seller.
•  
 Deferred Consideration
• Deferred consideration is a portion of the purchase price that is payable by the buyer in the future, after closing. Purchase
price is negotiated on the basis of a fair market value of the target firm. The actual amount of consideration in all forms is
determined and the terms of payment are decided.
• A variety of factors influence the actual negotiated price. Payment may be in the form of cash, debt, assumption or payment of
liabilities, stocks, or future payouts. There will be a payment up front in the form of equity in the buying firm or a promise to
pay cash depending on the achievement of profit targets or turnover targets. Future payments are agreed upon for the
following issues:

• Interest
• Payment interval
• Balloon payment
• Form of payment
• Collateral/security
• Restrictive and affirmative covenants
• Deferred consideration allows the purchaser to defer the acquisition cost. In periods of poor liquidity, a deferred consideration
system helps to get the deal through. However, the seller faces a risk and tries to secure a high upfront payment, sometimes
even in exchange for a reduced price. A seller may seek a bank guarantee or collateral whereby no assignation can take place
without the seller's consent. Sometimes deferred consideration may be set off by the buyer against indemnities payable by the
seller. If the consideration is contingent to certain conditions being met before payment can be made, then the parties agree
to a mechanism for payment. The funds may be placed in an account and released as per the terms agreed. Sellers have a
vested interest in the firm in the future in the form of deferred or contingent payment.
•  
 Comfort Letter
• A comfort letter is a document issued by an independent auditor in a
preliminary prospectus stating that while a full audit has not been
conducted, an audit of just the target company's financial statements
did not reveal any adverse change in operations or financial results.
• A comfort letter is requested from the auditors of both parties during a
merger if shareholders of the target company are receiving the
acquirer's shares. The prospectus in a merger transaction includes
combined pro forma financial data to show the financial status, had the
transaction occurred. Separate financial statements of both the target
and acquirer are, therefore, needed to show normal financial activity.
• A comfort letter provides assurance that the results of an audited
financial statement would be no different from the preliminary
prospectus had a full audit been performed.
 Tail Period
•  
• A tail period is the time period during which an investment banker working on a company's sale is entitled to payment,
even after termination of services, if the deal closes within the period. It is a provision in the engagement letter and is
found under clauses relating to termination of services.
•  
• A firm, after deciding to go in for sale, engages an investment banker to draft an information memorandum, solicit
interest from potential buyers, and negotiate a deal for which an engagement letter is issued. This document stipulates
the terms and conditions relating to the investment banker's work, payment, termination, etc. If a deal is carried out by
the firm within a specified time period (usually 12 to 24 months) after the termination of services of the investment
banker, the banker is still entitled to fees related to that transaction, whether it relates to the efforts of the investment
banker or not. The 12- to 24-month time period is called the tail period. This prevents potential unfairness to the
bankers who expend time, effort and resources to identify potential buyers, even if they don't seal the final deal. 
• The scope of payment and time frame under tail period provisions depends on the firm and the banker. Some
investment bankers prefer to cover the entire gamut of potential buyers who display an interest and then sign the
confidentiality agreement or are provided with the confidential memorandum. Most firms, however, try to restrict tail
period payouts to only those cases where the buyers have actually started negotiations for the sale. The actual amount
and time frame depends on the bargaining capacities of the firm and the banker. Whatever is decided is recorded in a
tail period clause in the engagement letter.
•  
•  
•  
 IB League Table
• An investment bank league table is a ranking of investment banks based on deals made within
a certain period. The rankings may be performed quarterly or annually. The rankings are used
by companies that compile this type of data for performance analysis and M&A purposes.
• Investment bank league tables use different financial metrics to analyze data and rank the
firms. For example, one table may rank i-banks based on the dollar volume of deal transactions
as well as market share value for a specific period, or they may rank banks by the amount of
accumulated transactional fees.
• Investment bank league tables assist investors involved in merger transactions in choosing firms
based on performance (as in how many deals a firm has completed), fees netted as a result of a
deal, and a transaction's terms and price.
• Financial activity rankings for companies in the dealmaking market can be regional or global.
Regional firm activities are deal transactions within a continent and global firm activities are
deal transactions across borders. Regional deal transactions may boost the number of deals for
banks, but collect less in fees. Global investment banks are more apt to collect transactional
fees in cross-border deals as bankers are required to be in multiple locations working with
international regulations, which can lengthen the deal completion period.
 Deal Fatigue
• Deal fatigue is a condition during a deal negotiation in which the involved parties begin to feel frustrated;
helpless, as well as irritated; and fully exhausted and fed up. There tend to be feelings of resignation as
negotiations drag on endlessly, causing the parties to lose hope of reaching an agreement. 
• Deal fatigue is an important issue and seasoned professionals can help you through this obstacle.
Experienced intermediaries remind participants about the mutual advantages of the deal and the overall
objectives of it if they are losing sight of the big picture and the major issues of the deal because they are
getting stuck on unimportant details.
•  
• It is natural for negotiating parties to become disillusioned and fatigued during protracted deal negotiations.
This may happen even to bankers, attorneys and other intermediaries handling the discussions. Many deals
are abruptly abandoned on account of parties suffering from deal fatigue. The bitterness can result in
unnecessary harsh words and the negotiators may lose ground already gained, causing all the money and
effort spent to be wasted. 
• Deal fatigue may also cause a lack of interest in active negotiation and the tendency to give in to pressure,
ultimately providing an unfair advantage to one single party. This issue must be promptly addressed by the
deal advisors. They should help the parties to negotiate without losing patience and maintain the spirit of
balance in search of a win-win compromise. The emotional elements that cause a deadlock should be
analyzed, and both parties should be guided to look for a creative-rational approach to solve the issues.
•  
Price and Form of Payment in M&A
Letter of Intent
Exclusive Right to Negotiate
Exclusivity Period
Managerial Know-How
Revenue Synergies
Cost Synergies
EBITDA Multiple
Going-Concern Enterprise Value
Contingent Payments
  
Governing the Earnouts

• A key challenge of earn-outs is balancing the desire of the buyer to fully integrate the acquired business with the seller’s goal to maximize the
value of the earn-out. In many instances, the seller retains no control of the acquired business, and is wary of the buyer implementing operational
changes that may adversely impact the revenue generation or expense structure of the target. Conversely, the buyer’s goal is to maximize the
long-term value of the target as part of its platform, regardless of potential short- term impacts to metrics that determine the earn-out. As a
result, there are number of considerations which are typical negotiation points in transactions containing earn-outs.
•   Procedure for determining earn-out financial metrics: Typically the buyer and the seller will agree on a set of accounting principles to be applied
during the earn-out period as a supplement to the usual financial statements, strictly for purposes of measuring the earn-out (i.e., procedures for
determination of earn-out EBITDA).
•   Operations of the business: There are a number of seller-friendly covenants that are sometimes contemplated when structuring earn-outs that
have been on the rise in recent years: (i) covenant for buyer to continue operating the business consistent with past practices, and (ii) covenant for
buyer to operate the business in order to maximize the earn-out. Conversely, buyers (especially those that are public) may limit their obligations
to the seller by explicitly disclaiming any fiduciary obligation to the seller with respect to the earn-out. For example, buyers may attempt to
negotiate the following or similar language:
• o “Seller agrees and acknowledges that the Buyer may from time to time make business decisions in a manner consistent with the best interests
of the consolidated business operations of the Buyer and its subsidiaries, taken as a whole, including actions that may have an impact on the Earn-
Out. Except as otherwise provided in this Agreement, the Seller shall have no right to claim any lost earn-out or other damages as a result of such
decisions so long as the Buyer did not intentionally take such actions for the primary purpose of the payment of the Earn-Out”
• o “For the avoidance of doubt, Seller acknowledges and agrees that Buyer shall retain full and sole discretion as to the conduct and operation of
the business of the Company, and in no event shall Buyer have any obligation (express or implied) to achieve or maximize the Earn-Out. Without
limiting the generality of the foregoing, Buyer may make from time to time such business decisions and take such actions as it deems appropriate
in good faith following the Closing, including decisions or actions that may have a negative impact on the Earn-Out.”
•  Acceleration of the earn-out upon a change of control event for the buyer during the earn-out period.
• Regardless of any provisions and covenants the seller may be able to obtain, ultimately control of the business is being relinquished to the buyer.
As a result, the value ascribed to an earn-out is greatly influenced by the level of trust between buyer and seller. Thus, while the overall cultivation
of trust throughout is important in any M&A process, it becomes even more crucial in transactions that involve earn-outs.
•  
 Measuring Performance in Earnouts
• Typically, the value of an earn-out is based on the achievement of some type of financial metric,
such as revenue or EBITDA, over a specified period of time. The economics of an earn-out can
also be based upon achieving non-financial targets, such as product milestones. Some earn-outs
employ a combination of financial and non-financial metrics. When structuring the economics of
a potential earn-out, some key considerations include:
•   Choosing the appropriate metric: For earn-outs tied to a financial metric, sellers often prefer
to use revenue as it is least affected by any operational changes made by the buyer. In contrast,
buyers prefer to use EBITDA or a similar profitability metric that is more reflective of the
contribution of the acquired business.
•   Complexity: Typically, earn-outs are structured as a percentage or multiple of revenue or
EBITDA, or as a payment for reaching a specific milestone. However, other more complex
features can be incorporated, such as minimum thresholds, caps on maximum payouts, tiered
payment structures, etc. The more complex an earn-out, the more difficult it is to document and
govern post-close. In these instances, revisiting an acceptable purchase price at close may be a
better alternative.
•   Duration: Based on data from SRS Acquiom, the majority of earn-outs (72%) resolve within
three years of close with nearly 50% concluding within two years. An overly long earn-out period
can interfere with the successful integration of an acquisition.
 Why Earnouts?
• Often, when buyers and sellers want to complete a deal but can’t agree on the price, they employ a strategy called an “earn-out.” An earn-out is a contingent payment that
the seller only receives from the buyer when specific performance targets are met.
• Why Earn-Outs Are Needed
As a seller, you know your business’s potential. Perhaps you’re introducing a new product that you’re confident will boost revenues. Or you can see that your marketing
campaign is starting to gain traction with customers. As a result, you sincerely believe that this upside should be reflected in the selling price.
• Of course all buyers are from Missouri—and have a “show-me” attitude toward predictions of future profits. Writing for Inc., Christine Lagorio-Chafkin points out, “it's
commonly known that roughly three-quarters of all mergers and acquisitions fall short of the expectations that are stated when the deal is announced. And about half of all
deals result in a loss of value for the buyer’s shareholders.”
• In other words, buyers have a rational basis to be concerned about paying full price for growth potential.
• Structuring an Earn-Out
The earn-out is a good way to hedge the buyer’s risk of overpaying. It also allows the seller to benefit, if and when the business’s potential materializes. The key factor to
keep in mind is that you, the seller, will normally be expected to stay on board, running the company during the earn-out period. This could extend for several years.
• That’s why the terms of your engagement during the earn-out period should receive close attention. Will you have autonomy as before? Will you be able to retain key
employees? And will you control the budget? If you don’t have the proper tools, you may not be able to achieve the results you’re expecting.
• You’ll also need a team of lawyers, accountants, and M&A consultants to negotiate the specific terms of the earn-out agreement. Foremost is the percentage of the selling
price that will be allocated to the earn-out. In general, experts say that 40% is typically thought of as the minimum amount needed to keep the seller motivated.
• Then you have to agree on the numbers themselves. Will the target be revenue growth, EBITDA (earnings before interest, taxes, depreciation, and amortization), or gross
profit? Or will a specific event, such as the signing of particular contracts, signify that the goal has been met? Will there be milestones or annual increases in the growth
figures? Who will compute the results? What accounting method will be used?
• In addition, there are also tax considerations that affect buyers and sellers differently. And don’t forget dispute resolution mechanisms, including the terms for what
happens when either the buyer or seller wants to exit the agreement earlier than the stipulated date.
• How to Make Earn-Outs Work
Obviously, there’s a lot here for the lawyers, accountants, and consultants to sink their teeth into. However, experts advise that the best strategy for both parties is to try to
keep the terms as simple as possible. Remember, during the earn-out period, you’ll be working as a partner (or possibly as an employee) of the acquirer. Thus, it’s in
everybody’s best interest to focus on success, rather than on milestones and a maze of intersecting benchmarks.
• Another key to success is for you to retain autonomy as CEO. As stated above, it’s essential to have the authority to make necessary expenditures, and to keep your key
people working with you. Smart buyers will understand this. In fact, in many acquisitions, keeping the previous owner involved may be as important a part of the earn-out
as the actual selling price. Of course, if the buyer wants to eliminate non-strategic redundancies—such as back office functions—there’s no reason to protest. In fact, it
could help make your job easier. 
•  
Intellectual Capital
Commercial Printing
Industry Consolidation
Strategic Acquisition
Fixed Price Deal
Acquisition Payment Mechanism
Tax Treatment of Earnouts
 What are the Alternatives Available for
Printicomm?
Develop Time and expense of creating viable software program with capabilities of
Marketelegence were likely to be high
Capability Used as an option when failed to reach a reasonable price for Digitech
Cost to develop technology: $50 million
Internally Time to have working prototype: ~2 years

Too late to acquire an alternative company

Find Another Digitech technology is superior to current competition, worth a premium price
Greene possessed strong managerial skill
Company to Difficult to find another guy with same managerial skills
Purchase Frustrating to start negotiating with new company – time and energy spent on
Digitech

Alternatives
Easiest to consummate
Requires standard purchase-and-sale agreement
Highlighting total consideration in amount and form
Fixed-Price Deal Risher opinion - If paid a premium price for Digitech, Digitech’s management
will have little incentives to stay and continue to grow business. Retention of
Greene and Buckingham was critical to integrating companies and
transferring business knowledge between two companies

Earnout
 Earnout Structure
5 -Year Earnout
3 -Year Earnout
3.5 3.5
2.5 2.5
3 3
2.5 2

1999 2000 2001 2002 2003 1999 2000 2001

Down Payment: $20 Million Down Payment: $28 Million

Seller will receive all operating profits exceeding trigger amounts over the life of the deal
What is your Choice for this Deal?

Fixed
Price
Choice
Earnout
If you are working with Digitech what will you prefer?
 Why Earnouts in this Deal?
Used to move potential transaction
forward
Additional
payments to
seller

Some portion of purchase price of

Digitech to be paid by Printicomm on
Digitech attaining certain agreed-
upon performance goals after closing
Motivation to
shareholders /
managers Benefits Bridge the
valuation gap

Made lot of sense from an economic

perspective

Retention of
shareholders
and managers

Win-win situation
What Digitech Should Choose?

Fixed Price
Choice 5-years
Earnout
3-Years
What Princticomm Should Choose?

Fixed Price
Choice 5-years
Earnout
3-Years
 Features of Earnouts

May be an Long the term,

instrument, an Incentive payment more the uncertain
agreement, or a plans are options in payment; will
contract have more value

Valuing an incentive An extremely useful

Challenging
payment requires device to break
instruments to
accounting for deadlocks in deal
structure
optionality negotiations
 Earnout
Time Deducted as
expense (Lower
period will be cost)

Based on achievable
performance goals

Key Tax
Treatment
Drivers
Elements

Provide Digitech Digitech management

management with should receive
required resources adequate
and operating compensation creating As dividend
freedom that value (Paid from after-
Earnout tax earnings) –
conservative
Targets View

Valuing Earnout: Simulation based valuation model

Expected distribution for value drivers - sales growth, profit margin
Why there is a Need for Earnout in this Deal?

Abandonment not desirable – good strategic and

Have toNegotiation
walk reached
away from
organizational the an impasse
deal
motives in the
for
over price
absence
deal of creative
alternative
 No for Earnout!

Misleads - Leads to legal

confuses the Agential Issues confusions and
shareholders preachment

May discourage
Complexity of
postacquisition
definition
integration
 Earnout Harms Printicomm
No compulsion on
Affect post Corporate
the acquired firm’s
transaction restructuring will
management to
integration be difficult
support

Accounting Selling below

Ballooned credits
numbers can be required ROA or
sales
easily managed ROE

Fail to spend any

May not maintain Will not bother of
sensible money in
the assets carefully customer loyalty
Capex
 Earnout Harms Printicomm
Digitech will impose
May not have long Digitech having
growth stimulating
term focus unlimited upside
behavior

Digitic may
Operating income
Step wise may not cummulate and try
ignores capital
motivate Digitech to hit the target
spending
once

What if there is no
Digitech may
liquidity in business Who will spend on
cannibalize
meet the payment common problems?
products
of Digitech?
 Earnout Harms Printicomm
Liquidity preference of the
seller’s shareholders could
How to bring in scale and
dominate the desire to
scope benefits?
maximize payment
through an earnout

Overly aggressive
performance goals
 It also Harms Digitech
Acquirer may not Stepwise target creates Printicomm may not
support acquired to doubt in the minds of encourage Digitech
reach the target Digitech products

What if parents go What will happen to

Too much control from agains t the interest of earnouts on non-
parents Digitech’s existence of the
management? company?

Buyer fails to provide

What if the acquired Occurs on postmerger
resources necessary to
firm if fails to honor the integration is handled
actually grow the target
claims of earnout? badly
and maximize value
 It also Harms Digitech
May invite legal action by
the seller on perceived
What is the level of How printicomm will pay
measurement problems
seniority treatment on on any assitance taken
and Lack of senior-
liquidation of the firm? from Digitech?
management support to
maximize performance

What will be the tax What if there is a macro

What is regulation
treatment on the economic shock on the
changes?
earnouts? firm?

What if industry goes Fails if manager’s don’t

What if tax issues pops in? through structural own a significant earnout
changes? claim
 It also Harms Digitech

What if industry goes

What if tax issues pops
through structural
in?
changes?

Acquirer may allot

Fails if manager’s don’t more Fixed cost, to
own a significant discourage booking
earnout claim higher operating
profits
 How the Earnouts can be Improved to be
More Effective?

Relatively constant series

Trigger amount should rise Can have one overall target
of triggers enhances
more aggressively for all 5 or 3 years
probability of future payoff

Structure the earnout as a

lump-sum payment at the
Year-by-year payment Peg earnout to the
terminus of the earnout
encourage short-term accumulated performance
period based on
thinking over time
performance over whole
period
How the Performance Goals in the Earnout
can be Imrpoved?

Clearly
defined

Easily Mutually
measurable Elements understood

Attainable
Alternative Targets in Earnouts

Revenues

Holdback Net
allowances income

Targets
Stock Free cash
options flows

Composite
Escrowed
of more
funds
than one
 Suitability of Performance Goals in Earnouts

Target Variable Suitability Risk Involved

Integrating operations of two companies

Selling products at low margin
Revenue When target management is not expected to
Capacity limitations
be with the company

Gross Margin Target to be profitable Buyer will dictate on expenses

Discourages integration
Pre-Tax Profit Target business to perform well in all respects
Requires freedom of operations for the target

When EBITDA multiple used to value the

target Will not work on a firm with accrual concept
Cashflow or EBITDA
of accounting
When buyer is short of cash

Non-financial requirements – R&D, new Measuring the milestone achievement may

Milestone
product, licensing, IPR be ambiguous

Attaching appropriate weight for each Vey confusing and too much pressure on
Combination of Above
variable Target firm
 What are the Critical Issues in Printicomm
Should Consider While Designing the Earnout?

Accounting policies Availability of Management

of target firm financing processes

Liquidity and
Change in Impact on buyer’s
transferability of
ownership during financial structure
earnout
earnout period (as leverage)
agreements

Tax and accounting

consideration
 Historical and Projected Income Statements
and Cash Flows
Actuals reported by Digitech Forecast by Printicomm
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Sales 15,350 10,633 11,313 6,747 7,400 18,651 23,450 28,140 32,361 36,244 39,506
Nominal Sales Growth -31% 6% -40% 10% 152% 26% 20% 15% 12% 9%
Cost of Goods Sold 9,655 8,700 8,890 5,096 3,850 14,800 16,850 21,867 24,868 27,539 30,018
S,G&A 2,500 1,900 1,950 2,200 2,400 2,600 2,600 3,374 3,837 4,249 4,632
Depreciation 55 55 55 55 65 65 65 84 96 106 116
Total Expenses 12,210 10,655 10,895 7,351 6,315 17,465 19,515 25,325 28,801 31,894 34,766
Operating Income 3,140 -22 418 -604 1,085 1,186 3,935 2,815 3,560 4,350 4,740
Operating Ratio 80% 100% 96% 109% 85% 94% 83% 90% 89% 88% 88%
Operating Income After Taxes (40% Tax) 1,689 2,136 2,610 2,844
Plus Depreciation and Amortization 84 96 106 116
Less Capital Expenditures (1% of Sales) -281 -324 -362 -395
Less Additions to Wkg. Cap. (2% of Sales) -563 -647 -725 -790
Free cash flow 929 1,261 1,629 1,775
Terminal value (Growth Rate: 5%, Discount Rate: 10%) 37274.92
Total free cash flow 928.80 1261.17 1628.86 39049.91
Present Value of FCF 844.36 1042.29 1223.79 26671.62
PV of Total Free Cash Flows 29,782
 Historical and Projected Income Statements
and Cash Flows
Actuals reported by Digitech Forecast by Digitech
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Sales 15,350 10,633 11,313 6,747 7,400 18,651 23,450 28,609 34,331 40,167 45,389
Nominal Sales Growth -31% 6% -40% 10% 152% 26% 22% 20% 17% 13%
Cost of Goods Sold 9,655 8,700 8,890 5,096 3,850 14,800 16,850 21,985 25,789 30,173 34,096
S,G&A 2,500 1,900 1,950 2,200 2,400 2,600 2,600 3,392 3,979 4,656 5,261
Depreciation 55 55 55 55 65 65 65 85 99 116 132
Total Expenses 12,210 10,655 10,895 7,351 6,315 17,465 19,515 25,462 29,867 34,945 39,489
Operating Income 3,140 -22 418 -604 1,085 1,186 3,935 3,147 4,464 5,222 5,900
Operating Ratio 80% 100% 96% 109% 85% 94% 83% 89% 87% 87% 87%
Operating Income After Taxes (40% Tax) 1,888 2,678 3,133 3,540
Plus Depreciation and Amortization 85 99 116 132
Less Capital Expenditures (1% of Sales) -286 -343 -402 -454
Less Additions to Wkg. Cap. (2% of Sales) -572 -687 -803 -908
Free cash flow 1,115 1,747 2,044 2,310
Terminal value (Growth Rate: 5%, Discount Rate: 10%) 48,514
Total free cash flow 1,115 1,747 2,044 50,824
Present Value of FCF 1,014 1,444 1,536 34,714
PV of Total Free Cash Flows 38707.08
Earn out structures to be useful vehicle for substituting risk of
future cash flows from buyer to seller rather than seeking to
mitigate risk by increasing its hurdle rate for transactions
 What is the worth of the Earnout?
Deterministic • Deterministic analysis (Exhibit: 1)
• Takes one path of performance over time
Approach • Ignores uncertainty around that path

Probabilistic • Buyer and seller have different outlook about uncertainty

• Seller is more optimistic on growth rate and margins
Approach • Buyer is less optimistic

Printicomm's View Digitech's View

Sales Growth Rate
High 15% 30%
Best guess 10% 20%
Low 5% 10%
Profit Margin
High 15% 25%
Best guess 10% 20%
Low 5% 15%
74
 Valuing Earnouts
• Simulation draws assumptions regarding sales-
Simulation growth rates and operating-profit margin from
their own uncertain distributions

Probability • Repeating – probability of NPV distribution

• Mean, median and mode
of NPV • SD and range

Probability • Cumulative distribution left to zero on

horizontal axis
of –NPV • Deal would destroy value
 Valuing Earnouts

Bridges the
Likely to be differences
Tailor-made for
valuable, even Not free to between an
Works like a call situations of
if they are out- buyer; very optimistic seller
option great
of-the-money costly and a
uncertainty
today pessimistic
buyer
Approaches to Earnout Valuation

Simulation
Valuation
Approaches
Call Option
Approach
 Simulation Approach
Use the parameters as
described by the buyers
Identify the relationship
Take a decision on Variable and sellers and simulate
between Revenue and
to be Simulated (Monte Carlo Simulation)
Expense Variable
the selected variable series
(may be 1000 times)

Estimating the present

Add Down payment + Vlaue Estimate the Value of
value of Earnouts at each
of Earnout to get a list of Earnout on each simulated
point and summing up to
possible total value for the point (Using defined target
get the total value of
seller / buyer for each year)
earnouts

Evaluate the distribution

structure of the total value
Infer the likely value of
of those Earnouts by
Earnout
constructing a Frequency
Distribution Chart
 Printicomm Valuation of 3 Year Earnout Printicomm Valuation of 5 Year Earnout

0.14 0.14
0.12 0.12

P ROBABILITY
PROBABILITY

0.1 0.1
0.08 0.08
0.06 0.06
0.04 0.04
0.02 0.02
0 0

Digitech Valuation of 3 Year Earnout Digitech Valuation of 5 Year Earnout

0.16 0.16
0.14 0.14

PROBABILITY
PROBABILITY

0.12 0.12
0.1 0.1
0.08 0.08
0.06 0.06
0.04 0.04
0.02 0.02
0 0

Total Value to Buyers / Sellers using Simulation Method

 Earnout vs. Stock Option
Comparison of Earnout and Call Options on Common Stock
Call Option in Common Stock Earnouts Implication for Value of Earnouts
Some index of financial or operating
performance
Revenues
Earnings
Cashflows
Underlying asset Shares Market share or product introduction Earnout is a derivative security
Exercise price Stated strike price Benchmark, hurdle or triggering event Lower the benchmark; greater the value of eranout
level of index
Price of the underlying asset Stock price of underlying Revenues, Earnings, Cashflows Higher the performance; greater the value
Interim payouts Dividends Interim cashflows associated with earnouts Higher the interim payout; lower the value of earnout
Term of the option Term of the contract Max. of 5 years Longer the life; more valuable
Unceratinity Volaility of underlying stocks return Uncertainity of underlying Greater the uncertainity; more valuable the earnout
 Price Negotiation Tips
• Detecting Escalation on the other side
• Avoid inducing bold, firm statements from an opponent
1

• Don’t let acquisition synergy to move to the opponent

2
• Consider the other side’s position, before diving headfirst
into a negotiation
3 • Think through the motivations of the other decision makers

82
 Price Negotiation Tips
• Recognize how attractive is the auction to you and as well as
to others
4
• Ignore sunk cost
• Money, time, and energy you’ve spent in the past should
5 rarely affect your future commitments

• Seek the counsel of a wise adviser, one without a vested

stake in your decision
6 • Listen openly to tough advice and follow through on it

83
 Price Negotiation Tips
• Discourage others from escalating
• Communication can be a very effective tool
7

• Stay out of the trap

• Identify negotiation as a trap before it even begins
8

• Relationship between the size of the premium and

the success of the deal is not linear
9

84
 Price Negotiation Tips

• Right price is relative, not absolute!

10
• There may be a vast difference between the price one
company can pay for an acquisition and the price another
11 can pay

• “It’s the last deal of its kind,” - Myth

12

85
 Price Negotiation Tips
• Assets unavailable today could easily be up for sale
tomorrow
13
• “If you don’t acquire a target, a major competitor will” - ,
if the numbers don’t work for you, you should let your
14 rival have the target company

• Use real option and decision trees if required

15
 Price Negotiation Tips
• Use simulation to estimate in
16 uncertainty

• Never allow the manger involved in

17 negotiation to fix the price

• Establish stringent time bound post

18 acquisition targets
 Price Negotiation Tips

• Compare the value created by the acquisition to the value

that could be created by buying back your own shares
19

• Routinely review each completed acquisition rigorously to

better understand what makes for success or failure
20
• Keep data on the performance of previous acquisitions to
help
21 • them price future deals
 Price Negotiation Tips
• Use post transaction monitoring process to track how well the
acquisition or merger was performing relative to expectations and to
22 draw lessons about what should be done differently in the future

• Ensure that analytical rigor triumphs over emotion and ego

23

• Do a thorough risk analysis

24
 Price Negotiation Tips
• The price of making a mistake is greater than the price of
missing an
25 • opportunity

• Do a good job of communicating with employees, both

before and after the
26 • deal closes

• Improve external communication to the capital markets,

customers, suppliers, regulatory bodies, and geographic
27 communities
 Price Negotiation Tips
• Explain to external stakeholders what the
benefits of the deal are and how the
stakeholders will be affected, both positively
28 and negatively

• Quantifying the value of expected synergies

and report the progress made in achieving
29 them
Advantages and Disadvantages of Alternative
Collar Agreements
Determinants of Magnitude and Composition of
Initial Offer Price
Typical Sales Process
 Reps-and-Warranties Insurance

Insurance coverage that

First introduced in the
protects against losses
May also cover breaches US in 1998, but seldom
from breaches of reps
of tax indemnities used in M&A until
and warranties in an
recently
acquisition agreement

In recent years,
substantial increase in E.g., in 2015, AIG alone More common in private
the use of reps-and- closed 330+ insured company acquisitions
warranties insurance in deals than public deals
M&A deals
Increase in the use of Reps-and Warranties
Insurance
Marke • Hot sellers’ market
t • High seller leverage
• Accelerated Processes
Factors
Policy • Better pricing
• Better process
Factors • Better terms
Insurance Companies offering Reps-and-
Warranties Insurance

AIG AWAC Ambridge

Beazley Chartis Chubb

Euclid (spinoff Vale (f/k/a

Concord from AIG) Maple Point)
Types of Reps-and-Warranties Insurance
Policies
• Buyer is insured; makes claims directly against the

Buyer’s insurer
• Broader coverage, including for sellers’ fraud –
Extended terms

Policies • Higher liability caps

• Today, most policies issued are buyer’s policies

Sellers’ • Sellers are the insured; sellers pay buyer and are
reimbursed by insurer

Policies
 Metrics

Deal size • Target enterprise values from $20 million to $3 billion

Policy limits • $5 million to $50 million per policy

• Stacking of multiple policies is possible

Pricing • ~3-4% of policy limit

• 1-2% of target enterprise value (with drop-down after 12 months)

Retention • Buyer and sellers can agree to share retention in various ways
• Generally 1% to 3% of the transaction value

Policy period • Up to six years

• Can be extended beyond survival in underlying agreement
 Metrics
Two Types of • Buyer-Side Policy (includes fraud protection)
Policies and Seller-Side Policy

Amount of • Up to $300+ million for any one transaction

Coverage available through layered insurance programs

Price of • Generally 2% to 4% of the limit of liability

Coverage
Coverage • M&A Deals $20 million to $2 billion in
Candidates purchase price
Use of Reps-and-Warranties Insurance
• Limit (or eliminate) indemnity and escrow exposure; increase
ROI – Expedite negotiations
• Increase likelihood of getting to a signed agreement

Sellers
• Distribute Sale Proceeds
• Increase Purchase Price
• Supplement Disclosure Process
• Protect Passive Sellers
• Insure Certainty of Purchase Price
• Expedite Sale

• Increase protection against downside risks

• Enhance competitive attractiveness of bid

Buyer •
•
•
•
Easier to collect
Expedite negotiations
Increase likelihood of getting to a signed agreement
Enhance Amount/Duration of Indemnity

s
• Distinguish Bid in Auction
• Protect Key Relationships
• Ameliorate Collection Concerns
• Protect the Deal
• Reduce Contingent Liabilities
Effect on Deal Terms
 Underwriting Process
1-3 Weeks Start to Finish

Engage
Select insurer
broker, solicit
and pay Insurer due Negotiate
non-binding
diligence fee diligence policy terms
indication
($25-50K)
letters (NBILs)
 Factors in Deciding Underwriting
Considerations

Nature, size,
Industry or
history, and Scope of reps and
geography specific
geography of warranties
risks
target business

Indemnification Quality of buyer’s

Policy terms
terms diligence
 Policy Terms
Not
Covered
covered

All reps, fundamental and non-fundamental Known problems

Losses covered by other insurance

Certain tax indemnities may also be covered

Purchase price adjustments

Covenants (other than, possibly, certain tax covenants),

estimates, projections and forward-looking information

Unfunded or underfunded benefit plans

Non-monetary relief

Deal-specific risks

Losses definitions

Rollover equity

Defense costs

Subrogation

Dispute resolution
M&A Insurance: Forever Changing the Way
Businesses are Bought and Sold

Protect buyers Reduce seller

and sellers of post closing
businesses deal obligations

Help buyers win

Protect
competitive
relationships
auctions
 Discussion Question

What does an M&A deal look like without M&A

insurance?
Discussion Question

What are Buyers and Sellers fighting about?

 Discussion Question

How does M&A insurance change an M&A deal?

 M&A Insurance

Provides access to the

M&A insurance facilitates insurance industry’s capital
mergers, acquisitions, and allow the transfer of
divestitures and other certain transaction-related
business transactions risks to the insurance
markets
Key Products of M&A Insurance

Representations
Tax Liability
& Warranties
Insurance
Insurance

Contingent
Liability
Insurance
 Trends in M&A Insurance

Buyers and sellers remain Broad coverage and

Maturing Market; Rapid
risk averse in a seller’s favorable terms in more
Growth Rate
market jurisdictions

Greater awareness,
understanding, and
Rapid response time and
recognition of product from
efficient underwriting Proven claims paying ability
the M&A community-private
process
equity, corporations and
individuals
Representations and Warranties Insurance
Marketplace
Protects a party from Key representations
financial losses resulting typically include
from inaccuracies in the compliance with law, no
representations and undisclosed liabilities,
warranties made about the accuracy of financial
target company or business statements and tax

Not intended to cover

known breaches, working
capital adjustments
 Discussion Question

Does the Company’s Board of Directors or

officers require a certain amount of
indemnification protection for M&A deals?
 Discussion Question

Are there stakeholder requirements that need to

be addressed?
 Discussion Question

Who will pay for the insurance?

 Discussion Question

How does Representations and Warranties

Insurance change the purchase price and where
money flows on a transaction?
Obtaining M&A Insurance
Execute NDA

Provide Submission to Requested information includes acquisition

Insurer agreement, financial information, offering memo

Obtain quote within 1-

No cost to obtain quote
3 days

Typically between $15,000 and $30,000 – used for

Pay underwriting fee
outside counsel fees

3-10 days - High level review of due diligence process

(if buyer-side) or disclosure process (if seller-side)

Access to legal, financial, tax DD reports (if buyer-

Underwriting process
side)

Conference call(s) with deal team

Concurrent with underwriting process

Policy negotiations

Work closely with brokers and outside counsel

 Claims

Claims notices have been

received on 23% of the
policies issued by AIG in
North America since 1998-
Millions of dollars paid
 Claims Example

• Seller-side policy responds to a claim brought by

Accounts buyer for breach of the financial statements
R&Ws in connection with the target’s issuance of
Receivable over $1mm of gift certificates which had not
been recorded in the financial statements

Patent • Seller-side policy responds to claim brought by

buyer for breach of the IP R&Ws resulting from a
Infringement third party claim of patent infringement
 Discussion Question

How do dealmakers use M&A Insurance to avoid

roadblocks on transactions?
 Discussion Question

What is the impact of M&A Insurance on

negotiations and financial considerations?
 Discussion Question

What is the current M&A landscape for

allocation of risk between buyers and sellers?
 Discussion Question

What are the key challenges of using M&A

insurance as a buyer?
 Discussion Question

What are the key challenges of using M&A

insurance as a seller?