BLACK SWAN AND ITS CONSEQUENCES IN M&A NEGOTIATIONS AND EARN-OUT CLAUSE

Black Swan, from the expression in English Black Swan, can be defined as a rare and unpredictable event, widely used to describe situations with a major impact on the financial market. The American crisis of 2008, the popularly known “Joesley Day” that occurred in 2017 in Brazil and more recently COVID-19 are good examples of situations of Black Swan which had a strong impact on the financial market. In the midst of the strong increase of 31.6% in the Ibovespa index in 2019, and in the fourth consecutive year of appreciation, investors expected a high valuation during 2020, not only due to the approval of the Social Security Reform at the end of 2019, but also due to guidelines such as the Tax and Administrative Reforms. However, the year began with some uncertain events, such as the outbreak of tension between the USA and Iran and the USA and China, the instability of the price of oil and, especially, the COVID-19 pandemic. Se The speech at the beginning of 2020 was filled with optimism, with a strong prospect of economic growth, the appreciation of the Ibovespa and high movement in the M&A market, the impact of COVID-19 on the world's leading economies significantly altered these plans. The new scenario shows a drop in stock prices, the appreciation of the dollar, economic downturn, and protectionist policies. Despite the pessimism that gripped the market, events of this magnitude are also responsible for providing opportunities, one of which is Mergers and Acquisitions (M&A). Companies that are not properly prepared to face high-impact crises, however, have attractive products or services, appear as an acquisition alternative for those with liquidity and seek opportunities for consolidation, portfolio expansion, and entry into new markets. Many entrepreneurs have an idea of what the fair value of their Company is, and some still have this amount supported by a Valuation Report (Valuation), which captures the value of the Asset through Cash Flow projections. However, during a negotiation, the other party's perception of value is generally lower, especially in times of crisis such as the current one. As much as the value of the Company is in the future, it is necessary to take into account the good results already presented, the prospects for recovery after COVID-19, the growth plans and the product/service portfolio. Thus, an instrument commonly used in negotiations to determine the final value in the deal, is Earn-Out.In a succinct way, Earn-Out refers to the portion corresponding to the part of the purchase price of a company, linked to compensation to sellers linked to future performance indicators previously agreed between the parties, such as Revenue, EBITDA, Net Income, etc. It is a clause that is widely used in M&A transactions to potentially correct the price expectations of the Buyer and Seller in relation to the asset The natural asymmetry of information between Seller and Buyer in a process of M&A, even after carrying out the process of Due Diligence, is one of the main reasons for the clause of Earn-Out and there is nothing fairer than defining rules that bring the vision of those involved closer together. In this hypothetical example, Company X intends to acquire Company Y, but the amounts sought by the board of directors of both companies differ by R$ 3 million. In view of the fact that the acquisition is a strategy for players, and that both want to continue the operation, was negotiated and a clause of Earn-Out in the Purchase and Sale Agreement (CCV). In the CCV, it was established that Company Y will receive R$ X million in cash upon signing the Contract, plus R$ 3 million subject to future performance, which will be linked to the achievement of Gross Annual Revenue (“ROB”) targets in the fiscal year of the year following the signing, calculated as follows:

• If ROB is equal to or greater than R$ 10 million, Company Y will receive 100% of the amount of R$ 3 million;
• If ROB is less than R$ 10 million and greater than R$ 8 million, Company Y will receive a proportion between 0% and 100% of the amount of R$ 3 million, calculated by linear interpolation in this interval; and
• If ROB is equal to or less than R$ 8 million, Company Y will not receive any amount.

The clauses of Earn-Out they can be simple and objective, as the example above, however, they can also be complex, including different scenarios and rules. The discussions are always very delicate because the Seller's optimistic view is confronted with the Buyer's pessimistic view, which can prolong negotiations for months and even make the transaction unfeasible. Major crises, such as the one provided by COVID-19, directly impact the discussions of earn-out, making the process even more complex. Unpredictable events that generate major crises are surrounded by pessimism and economic downturn, but they create M&A opportunities that must be carefully addressed. In these cases, there are two different scenarios that must be analyzed: M&A transactions already concluded with a clause of Earn-Out and transactions that will take place due to the opportunity provided by COVID-19. In the first, the goals of Earn-Out tend to be strongly impacted, impeding the good performance of the Selling Company and consequently resulting in an aggravation of frustrations and potential litigation (if the State of Public Calamity is not provided for in the contract). Therefore, it is up to the selling company to document the actions taken by the company to mitigate the impacts caused by the pandemic. In addition, a new round of negotiation of the contractual terms is recommended to extend the period established to achieve the goals or even eliminate the effects of the crisis from the parameters of Earn-Out.In the second, the potential Seller must be very attentive to the goals established for the clause of Earn-Out, observing the consequences of the crisis, the resumption of growth, new unpredictable events, and the profitability history presented by the Company. Alternatively, the parties may agree to link targets and performance indicators with lower volatility or even adopt targets with a longer time horizon, so that the weighted profitability analysis involves the recovery of the crisis event to the levels previously observed. In periods of “fat cows”, many details end up not receiving due importance, and the clause of earn-out, if not well agreed, it may incur litigation between those involved, generating more heated discussions and even lawsuits. Times of crisis are also times of learning and, if well used, can generate great opportunities.

ARTICLE WRITTEN BY PEDRO FENATI — PARTNER OF FC PARTNERSGo to our site: http://www.fcpartners.com.br