Market Watch: How to evaluate contingent payments in sale transactions

Jerry Grossman

Undeniably, the cash has flowed over the past three years as defense and government IT companies have participated in an active mergers and acquisitions market. But in an estimated one-fourth of those transactions, the flow has tended toward non-cash payments.

Of the more than 550 transactions announced during this period, 144 were disclosed in detail. Of those, selling shareholders received 100 percent of sale proceeds in cash in most of the deals. However, in about 27 percent of these deals, sellers received some proceeds in non-cash forms. When, in lieu of cash, sellers are offered contractual commitments, they must decide whether to accept proffered non-cash elements, most commonly stock, debt and contingent payments, and then determine their value.

Unsurprisingly, most selling shareholders prefer cash. Its value is known, and it is highly liquid, allowing sellers to determine their individual plans to invest or spend the proceeds. Cash also provides the wherewithal to pay any taxes due on sale proceeds.

But in some circumstances, a non-cash consideration component is necessary, desirable or both. Sellers who seek partial liquidity, combined with the opportunity to grow their company with the assistance of a solid financial partner (generally, private equity shops), can expect one-third or more of the value they receive to be in deferred or contingent form. Such an arrangement provides continuing equity incentive for founder executives, as with the recent acquisition of ITS Services Inc. by Arlington Capital.

Before prospective sellers can accurately evaluate any non-cash components, they must first decide: their own preferences relative to the form of transaction consideration; how, why and under what circumstances they might consider accepting non-cash components; what seller actions will increase the probability that they get the mix of consideration they are seeking; and what parameters and guidelines they can incorporate into the negotiation and valuation of non-cash components.

In other instances, sellers must accept a component of proceeds in non-cash and contingent form as a result of the basic attributes of their business or poor timing of the decision to go to market. These include a variety of factors.

For example, a company might have significant proportions of small business and 8(a) set-aside contracts that are not readily transferable to a large buyer. The company may have pending awards for large contracts near maturity and high-probability outstanding bids that will have a significant impact on the business, or it may be subject to large contingent events such as in-process litigation or environmental problems.

Although proper timing of a sale will reduce or avoid the uncertainty created by these issues and thus mitigate the need for buyers to negotiate significant contingent payments, such uncertainties and risks are unavoidable for some companies at certain points in their development. Owners of these companies are confident of the upside, while prudent buyers fear the downside if performance targets are not met. Under such circumstances, contingent payment arrangements, or earnouts, may be the only comfortable solution for both seller and buyer.

In these cases, it is important to remember a few guiding principles:

  • Keep the contingent measurements simple

  • Use revenue goals rather than profit goals

  • Make the time for measurement less than one year if possible.

After a deal is closed, the parties need to harmonize their actions and goals, rather than proceeding independently and keeping score throughout a lengthy earnout period.

But the best advice is heeded at the very outset of a prospective sale: Seek good advice in planning, negotiating and closing the deal.

Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at

About the Author

Jerry Grossman is managing director at Houlihan Lokey Howard and Zukin.

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