Earnout business combinations


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Earnout business combinations
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xi, 251 leaves. : 28 cm.
Yeakel, John Albert, 1930-
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Consolidation and merger of corporations   ( lcsh )
Accounting thesis Ph. D   ( lcsh )
Dissertations, Academic -- Accounting -- UF   ( lcsh )
bibliography   ( marcgt )
non-fiction   ( marcgt )


Thesis -- University of Florida.
Bibliography: leaves 244-249.
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Manuscript copy.
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University of Florida
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Table of Contents
    Title Page
        Page i
        Page ii
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    Table of Contents
        Page v
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    List of Tables
        Page vii
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        Page ix
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    Chapter 1. Introduction and purpose of the study
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    Chapter 2. Incidence and basic considerations
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    Chapter 3. Legal factors
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    Chapter 4. Analysis of the terms of earnout business combinations
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    Chapter 5. Accounting and disclosure aspects of earnout combinations
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    Chapter 6. The case for earnouts as contingent liabilities
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    Chapter 7. Summary of findings
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    Biographical sketch
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Full Text

Earnout Business Combinations








Copyright by

John Albert Yeakel



The author expresses appreciation for their assistance

to the members of his Supervisory Committee and in particular

to Dr. Williard E. Stone, Chairman.

Financial assistance provided to the author by the

American Institute of Certified Public Accountants while con-

ducting this research is gratefully acknowledged.


List of Tables . .

Abstract . . & a

Chapter I. Introduction and Purpose of the Study

An Early Earnout: The Gillette-Toni Merger
in 1948 . o. * o o a
Purpose and Design of the Study . . .

Chapter II.

Incidence and Basic Considerations .

The Merger Movement Background . .
The Increase in the Use of the Earnout
Advantages and Limitations of the
Earnout Form of Acquisition .

Chapter III. Legal Factors . . .

Federal Securities Laws Considerations
Federal Tax Considerations * .

Chapter IV. Analysis of the Terms of
Earnout Business Combinations . . *

0 0 0 0 0

5 S 0 0 0
0 0 0 0

* 0 0 0
* 0 0 0 0 0

* 0 0 0

Hecht's Earnout Classifications .. .. .
Basic Earnout Models .***..* e
Simple Profit Sharing Earnouts 0 . .
Target-Attainment Earnouts . . *
Excess Earnings-Fixed Divisor Earnouts . .
Excess Earnings-Market Value Earnouts .
Formulations Dependent upon the
earnings of the Buyer . .
Frequency of Use of the Basic Earnout Models
Earnings Goals * & * * . *
The Definition of Earnings . e * *
Duration of the Earnings Period........
Timing of Contingent Payments . 0 0
Payment Media . 0 .* 0 0 0 *
Limitations on Contingent Payments 0 a
Escrow Provisions..... 0 0 0 &..
Earnout Options . . . . . . . 0

* 0

* 0

* S

* 0
* 0

& 0 0










Chapter V. Accounting and Disclosure Aspects
of Earnout Combinations .. .. .. . .

Purchase Accounting . . * .
Pooling of Interests Accounting . a
The Purchase-Pooling Controversy . .
The Choice of Purchase or
Pooling Accounting for Earnouts . .
Accounting for Pooled Earnout Combinations
Initial Payments . . . . . .
Earnout Payments . . . . . .
Accounting for Purchase Earnout Combinations
Initial Payments . . ......
Earnout Payments . . .
Contingent Payments Recorded
as if Already Earned . . . .
Part-Purchase, Part-Pooling . . ...
Accounting Principles Board Opinions
Relating to Accounting for Earnouts .
Securities and Exchange Commission Policy
Relating to Accounting for Earnouts .
Disclosure Principles in Annual Reports
to Shareholders . . . . . .
Examples of Informative Disclosure . . .

* 0

* 0

* 0

* 0 0

Chapter VI. The Case for Earnouts As
Contingent Liabilities o . * * # &

The Meaning of Contingent Liabilities .. .. .
Are Earnout Obligations Contingent
Liabilities? . . . . . . . *
Implications from the Evidence o * * & e o

Chapter VII. Summary of Findings # * * o o

Significance of the Research *. .. . . & .

Bibliography .. . . . * 0. * * a .

Biographical Sketch . . . . . . . .















Table 1.

Table 2.

Table 3.

Table 4.

Table 5.

Table 6.

Table 7.

Table 8.

Table 9.

Table 10.

Table 11.

Table 12.

Table 13.

Table 14.

Acquisitions of Manufacturing and
Mining Firms with Assets of
$10 Million or More, 1948-1967 .

Acquisitions of Manufacturing and
Mining Firms with Assets of
$10 Million or More, by Type of
Acquisition, 1948-1967 .. *

Annual Merger Activity, 1963-1969 . . .

Transaction Comparison by Years . . .

Incidence of Earnout Use During 1960-1968,
by Corporations Listed on the New York
Stock Exchange . . . . . .

Distribution of Earnouts by
"Frequent" and "Infrequent" Users

The Ten Corporations Using
Earnouts Most Frequently .

Size of Firms Acquired Through
Earnouts, 1960-1968 . . . .

Profitability of Firms Acquired
Through Earnouts, 1960-1968 . .

Age of the Firm at the Time of
Its Acquisition . . . . .

Diversity of Ownership of
Acquired Firms . . * .

Basic Earnout Models Utilized in
1960-1968 Business Combinations .

0 0 0 * *

O 0 0 0 0

. 0 0 0 0 0
* 0

Earnings Goals of the Acquired Business
Which Must Be Met Before Contingent
Payments Are Made . 0 0 0 .

Earnings Goals and Current
Profitability of the Acquired Company .











0 ~

~ 0 0

Table 15.

Table 16.

Table 17.

Table 18.

Table 19.

Table 20.

Table 21.

Duration of the Earnings Period . .

Timing of the Contingent Payment(s)
as Specified in Earnout Agreements,
1960-1968 . . . . . . .
Payment Media Specified in Earnout
Transactions, 1960-1968 . . .

Method of Accounting for Earnout
Combinations, 1960-1968 . . .
Earnout Disclosure in
Shareholder Annual Reports . . ..

Economic Success of Earnout
Acquisitions . . . . ..

Classification of Successful
Acquisitions by Type of Earnout . .

0 0 . 125

. . 127

* . 129

* . 154

* . 185

* . 206

* . 208


Abstract of Dissertation Presented to the
Graduate Council of the University of Florida
in Partial Fulfillment of the Requirements for the
Degree of Doctor of Philosophy


John Albert Yeakel

June, 1971
Chairman: Dr. Williard E, Stone
Major Department: Accounting

In the earnout form of business merger the parties agree

that, in addition to the acquirer's initial payment to the

seller at the closing, future payments may be required at
specified dates based upon the subsequent earnings of the
acquired entity. Objectives of the research include (1) in-

vestigation of the incidence of the use of the earnout ap-

proach, (2) analysis of the terms of earnout agreements,
(3) analysis of the accounting and disclosure principles
employed by earnout acquirers, (4) a search for evidence of

the subsequent economic success of the acquired enterprises.
Inquiry was made into the nature of contingent liabilities
and the hypothesis was tested that the profitability experi-
enced by the acquired businesses would indicate that an

estimated liability, rather than a contingent liability, is

the appropriate accounting treatment at the date of acquisi-
tion for future payments.

Advantages and limitations of the earnout form of acqui-

sition were considered in addition to the effects of the
Federal securities laws and the Federal income tax code on
agreements. Acquisitions negotiated by NYSE listed companies

during the time period from 1960 through 1968 were analyzed.

The research is based upon earnouts effected primarily through
the use of securities rather than cash. Primary sources of
data included listing applications filed with the New York

Stock Exchange, annual reports to shareholders and corpora-

tion annual reports (Form 10-K) filed with the Securities and
Exchange Commission.

It was found that the incidence of the earnout combina-

tion increased greatly during the late 1960's and that the
acquirers utilizing earnouts most frequently were those

commonly known as conglomerates in the financial press. The
acquired enterprises usually have been small firms as measured

by sales volume and total assets. Analysis of 265 acquisitions

showed that the agreements could be differentiated into four
mutually exclusive classes: profit sharing, target-attainment,
excess earnings-fixed divisor, and excess earnings-market
value earnouts.

Analysis of 110 shareholder annual reports showed that
acquirers selected those accounting principles (pooling of

interests accounting and non-amortization of goodwill in the

case of purchase accounting) that would result in the most
favorable earnings per share, It was found that, in general,

shareholders have been given only fragmentary information

regarding earnouts through the use of footnotes that tended

to be inadequate. The research suggests that by the use of

supplementary schedules the potential dilution arising through

the use of earnout shares and the resulting economic success

of the acquired entity may be conveniently and usefully

Future payments based upon profitability have been

treated as contingent liabilities by acquiring corporations
generally and apparently are so viewed by the APB and the

SEC. Evidence in this research indicates that earnouts fail
in the definition of contingent liabilities with respect to

the prospect that payments will be made in the future. Of
100 earnout acquisitions for which evidence was obtainable,
88 have proved economically successful in meeting earnings

goals with the result that one or more earnout payments were

made. The tested hypothesis was accepted and the conclusion
drawn that an estimate should be made of the future payments

likely to be made under the agreement, and this estimate

should be recorded at the date of acquisition as a liability.
The findings of this research study are in contradiction to
the conclusions contained in APB Opinion No. 16 relative to
the appropriate accounting for earnout acquisitions.



An Early Earnout: The Gillette-Toni Merger in 1948

On January 2, 1948, the Gillette Safety Razor Company

purchased, for cash, all of the outstanding stock of the Toni

Company, the Chicago manufacturer of a home permanent wave kit
and shampoo cream. Although the Toni Company had been formed

only a few years earlier in 1944, its success was spectacular,

largely because the introduction of its home permanent wave

kits was very well timed. During World War II, some 20 to

25% of the beauty shops in the United States were shut down

because their operators went into war industry jobs that were

better paying. For many women, the inexpensive and convenient

home kits were exactly what was needed. By 1946 Toni had

national distribution of its product and reported net income

after taxes at $4.5 million, on sales of approximately

$20 million.1 In January, 1948, Toni's book value was roughly

$4.7 million.

Gillette, for its part, was in the number one sales posi-

tion, nationally, in its field but had a great deal of competi-

tion nonetheless. Its purchase of Toni was for protection of

its own future against a depression, albeit at a time when its

net sales were in excess of $50 million.2 The thinking was


that in bad times women would be more inclined to do their

hair waving at home, even though men might well switch to

cheaper razor blades.

For a company having high and rapidly growing earnings

with reference to invested capital or book value, it is to be

anticipated that the owners would expect to receive more than

book value when selling out. The Toni Company was a case of

rather extreme disproportion between earning power and book

value: at the purchase time, yearly earnings were virtually

100% of book value. The problems of establishing a value

basis with regard to both book value and earnings were re-

solved in the Gillette-Toni case by the use of a formula

which considered the total purchase price in three separate

parts. Gillette purchased the Toni stock for cash equal to

1) the book value of $4.7 million, 2) additional cash of $8

million, and 3) up to an additional $8 million, after Jillette

had recouped the first $8 million, out of future Toni net

profits. Under the purchase agreement, when cumulative net

profits after taxes of the Toni Company earned subsequent to

December 31, 1947 aggregated $8 million, Gillette would

thereafter pay to the former Toni stockholders additional

amounts equivalent to 50% of Toni's annual net profits after

taxes until such payments aggregated a further $8 million.3

The Toni Company was operated as a separate division of

Gillette and maintained its identity as a separate organiza-

tion under the same management as before the acquisition.

During calendar 1948 and 1949, the Toni Division earned


$7,550,567, and by the end of the first quarter of 1950, Toni

had earned more than $8,000,000. During December of 1950,

Gillette made its first payment to the former shareholders of

Toni under the contingent payment agreement. At the end of

1952, the remaining contingent liability had been reduced to

$2,982,852, and during 1953 the Company elected to exercise

its option under the Toni purchase contract to prepay this re-

maining amount due, even though the payment amount was not
measured by the Toni Division's earnings. Including initial

and contingent payments, Gillette paid in excess of .120 mil-

lion for Toni. Thus, the purchase price vis-a-vis the gross

sales of Toni was in a 1-to-1 ratio.

",'rom the date of purchase and through the payment of the

contingent amounts, Gillette fully disclosed the accounting

principles it was employing with respect to the Toni acquisi-

tion, as well as the net results of operations of the Toni

Division, and the resulting contingent payments. This disclo-

sure is interesting in view of the fact that, for fiscal 1949,

(Cillette's income statement did not yet disclose revenue and

expense data: the statement began by showing a total for

"profit from operations."

Typical of the extent of Gillette's disclosure is the

detail found in Note 3 of the 1950 Annual Report:

Under the contract dated January 2, 1948 cov-
ering the acquisition by the Company of the
stock of the Toni Company, there was accrued
during 1950 $1 402 293 of the total contin-
gent liability of '7,547,600 due to the former
shareholders of the Toni Company (reduced in
1950 from $8,000,000 by the acquisition of the

interest of one of the former sharehold-
ers). $769,808 of this accrual was paid in
December 1950 and the balance, $632,485 is
payable on or before April 30, 1951. Fur-
ther payments will accrue in subsequent
years in amounts equivalent to 47.172,Z
(reduced from 50%) of the net earnings
after taxes of the Toni Division as defined
in the contract, until the remaining
$6,145,307 of that contingent liability has
been paid in full. Under the contract the
provision for taxes to be made in determin-
ing the net earnings of the Toni Division
are to be computed as though the Toni Divi-
sion had continued as a separate entity.
As a consequence, no allocation of the
Company's excess profits tax liability for
1950 has been made since the Toni Division
would not have been liable for any excess
profits tax had it continued as a separate

Gillette valued its investment in the Toni Company at the

total of Toni's net book value at the January 2, 1948, acqui-

sition date plus the initial $8 million payment--with the lat-

ter shown as part of its total "Goodwill Trademarks, and Pat-

ents." However, as of December 31, 1949, "in line with current

accounting practice,"6 all intangibles appearing on its con-

solidated balance sheet were reduced to a nominal figure by

charges to capital surplus and to earned surplus. The result

of this decision was that the initial goodwill of $8 million

arising out of the acquisition of the Toni Company was elimi-

nated by a reduction of earned surplus. Thereafter, the

policy of Gillette was to write off annually the increases in

goodwill that resulted from the further payments to the former

stockholders of Toni. In each year in which payments were

made, the goodwill write-off was shown as a special charge on

the combined Income and Earned Surplus Statement, but in no


year was the unusual item handled in such a way that reported

earnings per share for the period would be thereby lowered.

Some observations on the Gillette-Toni business combina-

tion seem appropriate. The merger terms made use of a flexi-

ble formula which might be employed in the case of an acquisi-

tion of high and rapidly growing earnings. The contingent

payment approach was a practical method of solving the valua-

tion problem which is inherent in virtually all acquisitions.

Although the approach was practical, at the time of the

Gillette-Toni merger in 1948, it was nevertheless regarded as

novel.7 As will be shown later, the contingent payment or

"earnout" method, as it came to be known by many, became a

rather common approach to setting acquisition terms during the

increasing merger activity of the later 1960's. In addition

to helping to resolve valuation problems, earnouts constitute

a method of financing acquisitions since the acquiring company

may finance the purchase, at least in part, from income derived

from operations of the acquired company during the period of

the contingent payments.

The agreement in the Gillette-Toni merger did not contain

complex terms. The earnout provision was straightforward:

after the first $8 million of net profits, the former owners

would receive one-half of subsequent net profits up to an addi-

tional $8 million. Since the contingent payments were to be

made in cash, no problem of valuation of the medium of payment

arose, as might be true in the case of the use of debt or

equity securities. Without a limitation on the duration of

time over which the contingent payments were to be made, it

seems that the principal variable was the timing of the sub-

sequent payments to the former owners of Toni. The selling

company had been highly profitable before the acquisition

and the expectation was for continued profitability, particu-

larly in view of the management continuity involved and the

added resources of the buyer. Still, the buyer handled the

transaction as a contingent and not as an estimated or de-

ferred liability. Only a portion ($4.7 million) of the total

cost of more than $20 million was capitalized by Gillette as

an investment, even though there could be little doubt as to

the amount of its fair market value. Total earnings in

future years were unaffected to the extent of $16 million

and, it may be argued, were accordingly understated. Disclo-

sure of the terms of the acquisition and its subsequent

economic success was detailed to a great extent for the

shareholders of Gillette in its annual reports.

Purpose and Design of the Study

As indicated earlier, the 1948 contingent-payment busi-

ness combination of the Gillette and Toni Corporations was

viewed as a novel approach to the financing of a business ac-

quisition. Nevertheless, as late as 1967, one author referred

to the earnout as the "newest type of merger financing.'8

Apparently, business combinations of the contingent payment

variety have not been a subject of much interest until recently.


Correspondence with the research director of W. T. Grimm & Co.
revealed that the data bank of that prominent firm special-

izing in acquisitions, mergers, and sales of companies con-
tains information concerning "incentive transactions"--the

term they use to refer to contingent payment acquisitions--
beginning only with the year 1968. Inquiries to the New York

Stock Exchange, national certified public accounting firms,
Federal Trade Commission, Securities and Exchange Commission,
and others revealed that no data have been compiled, apparently,

with regard to contingent payment agreements. An initial ob-

jective of this study is to investigate the extent to which
this form of acquisition is being utilized. The source of
this information will consist mainly of listing applications

to the New York Stock Exchange.

From the data indicating the incidence of earnout business
acquisitions, detailed study will be made of selected combina-

tions. Generalizations can then be formulated concerning the

terms by which earnout acquisitions are consummated. Random

study of recent acquisitions suggests that the earnout has
evolved, in some cases at least, into a relatively complex

form of business combination. It has been said to be a "tool"

of sophisticated buyers," with the seller in the less advan-
tageous position.9 The study will investigate the forms which
the earnout has taken during the period from 1960 through 1968.
Attributes of selling companies, such as size and profitabil-
ity, will be examined as well as the subsequent operation of

the acquired entity and retention of its owner-management.

Provisions of the Internal Revenue Code have definite

effects upon business combinations, and earnouts are no excep-

tion. Relevant sections of the Code and Revenue Procedures

and Rulings must be considered in any discussion of contingent

payment acquisitions. Additionally, the position of the Secu-

rities and Exchange Commission exerts an impact upon the terms

to which the buyer and seller agree, and also upon the amount

and kind of disclosure to the public which is provided by the

acquirer through annual reports to shareholders and through

reporting to the Commission.

Prospective mergers are sometimes not consummated because

the acceptable forms of accounting would have led to unde-

sirable market value results, as subjectively determined by

the stock-trading public.10 Currently acceptable forms of ac-

counting for business combinations include pooling of interest,

purchase, and part-pooling--part-purchase, even though these

variations produce differing asset valuations and reported

earnings figures upon which the stock-trading public may rely.

The accounting policies of buyers making acquisitions via the

contingent payment route are therefore significant, and will

be critically evaluated. These policies are usually evidenced

most clearly in listing applications. The disclosure princi-

ples of acquirin; corporations used in their annual reports

to shareholders will be studied and critically evaluated. The

Gillette-Toni combination was perhaps notable because of the

fullness of disclosure of the transaction and of its subsequent

economic success to the shareholders of the resulting entity.

The joining together of two businesses should result in
benefits to both the buyers and the sellers. Hopefully, the

emergent enterprise will be more profitable than the sum of

its separate components prior to the amalgamation. From the

standpoint of the sellers, a successful earnout results when

their acquired company produces earnings such that the future

payments provided for in the merger agreement are in fact

made. Such a result indicates a successful acquisition from

the standpoint of the buyer as well.

If the agreement provides for the contingent payments to

be made in cash, the record of such payments as actually occur

will be found within the corporation's internal records, and

will normally be unavailable to the outside investigator. Con-

tingent payments in the form of shares of the buyer's stock,

however, represent changes in the outstanding securities of

the corporation and are subject to disclosure as required by

the Securities and Exchange Commission. Since 1965, such

changes constitute one of the items (Item 2) to be reported

on Form 10-K, the required annual report pursuant to Section 13

of the Securities Exchange Act of 1934.11 This study therefore

contemplates a determination of the economic success of ac-

quired companies subsequent to their acquisition primarily by

examination of reports filed with Securities and Exchange Com-

mission. Only acquirers whose securities are listed on the

New York Stock Exchange will be studied.

As will be contended in a later chapter of this study,

the accounting for earnout combinations should not be considered

in isolation from the economic success of the acquired busi-

ness. In this study, it is hypothesized that the profitabil-

ity experienced by the selling companies will indicate that an

estimated liability, rather than a contingent liability, is

the appropriate accounting treatment for the future payments,

at the date of acquisition.

In summary, this study has four basic objectives. The

first is to determine something of the degree of usage which

major, listed corporations are making of contingent payments

in their acquisitions. The second is to analyze the attributes

of this newly-popular mode of business combination. Thirdly,

the study will investigate the accounting and disclosure

principles that are employed by the acquiring corporations.

Lastly, inquiry will be made into the nature of contingent

liabilities and into the available evidence of the subsequent

economic success of the acquired enterprises. Inferences can

then be drawn with reference to the accounting principles

appropriate for contingent payment business combinations.

The study is restricted in scope to contingent payment

acquisitions made by corporations listed on the New York Stock

Exchange. The reason for this is the need for details about

merger terms; such details are commonly to be found in the

listing applications submitted to the New York Stock Exchange.

Since the listing applications are concerned with the out-

standing securities of the corporation making application, ac-

quisitions for cash are not typically described in the applica-

tions. The writer presumes that a large number of contingent


payment business combinations takes place by the use of cash

terms. However, details concerning such combinations are not

commonly made publicly available. In cases where the details

are made available through the financial press or otherwise,

no means exist for the outside researcher to follow up on

whether or not the contingent payments are in fact subse-

quently made, except as to occasional disclosure which may be

made by the acquirer. Therefore, this study does not include

analysis of acquisitions made solely by the use of cash.

Acquisitions during the time period from 1960 through

1968 will be studied in depth. The earlier year was selected

so that study could be made of earnout combinations not only

durin- the more recent past when their popularity as a merger

method appears high, but also during a time when the earnout

was relatively infrequent. By its nature, an earnout cannot

be judged to be successful or unsuccessful until such time

elapses as is called for under the terms of the contract.

Only then, after the profitability or lack of profitability

of the acquired company has been established, may the buyer

be obligated to make additional payments to the sellers. The

end of the year 1968 was selected as a cut-off point so that

follow-up could be done on those 1968 acquisitions which may

have required payments during 1969.

Primary sources of data for the study include listing

applications filed with the New York Stock Exchange, corpora-

tion annual reports to shareholders, and corporation annual

reports filed with the Securities and Exchange Commission.

Listing applications in particular contain much data which

will be utilized in this study.

Of the variety of terms which are used in reference to

business amalgamations, the most common is probably "merger."

Even though this term does have a technical meaning, it is

frequently used outside of its precise technical context.

Other terms include "acquisition" and "business combination,"

the latter being basically an accounting term. In this study,

no legalistic precision is implied by the use of any one of

various terms which connote the concept of a business amalga-


When merger agreements provide for payments in the form

of cash or in securities at some time after the closing date

of the acquisition based on the future earnings of the acquired

company, the agreement is frequently called an "earnout."

Another term for describing the same combination is "incentive

transaction." Still another is "contingent payment agreement."

Each of these terms is used interchangeably in the present

study. In addition to being dependent upon future earnings,

additional payments are sometimes contingent upon the future

quoted market price of the acquiring company's-capital stock

or upon other matters such as litigation, income tax disputes,

product warranties, and contingent liabilities. This study is

concerned with the analysis of business combinations whose

agreements provide for additional payments that are dependent


upon future earnings, and not upon other factors such as

those just mentioned. In some of the cases analyzed, however,

one or more of the other contingencies may be found, in

addition to the future profit contingency.


1. "Gillette Begins to Diversify," Business 4eek (January
10, 1948), p. 44.

2. Ibid., p. 46.

3. G illette Safety Razor Company, 1949 Annual Report to
Stockholders, Note #8 to the financial statements.
4. Gillette Safety Razor Company, Annual Reports to
Stockholders, 1950-1953.

5. Ibid., 1950, pp. 15-16.
6. Ibid., p. 7.

7. J. B. Walker, Jr. and Neil Kirkpatrick, "Financing the
Acquisition," Corporate Growth Through Merger
and Acquisition, Management Report 75. American
Management Association, 1963, p. 92.

8. Charles J. Hecht, "Earnouts," Mergers & Acquisitions,
the Journal of Corporate Venture (Summer, 1967),
p. 2.

9. Ibid., p. 12.
10. Warren C. Wintrub, ed., Planning Business Combinations.
Lybrand, Ross Bros. & Montg-omery, 1968, p. 79.
11. Section 13 is concerned with periodical and other
reports required for securities registered on a
national securities exchange.



The Merger Movement Background

Even though contingent payout acquisitions may be a

relatively novel phenomenon today, corporate acquisitions and

mergers generally in the United States are not new. Since

about the turn of the century, there have occurred three iden-

tifiable periods during which manufacturing and mining concern

mergers have increased substantially. The first wave of merg-

ers lasted from about 1895 to 1904, and the second from 1925
to 1931. We are apparently still in the midst of the third

movement, which had its beginning in 1945, subsequent to World

War II.

The first merger movement was sharp, and of short dura-

tion. It brought together businesses that were competitive

within a given industry, and resulted in the formation of some

of our country's largest corporations. These included General

Electric, United States Steel, and E. I. duPont, for example.

The combinations of this first period were successfully joined

largely as the result of the efforts of investment bankers.2

The purpose of combining, allegedly, was to create monopolistic

corporate structures so that competition could be eliminated,


with profits and stability enhanced by the exercise of control

within the industry.

The second major merger movement took place during the

1920's and, again, much of the impetus for the combinations

effected during this period came from bankers. However, the

internal managements of the corporations played a larger role

than before and were better qualified to participate in the

merger negotiations and to foresee in advance the problems

which would emerge after merging.3 Their motivations were

largely of a financial nature and the result was the creation

of artificially inflated paper values. Many of these combina-

tions collapsed in the stock market crash of 1929 and the sub-

sequent economic depression of the 1930's. This second merger

movement, from 1925 to 1931, took place during the period of

the greatest relative stock market activity in our history.

In fact, merger movements generally parallel stock market

prices.4 This is not surprising, of course, inasmuch as the

acquisition of a company actually constitutes an investment

from the buyer's viewpoint.

The third merger movement has been the longest in dura-

tion. The motivations for combination during this period

seem to be more varied than in the preceding period. Most of

these more recent mergers have come about through the efforts

of the operating executives of corporations rather than from

the investment bankers. The current wave might well be called

the period of "management-oriented" mergers.5 The basic pur-

pose seems to be to create and bring together logical industrial

and operational enterprises. After World War II, many family

and closely held businesses became very profitable and were

acquired by larger, growth-minded corporations in so-called

"tax-free" exchanges of stock. During the 1960's, the third

merger movement became characterized by the large number of

conglomerate business combinations effected, as oompared with

the predominance of horizontal acquisitions of the first move-

ment and the rise of vertical acquisitions of the second.

Of the variety of motivations leading to the mergers of this

third period, however, the dominant one "was the desire of some

managements to capitalize on what appeared to be unusually

good growth prospects coupled with a desire of other manage-

ments to relinquish their positions, to become part of a

stronger unit, or to strengthen their personal positions pre-

paratory to retirement."6 In the case of earnout business

combinations, it may be noted, the management of the selling

company does not ordinarily relinquish its position.

There are no completely reliable statistics available on

the number of mergers and acquisitions that are accomplished

in the United States. Periodically, the Federal Trade Commis-

sion issues summaries of nonconfidential merger data that it

compiles. One of these is the report on large mergers involv-

ing manufacturing and mining companies, with large mergers

being defined by the Commission as those transactions where

the acquired company has $10 million or more in assets at the

time it was acquired. Table 1 shows the frequency of such ac-

quisitions and the value of the total assets acquired for a

Table 1
Acquisitions of Manufacturing and Mining Firms With
Assets of $10 Million or More, 1948-1967

Number of Assets
Year Acquisitions (millions)
1948 4 66
1949 5 67
1950 4 173
1951 9 201
1952 13 327
1953 23 679
1954 35 1,425
1955 68 2,129
1956 58 2 037
1957 50 1,469
1958 38 1,107
1959 64 1,960
1960 62 1,710
1961 59 2 129
1962 72 2,194
1963 68 2,889
1964 91 2,798
1965 93 3,900
1966 101 4,078
1967 166 8,172
Total 1,083 S339,510

Source: Federal Trade Commission, Large
Mergers in Manufacturing and Mining
1948-1967, May 1968, p. 8.

period of twenty years. This time approximates the duration
of the third major merger movement thus far. As is indicated
by the table, merger activity was greatly intensified during

the year 1967, and has been growing almost steadily throughout

these twenty years.

Table 2 breaks down these large mergers between 1948 and
1967 as to the kind of acquisition effected and illustrates

the predominance of the conglomerate type. The Commission

defines all mergers that are neither horizontal nor vertical

as *conglomerate.' Of the 1,083 mergers tabulated, approxi-

mately two-thirds fall within the conglomerate category.

Two other, more recent, sources of merger statistics are
the financial consulting firm of W. T. Grimm & Co. of Chicago

and the periodical, Mergers and Acquisitions, the Journal of

Corporate Venture. Grimm & Co. has compiled data since 1963

and includes announcements of corporate mergers, net of can-

cellations. Table 3 indicates that activity in the merger

field has increased substantially since statistics were first

compiled. The year 1968 showed a 50% increase in announcements

from 1967. The rising stock market and the upward trend of
interest rates resulted in a shift in 1967 from cash to the

use of equity securities in consolidation transactions. This
trend is evidenced by the breakdown in Table 4 of the mergers
during 1965 through 1968, according to the payment media used

by the acquirers.
Although the number of mergers during 1969 exceeded that
of 1968 by 37%, this rise was less dramatic than that of a year

Table 2

Acquisitions of Manufacturing and Mining Firms With
Assets of $10 Million or More, by Type of Acquisition, 1948"1967

Number Per cent


Per cent




Total 1,083







$ 7,099







Source: Federal Trade Commission Large Mergers in Manu-
facturing and Mining 1946-1967, May 1968, p. 9.

Table 3

Annual Merger Activity, 1963-1969

Number of


Increase over


previous year
Per cent


*Merger announcements, net of cancellation.


W. T. Grimm & Co., 1968 Merger Summary,
p. 1; and The Wall Street Journal,
January 15, 1970, p. 1.



Table 4
Transaction Comparison by Years

19.65 1966 197 96
Cash Transactions 1436 (67%) 1438 (60%) 1077 (36%) 1314 (29%)
Stock Transactions 604 (29%) 820 (35%) 1783 (60%) 2762 (62,)
Combination Cash & Stock 8 5 ( 4%) 11 ( 115 ( 4%) 386 (9%)
Total 2125 (100%) 2377 (100%) 2975 (100%) 4462 (100%)

Source: W. T. Grimm & Co., 1968 Merger Summary, p. 2.


earlier when the increase was 50%. During 1969, there were a

number of factors at work against the merger trend. One was

the deterioration in stock market prices which makes acquisi"

tions for stock less attractive to the prospective merger candi-

dates. Another was the sharp rise in interest rates which would

raise the cost of cash acquisitions. Also during 1968 and 1969,

there was anti-merger activity by the Federal Trade Commission

and other agencies of the federal government directed especially

toward the conglomerate type of acquirer. As a result, during

the first half of 1969, the ten largest conglomerates announced

only 63 completed acquisitions, as compared to 134 during the

first six months of 1968.7

The trade publication, Mergers & Acquisitions, reported

the following corporate mergers:

1,373 in 1967,

1,831 in 1968,8 and

1,710 in 1969.9

The difference between the Grimm & Co. figures and those just

noted is that the above publication counts only those transac-

tions which involve the transfer of at least $700,000 or more

in cash or securities. Mergers and Acquisitions also confirmed

that many of the conglomerate acquirers were relatively less

active in making acquisitions during 1969 than in 1968.

No one, of course, knows whether the signs of lessened

merger activity noted during 1969 portend an arresting of the

merger boom. According to one analysis, the merger trend can

continue virtually indefinitely, and even increase.10 This

analysis estimates the merger universe at 300,000 candidates

for combination, of which 100,000 are divisional, subsidiary,

or branch operations which for one reason or another would be

better off by being sold. These reasons include the prospect

of anti-trust activity; probable Securities and Exchange Com-

mission requirements for increased reporting of conglomerate

divisional profits and, significantly, losses; and the possi-

bility of obtaining capital quickly and showing additional

earnings by selling off a division at a profit.

The Increase in the Use of the Earnout

Research interest in the compilation of statistical data

concerning earnouts is quite recent, presumably because they

were not used frequently in the past. Earnout statistics are

still scant, although several writers have announced recently

that the earnout device has become increasingly popular in
merger negotiations.

In its 1968 Merger Summary, Grimm & Co. counted 305 earn-

out transactions as compared with 114 in 1967.12 Thus, while

total merger activity during 1968 increased 50% over that

during 1967 (see Table 3), the number of earnout-type mergers

increased more than three times as rapidly, at 168%. During
1967, 3.8% of the total announced mergers were earnouts; for

1968, the proportion had risen to 6.8-. For the first nine

months of 1969, Grimm tabulated 433 incentive transactions

versus 236 for the same period in 1968. By the end of the

first nine months of 1969, earnout transactions had increased


to 10.1% of total merger activity.13 The increasing tendency

toward use of the earnout has prompted Grimm's research direc-

tor to declare that this method "is well on its way to becoming
a major factor in total merger activity.*14

Examination of listing applications to the New York Stock

Exchange by the writer revealed that, during the years 1960
through 1968, listed companies negotiated 405 earnout-type
combinations, as shown in Table 5. From this table, it can be
seen that the number of earnouts totaled 20 or less annually

during 1960 through 1965, and that significant increases took

place during 1966, 1967, and 1968. Comparison of the percent-
ages in Table 5 with those in Table 3 confirms that, during

each year from 1964 through 1968, earnout merger activity was

increasing at a more rapid rate than merger activity generally.

While total mergers more than doubled during this period, the

number of earnouts was fourteen times as great.

The total of 405 earnout transactions involved 133 buying
corporations. However, more than one-half of the earnouts were
the result of the efforts of just fifteen of the buyers. More

than one-half of the buyers had only one acquisition each via
the earnout route. Specifically, there were 71 buyers with

just one earnout each; 32 with two earnouts each; 7 with three
earnouts each; 5 with four earnouts each; 3 with five earnouts

each; and 15 with six or more earnouts each. In the last cate-

gory are included 214 earnouts, with one buyer accounting for
41 alone. Note that these data exclude most cash earnouts.

Table 5
Incidence of Earnout Use During 1960-1968,
by Corporations Listed on the New York Stock Exchange

Number of Earnout Increase (Decrease) over previous year
Year Combinations Numerical Per cent
1960 5
1961 13 8
1962 9 (4)
1963 7 (2)
1964 14 7 100.0
1965 20 6 42.9
1966 39 19 95.0
1967 102 63 161.5
1968 196 94 92.2

Total 405

Source: Listing applications to the New York Stock Exchange.

Further analysis of the listing application buyers re-

vealed that most of the major users of the earnout method have
consummated most of these acquisitions during 1967 and 1968.

Table 6 gives data regarding the incidence of earnout acquisi-
tions by time periods, and broken down according to those ac-

quirers who were categorized as "frequent' and "infrequent"

users of earnout terms. A frequent user was arbitrarily defined
as one that had employed earnouts in six or more acquisitions

during the time periods noted. By this definition, during
1960-1966, three corporations qualified as frequent users:

Genesco, Inc., with seven acquisitions; Litton Industries, Inc.,

and Consolidated Foods Corporation, with six each.
The ten frequent users of earnout acquisition agreements

during 1967 and 1968 are listed in Table 7. With the exception
of Consolidated Foods and Genesco, these ten acquirers have had
virtually all of their earnout merger activity during these
two years. Also all of these acquirers, with the possible
exception of Consolidated Foods, are commonly known as con-

glomerate type organizations in the financial press. The most
active earnout acquirer, U. S. Industries, was also the most

active corporate acquirer during 1968.15 In fact, U. S. In-
dustries has made few acquisitions during recent years which

have not been earnouts. The same is also true for Genesco and

Consolidated Foods.

It has been noted that deferred-payment merger deals have
been around for more than twenty years, at least since the

Gillette-Toni combination. Widespread use of the earnout

Table 6

Distribution of Earnouts
by "Frequent" and "Infrequent" Users

Time Period

Number of buyers using
earnouts for:
Six or more Less than six
acquisitions acquisitions

Number of earnouts



Source: Listing applications to the New York Stock Exchange.







Table 7

The Ten Corporations Using Earnouts Most Frequently

Number of earnout acquisitions
Corporation 1967-1768 1960-1966 Total

U. S. Industries, Inc. 40 1 41
Consolidated Foods Corp. 19 6 25
Republic Corp. 22 0 22
Whittaker Corp. 18 0 18
Genesco, Inc. 8 7 15
Walter Kidde & Co., Inc. 15 0 15
Teledyne, Inc. 10 3 13
Beatrice Foods Co. 9 1 10
Fuqua Industries, Inc. 11 0 11
Lehigh Valley Industries, Inc. 6 1 7

Total 158 19 177

Source: Listing applications to the New York Stock Exchange.

technique, however, has not taken place until the latter part

of the 1960 decade. Since 1967, it has become an increasingly

significant factor in effecting corporate acquisitions and

mergers, with at least one in every ten business combinations

reflecting its use during 1969. It is more widely employed

by certain corporations than by others in making acquisitions,

with several acquirers seeming to favor it almost exclusively

over other methods. Data on selling firms are in Tables 8-11.

Advantages and Limitations of
the Earnout Form of Acquisition

The earnout occurs when the acquirer makes a down pay-

ment of stock or cash, or both, but agrees to pay more if the

acquired business can maintain or increase its earnings. This

additional installment which is based upon the future earnings

of the purchased company is the characteristic that identifies

the earnout from the traditional or "straight" cash or stock

business combination. By use of the earnout the acquiring

company may finance the purchase, at least in part, from in-

come derived from the operations of the acquired company over

the period of the installment payments. The transaction is

open-ended, and this open-endedness is advantageous to the

buyer since it limits the initial payout of assets when cash

is the medium of exchange. If the buyer issues shares of its

capital stock initially, the earnout method of acquisition will

restrict the immediate dilution of stockholders' equity and

earnings per share. It will also aid in preventing the buyer

Table 8
Size of Firms Acquired Through Earnouts

Sales Volume* of Firms Per cent
under $1,000 000 34 13.5
$ 1,000 000 $4,999,999 93 36.9
$ 5,000,000 $ 9,999,999 66 26.2
10,000,000 $14,999,999 26 10.3
15,00o00 $19,999,999 12 4.7
20 000 000 $24,999,999 10 4.0
,25,000,000 and over 11 4.4
Total 3J2 100.0

Total Assets** of Firms Per cent
under $1,000,000 74 28.9
1 1,000,000 $1,999,999 48 18.7
1 2,000,000 $2,999,999 32 12.5
3,000,000 !3,999t999 34 13.3
4,000,000 4,999,999 11 4.3
5,000,000 l5,999,999 14 5.5
I 6,000,000 46,999,999 12 4.7
7,000,000 17,999,999 7 2.7
:! 8,000,000 18,999,999 5 2.0
:J 9,000,000 $9,999,999 3 1.2
10,000,000 and over 16 6.2

Total 6 100.0

Reported sales during the fiscal period prior to
acquisition; annualized where necessary.
**As reported on the most recent balance sheet prior
to acquisition.

Source: Listing applications to the New York
Stock Exchange.

Table 9
Profitability of Firms Acquired Through Earnouts

Year of


Number of


Return,** as a Per cent of:
Assets Owners' EQuity



*In addition to these firms, a total of 11 were
unprofitable during the fiscal period prior to
**Reported net income before taxes for the fiscal
period prior to acquisition; annualized where
Source: Listing applications to the New York Stock

Table 10

Age of the Firm at the Time of
Its Acquisition

Number of years
in Operation

of Firms

Per cent

0- 5
6 10
11 15
16 20
21 25
26 30

46 50

over 50





Source: Listing applications to the New
York Stock Exchange.

Table 11

Diversity of Ownership of Acquired Firms

Number of
Individual Sellers

5 to 48

Total known to be
privately held

Total known to be
publicly held*

Total verifiable

Number of


*Shares were traded either
counter or American Stock


Source: Listing applications to the
New York Stock Exchange.


from paying more in the aggregate for an acquisition than it

should, based upon the seller's proven earning capacity.
In cases where the acquired business has had only a

limited term of existence with earning power not yet estab-
lished, the earnout approach may be particularly appropriate.

Closely held, family-owned businesses have most often been the
type of enterprise acquired via earnout terms. In addition,

if the earning power of the business is not subject to ease
of verification because of lack of audited financial state-

ments or because of insufficient accounting records, the ac-

quirer may use the earnout as a device for providing financial

protection against overpayment for the seller's business.
While the earnout agreement is difficult to negotiate and

administer, more buyers apparently.adopted the attitude that

being able to pay later for earnings that can be documented
makes it worth the effort.

When the parties involved in a prospective combination
encounter difficulties in agreeing upon a fixed price or basis

of exchange of their securities, they may utilize the contin-
gent payment device. It seems to be a logical method of ad-

Justing the difference between the amount the buyer is willing

to give and the amount the seller would prefer to receive.
Without the earnout factor, it is likely that many proposed
deals could not be closed where there is disagreement on a

proper purchase price. Such difficulties in the evaluation of
prospective merger candidates are particularly prevalent where
the candidate is a small business. These companies often are


in existence because of the talent and product of one person

or a small group of individuals who are frequently the founder-

owners. The product is typically specialized and, while its

sales record may be short, sales growth may be very impressive--

even if profits have not been. The owners may have reached the

point where additional infusion of capital is needed which

they are no longer able to provide. In merger negotiations,

their asking price for the business may bear little or no

relationship to either current earnings or the tangible value

of the business assets. Also, owners of young, small busines-

ses often want to stay on and continue managing the enterprises

they have founded.

The evaluation of a small business, therefore, reduces

itself to the difficult appraisal of future potential. The

traditional techniques of evaluation based upon past performance

and financial analysis are quite limited in value, and can even

be misleading. The evaluation of small companies often con-

sists of the appraisal of talented individuals and unique prod-

ucts and potential markets. In the words of one writer, it

calls for a "rare combination of skill and luck." 16

Earnout arrangements can be effectively employed to aid

in reducing the greater uncertainty which attends the evalua-

tion of the small enterprise. During June 1967, for example,

Republic Corporation agreed to acquire IKM Industries by use

of an earnout. IKM was a small California corporation whose

principal products were highly specialized optical scanning

equipment and industrial monorail systems. The company employed

only twenty-two persons and had been incorporated only the

year before, during October of 1966. Its unaudited financial

statements before its acquisition showed assets totaling

$192,000; financed $133,000 by creditors, $24,000 by the

owners, and $35,000 by profits earned during its brief exis-

tence. Republic Corporation offered to buy IKM with shares

of common stock. Pricing negotiations in this case could

hardly revolve around historical financial statements, since

the seller had such a brief history and since its management

would be interested in a price based almost entirely on the

company's future. The acquisition was made by the use of an

earnout and the common difficulty of determination of the

purchase price was noted in the following statement prefacing

the terms of the acquisition agreement:

The parties hereto acknowledge that they
have been unable to reach final mutual
agreement as to the respective values to
be attributed to the business and assets
of IKM on the one hand and the Common
Stock of Republic on the other hand. Ac-
cordingly, the parties hereto have agreed
and do hereby agree to resolve their dif-
ferences by providing for a fixed and
contingent number of shares of Republic
Common Stock to be issued....

Not only is the earnout a practical way of setting an
equitable selling price; it will also provide the former owner-

managers incentive to manage the enterprise as profitably as

possible. The assumption here is that the former managers

continue in their previous positions. Actually, an earnout is

only sensible when the acquired company is operated by the

sellers after the acquisition and when their decision-making

is comparatively free from interference from the new owners.

The new parent organization must be willing to leave profit

and loss responsibility in the hands of the sellers, at least

for the life of the earnout period. Concomitant with this

decentralization of control, earnout agreements frequently

include employment contracts with the seller's key executives

for the duration of the contingent payout. This dependency of

earnout arrangements upon the continuity of the original

mana,-ement is reflected in the following statement with refer-

ence to the acquisition of Jennings Radio Manufacturing Cor-

poration by International Telephone and Telegraph Corporation:

Because of the contingent nature of this
the earnout] portion of the consideration
or the business and assets of Jennings,
ITT has agreed to continue the present
management of the Jennings business but
may change such management at any time
upon payment in shares of Capital Stock
of the balance of the $P000 000 Ethe maxi-
mum contingent payoutj.16
For the acquiring firms, the major attraction of earn-

outs is the way the plans serve to retain and motivate execu-

tives of the acquired firms.19 When such an incentive is not
involved in an acquisition, key executives will be more tempted

to leave after receiving their share of the total purchase

price. The ability to induce the founders of companies to

stay on and to manage the businesses they have sold out is

claimed to be one of the "secrets of success" of U. S. Indus-

tries, Inc., the most active acquirer in recent years making

use of the earnout method.20 In addition, earnout arrangements
provide time for training and building up the next level of

mana,-ement so that when the founders do finally retire, the

new group is ready to take over the business and manage it.

Investors in growth-minded corporations usually look to

earnings per share as the barometer of the success of the

business. To increase per share earnings, either total

earnings must be increased or else total outstanding shares

of stock must be decreased, or both. Acquisition-oriented

corporations can make use of both of these ideas if they ac-

quire by means of earnout agreements. By increasing the aggre,

gate earnings of the acquiring company proportionately more

than the increase in outstanding stock attributable to the

merger, the buyer can increase earnings per share in earnout

situations. The newly combined organization will be able to

report higher earnings per share by using an earnout than by

using a straight stock acquisition. This is true because in

the first few years of the earnout the amount of stock trans-

ferred will be something less--perhaps considerably less--than

the amount of stock which would have been transferred under

a straight stock-for-stock acquisition.21

Still another reason for the use of the earnout offer is

to eliminate certain acquisition candidates from consideration

by the buyer. For sellers who are exaggerating their earnings

prospects, an earnout is not enticing since the resulting per-

formance of the business will not likely result in additional
compensation to the former owners. The offer of conditional

future payments based on profits tends to differentiate those


prospective sellers who believe their own growth claims from

those who do not.22

Sellers are attracted to contingent payment purchase

offers because of the possibility of receiving higher aggre-

gate amounts for their businesses. The earnout provides the

incentive to increase the earnings of the business after it

is sold, and if such earnings are increased substantially, the

former owners stand to increase the compensation significantly

over the amount received at the closing. Selling owner-

founders are also attracted to earnout offers because of the

continued need for their managerial services after the busi-

ness has been acquired. The earnout, with its customary em-

ployment continuity, reduces the vulnerability to which execu-

tives are subject in time of merger, with regard to their job

status. The contingent payment acquisition provides the seller

with an opportunity to perpetuate his company while remaining

as its operating executive, in addition to the opportunity to

be well paid for his business.

Certain limitations and disadvantages may be found in

deferred payment combinations. The acquired business must be

capable of being operated as an autonomous entity (usually a

subsidiary or division) or else the product line of the ac-

quired company must be sufficiently distinguishable from that

of the parent to permit the degree of separation that is needed

in accounting for the earnout results. As already noted, the

buyer has to be willing to allow the seller to be responsible

for the profit or loss of his business on a relatively

autonomous basis. This need for separateness can produce

disadvantageous results for the buyer. The following explana-

tion for the dropping of the earnout arrangement between

Beckman Instruments, Inc. and General Instruments Company

illustrates such an unfavorable outcome:

Beckman, from its experience in operating
General as a wholly owned subsidiary since
August 1965, has learned that the contin-
gency for measuring its duty to issue con-
tingent shares is impractical and is detri-
mental to the best interests of Beckman and
of Jamal Tadayon (who founded and managed
General and was its principal shareholder
and who has continued and still continues
to manage General) for the principal reason
that to achieve fairly and impartially the
operating results that constitute the basis
of the contingency formula it is necessary,
among other things, to separate to an unde-
sirable and uneconomic degree General's
operations from Beckman's overall operations,
and it is necessary for Jamal Tadayon to
devote all of his time and attention to
General whereas his skills and experience
can better be used in ot r aspects of
Beckman's operations....

A new agreement was executed in 1967 whereby Beckman agreed

to issue 20,000 common shares to Tadayon and was released from

its obligations to issue any shares contingent upon earnings.

Earnouts are best suited for business combinations where

the acquired company is closely held and where its executives

are also the principal stockholders since the executives must

be willing to work to enhance the future growth of the new

business entity. If the number of shareholders is small,

negotiations for acquiring the seller will be facilitated

because of the direct communication which is possible with all

of the principal owners. Acquisition of publicly held

corporations by means of the deferred payment route poses

additional problems. For example, the selling company must

prepare and distribute to its shareholders a merger proxy which

satisfies the requirements of the Securities Exchange Act of

1934, after which a formal vote on the proposed merger must

be taken. If the selling company is listed on a national

securities exchange, additional requirements may need to be

satisfied with respect to the listing of additional securities.

With a large number of owners entitled to additional possible

payments, there ensues the added difficulty of maintaining

records to insure that those shareholders of the larger, sur-

viving corporation who may be entitled to subsequent payments

can be easily identified to then receive these payments.

In some of the more recent acquisitions of large publicly

held corporations, a security known as a "certificate of con-

tingent interest" has been issued to the former owners of the

acquired enterprise. This security because of Federal in-

come tax considerations is generally nonnegotiable. A number

of unresolved problem areas surround the certificate of con-

tingent interest, and consideration will be given in the next

chapter to these difficulties in connection with specific ac-

quisition agreements where its use is necessitated.

Since earnout agreements are hinged upon the subsequent

performance of the acquired company, both parties to the agree-

ment must understand the critical importance of clearly defin-

ing what is meant by earnings. One approach is to state that

earnings will be computed in accordance with generally accepted


principles of accounting; however, this would seldom be satis-

factory and could lead to disputes because of a variety of

specific problem areas.

Programmed budget items such as research and development

costs require definite policies with regard to their status

in the calculations of earnings. The seller needs protection

against unusual expenses charged against earnings which are

expected to result in increased profits after the expiration

of the earnout period. Correspondingly, the buyer needs as-

surance that expenditures will be made which are necessary for

the long-run benefit of the corporation.

Inclusion or exclusion of income taxes needs to be

agreed upon in any earnings computation. Also needing to be

specified is the party which is to benefit from any tax refunds

or additional tax liabilities which are based upon a period

before the merger, but are not known until after the merger

is consummated. If earnings are to be computed after income

taxes, then additional computations are frequently needed so

that income taxes are deducted on a pro forma basis, as if

the acquired business were a separate corporation.

Because the selling company is frequently a small, closely

held and growing enterprise, it is quite likely that it is in

need of additional capital. If this needed capital is pro-

vided by the acquiring corporation, the buyer and seller must

negotiate the rate of interest which is to be charged against

the earnings of the seller. It may be useful to set this rate

as a specified percentage with relation to prime or other

interest rates, so that neither party to the agreement gets

unfairly "locked in" during a period of fluctuating interest


Extraordinary, nonrecurring gains and losses should

usually be excluded from income determination. If, however,

such gains or losses stem directly from decisions made by the

sellers during a period prior to the merger, questions as to

the fairness of such exclusions may arise. For example, the

sale of investment securities, acquired before the merger, at

a substantial profit may lead to problems of equity if such

profits are denied to the sellers.

The merger agreement should specify whether or not

charges for management services and general and administrative

overhead shall be allocated by the buyer's corporate offices

to reduce earnings of the selling business. There must be a

clearly definable entity for which earnings are computed. If

there is not, then the problem areas just discussed become

much more acute. While not intended to be exhaustive, the

various problem areas already noted suggest that a great deal

of time and effort should be involved in a proper definition

of earnings when negotiating an earnout agreement. Numerous

alternatives are possible, of course. One illustration of the

way in which earnings may be defined follows, from an agree-

ment dated September 28, 1967, between Fuque Industries, Inc.

and McDonough Securities Co. Net income was to be computed:

...before Federal income taxes and Federal
taxes measured by income and income taxes
of every other character...and before pre-
miums, if any, on life insurance covering

McDonough's executives---as determined by
the then regularly employed independent
certified public accountants of the Sur-
viving Corporation in accordance with
generally accepted accounting principles
applied on a basis consistent with those
used in the fiscal year (of McDonough
Power Equipment, Inc.) ended September 30,
1966, except that (i) any gains or losses
resulting from extraordinary items, and
(ii) charges with respect to services by
the Surviving Corporation to the business
operated by Power, shall not be taken into
account. In determining said net income,
if the Surviving Corporation should elect
to advance any funds to the business now
operated by Power, the interest rate on
such advances will be the effective rate
of interest charged to the Surviving Cor-
poration on indebtedness, if any, it may
have to the Chase Manhttan Bank, N.A., or
any successor lenders.

Should the earnout payments be required to be made in

cash rather than in securities the buyer may find himself

in a situation requiring additional financing. The issuance

of additional stock will dilute subsequent earnings per share,

and conceivably the dilution could be so substantial as to

create a downward trend in per-share earnings. Also, if the

contingent payments are to be made in stock, the seller may

be able to exercise more voting control in the surviving

entity than the buyer believes desirable if the number of

additional shares is large. But these adverse considerations

from the buyer's standpoint will normally be offset by the

fact that additional payments will be made only when requi-

site earnings have accrued and also because the risk of over-

payment at the date of acquisition is eliminated.25


1. George D. McCarthy, Acquisitions and Mergers. New
York: The Ronald Press Co., 1963, P. 3.
2. Arthur R. Wyatt, "A Critical Study of Accounting for
Business Combinations," Accounting Research Study
No, 5. New York: American Institute of Certified
Public Accountants, 1963, p. 2.
3. Ibid., p. 3.
4. McCarthy, op. cit., p. 4.
5. Robert G. Dettmer, "Reasons for Mergers and Acquisi-
tions,N Corporate Growth Through Merger and
Acquisition, Management Re port 75. American
Management Association, 1963, p. 29.

6. Wyatt, op. cit., p. 5.

7. The Wall Street Journal (July 1, 1969), p. 8.
8. "Mergers on Parade," Mergers & Acquisitions, the Journal
of Corporate Venture (January-February, 1969),
p. 49.
9. The Wall Street Journal (January 1, 1970), p. 1.
10. Mergers & Acquisitions, 2p. ct., p. 51.
11. See, for example, Harlan Byrne, "Merger Come-OnsN
The Wall Street Journal (June 6, 1969), p. 1;
and Main Lafrentz & Co., "The Contingent Payout,"
in its Mergers & Acquisitions Newsletter
(August, 1969).
12. W. T. Grimm & Co., 1968 Merger Summary, p. 5.
13. News Release from Howard J. Carswell of W. T. Grimm &
Co., October 2, 1969, p. 2.
14. Ibid.

15. The Wall Street Journal, "U.S. Industries Inc. Led
Merger Parade Last Year" (February 24, 1969),
P. 5.
16. I. Gordon Odell, "Evaluation Factors and Techniques,"
Corporate Growth Through Merger and Acquisition,
Management Report 75. American Management
Association, 1963, p. 69.

17. Republic Corporation, Listing Application No. A-24684
to the New York Stock Exchange, August 7, 1967,
P. 3.
18. International Telephone and Telegraph Corporation,
Listing Application No. A-19757 to the New York
Stock Exchange, June 14, 1961, p. 1.

19. Byrne, loc. cit.

20. Advertisement in The Wall Street Journal (March 11,
1970), p. 8.

21. Charles J. Hecht, "Earnouts," Mergers & Acquisitions,
the Journal of Corporate Venture (Summer, 1967),
P. 2.

22. Byrne, loc. cit.

23. Beckman Instruments, Inc., Supplement to Listing
Application No. A-22697 to the New York Stock
Exchange, December 11, 1967, p. 1.

24. Fuqua Industries, Inc., Proxy Statement dated September
28, 1967, p. 75.

25. Samuel P. 11unther, "Contingent Pay-Outs in Mergers and
Acquisitions," The Journal of Accountancy (June,
1968), p. 33.



In any business decision by one corporation to acquire

another entity, appropriate legal requirements must be adhered

to. Certain Federal statutes are especially relevant to ac-

quisitions by publicly held corporations. These laws are in

two main fields of interest: those pertaining to the regula-

tion of the issuance of securities, and those dealing with

Federal income taxation. This chapter is concerned with the

study of both areas.

Federal Securities Laws Considerations

During the early 1930's, there were several statutes

enacted by the Congress for the purpose of providing full and

fair disclosure with respect to purchases and sales of securi-

ties and for the purpose of maintaining equitable and orderly

markets for the purchases and sales of securities. The

Securities Act of 1933 is mainly concerned with the initial

sale of securities to the public. Its purpose is "to provide

full and fair disclosure of the character of securities sold

in interstate and foreign commerce and through the mails, and

to prevent frauds in the sale thereof, and for other purposes.i

The Securities Exchange Act of 1934 is mainly concerned with


trading in securities in both the over-the-counter market and

the organized exchanges. Its purpose is "to provide for the

regulation of securities exchanges and of over-the-counter mar-

kets operating in interstate and foreign commerce and through

the mails, to prevent inequitable and unfair practices on such

exchanges and markets, and for other purposes.",2 The 1934 Act

provides for the registration of securities exchanges and for

the securities which are listed for trading on these exchanges.

In Section 4 of the 1934 Act, the Securities and Exchange Com-

mission was established to administer the 1933 Act and the

1934 Act, in addition to several other statutes.

Since companies subject to the filing and reporting re-

quirements of the Securities and Exchange Commission include

those whose securities are listed on a national securities

exchange, all of the acquiring corporations in this study are

so subject, since they are all companies whose securities are

listed on the New York Stock Exchange. A corporate acquisition

or merger by one of these corporations may require its filing

a registration statement under the Securities Act of 1933 or

a proxy statement under the Securities Exchange Act of 1934.

Such transactions may also require the filing of a current

report, usually Form 8-K or Form 10-K.

In a technical sense, when a business combination involves

an offer or an exchange of securities, a "sale" has taken

place, since the term "sale" or "sell" shall include every

contract of sale or disposition of a security or interest in

a security, for value. The term "offer to sell," "offer for

sale," or "offer" shall include every attempt or offer to

dispose of, or solicitation of an offer to buy, a security or

interest in a security, for value.3 When stock is involved
in an acquisition or merger, the acquiring corporation ulti-

mately disposes of its shares to the owners of the acquired
company in exchange for the value of the business. Accord-

ingly, one might expect that such acquisition and merger trans-
actions would be subject to the registration requirements of

the Securities Act of 1933. This is generally not the case,


There are two major provisions for exemption from the
registration requirements: the first of these is contained

in Rule 133 of the Rules and Regulations under the 1933 Act;
and the second is provided by Section 4(2) of the Securities

Act of 1933.

Rule 133, adopted in 1951, states that no "'sale,' 'offer
to sell,' or 'offer for sale' shall be deemed to be involved

so far as the stockholders of a corporation are concerned
where, pursuant to statutory provisions in the State of incor-

poration or provisions contained in the certificate of incor-

poration, there is submitted to the vote of such stockholders
a plan or agreement for a statutory merger or consolidation

or reclassification of securities, or a proposal for the

transfer of assets of such corporation to another person in

consideration of the issuance of securities of such other
person or securities of a corporation which owns stock posses-
sing at least 80% of the total combined voting power


of all classes of stock entitled to vote and at least 80 per-

cent of the total number of shares of all other classes of

stock of such person.... ,,4 The Rule, in effect, excludes

from registration securities which are transferred under a

statutory merger and under what is known as a "Type C" reorgani-

zation. Rule 133, also, limits the area within which the con-

trolling persons of an acquired corporation may sell the stock

they have received from the buyer. In substance, for New

York Stock Exchange listed corporations, any of the controlling

persons who is classified as an "affiliate" within the meaning

of the Act is only entitled to sell stock in an amount not to

exceed in any six month period 1% of the total outstanding

shares of the acquirer or no more than the total shares traded

in any one week on the NYSE within four weeks prior to the

sale, whichever total is the lesser. Although this Rule

limits the sale of acquired shares by these controlling per-

sons it also assures them some protection against being

"locked into" their investment with no relief.

The second provision for exemption from these registra-

tion requirements of which the acquirer can usually avail him-

self is covered under Section 4(2), which states that regis-

tration is not applicable to "transactions by an issuer not

involving any public offering."6 This exemption is commonly

referred to as the "private offering" exemption, and is

generally available in cases where the number of recipients

involved is limited; however, the burden of proof as to the

availability of an exemption rests upon the person claiming

it.7 An important factor in determining whether or not an

exemption is available under the private offering section is

consideration of the risk that the recipient will make a

secondary distribution of the securities and thus become an

underwriter, within the meaning of the Act, thereby rendering

the exemption unavailable.8 If stock is taken pursuant to

this exemption, it can only be taken for "investment" purposes

and not with the prospect of distribution. The stock may be

sold only after it has been held for a sufficient period of

time so as not to contradict the original intent of taking it

for investment. An unsettled question is how long the securi-

ties need to be held in order to assure retention of the exemp-

tion from registration, although one writer states that a suf-

ficient period of time is normally three years.9 Coupled with

the holding period is the principle known as "stock fungibil-

ity," which states that when a shareholder is to receive stock

over a period of time, he is considered upon resale of any of

such stock to have sold the last block of stock received first.

It is analogous to the LIFO inventory method of accounting.

If the earnout shares are received pursuant to an acquisition

under Rule 133, it is not clear whether the fungibility con-

cept should apply; however, it is prudent to plan acquisitions

as if it does.10 In business combinations with several recipi-

ents of earnout shares, even if some shareholders abide by

their covenants to hold the securities only for investment,

there is still additional risk involved should some of the

other shareholders decide to distribute their share publicly

and thereby invalidate for all the exemption presumed to be

in effect.

In order to provide some measure of protection against

such secondary distributions which would invalidate the exemp-

tion which was relied upon, it is common for the acquiring

corporation to obtain "investment letters" from the sellers

who are to receive the buyer's securities. For example, in

the acquisition of Fireside Securities Corporation by Tele-

dyne, Inc., the following paragraph from the sellers' invest-

ment letters to Teledyne illustrates the agreement:

The undersigned, for good and valuable con-
sideration, the receipt and sufficiency of
which is hereby acknowledged, warrants,
covenants, and agrees that he shall not sell
or dispose of the Teledyne Common Stock re-
ceived by him in liquidation of Fireside
Securities Corporation...and does hereby
agree to indemnify Teledyne against all
liabilities, costs and expenses arising as
a result of any sale or distribution of such
shark by him in violation of the Securities

In addition to the investment letter, another method of

protecting the private placement exemption is by means of a

stamped warning on the securities indicating that they are not

registered and requesting that the transfer agent effect no

transfers without the issuing corporation's consent. In Sec-

tion 8.1 of the earnout agreement between Genesco, Inc. (the

buyer) and Berkshire Apparel Corporation is the following

illustrative provision:

None of the principal stockholders, officers
or directors of Berkshire...will dispose of

any Genesco securities held by him without
registration under the Securities Act of
1933, as amended...the Genesco preferred
stock, debentures, and common stock to be
received by the above-mentioned persons
may be stamped with a restrictive legend
and Genesco may refuse to effect a transfer
or to recognize the v@jidity of any transfer
in violation thereof.

This need to hold the acquired securities for a "suffi-

cient" period of time in order not to negate the registration

exemption can be a source of concern to the selling owners

when they have sold their business by recourse to the earnout

method. Additional shares which are earned and then delivered

to them may be issued during or throughout the earnout period.

The principle of stock fungibility may be applicable, however,

and the person receiving the stock may be considered to have

received all of the stock as of the date of the last payment.13

Thus, the recipient of earnout shares will not be able to sell

his shares during the earnout period because he will not be

able to satisfy the holding period requirement under the "stock

fungibility" principle.14

Therefore, in order to protect the acquiring corporation

against a subsequent sale of securities by the controlling

persons of the acquired company which would violate the private

placement exemption, and to enable the controlling persons to

sell the shares they receive in the event they later so decide,

the merger agreement should provide for subsequent registration

of the securities. The buyer, and not the acquired company,

needs to file the registration statement. Accordingly, unless


the agreement provides for some registration guarantees, the

sellers will have no recourse after the acquisition should

they want to sell their stock.

In Genesco's acquisition of Berkshire, referred to

earlier, the agreement spelled out such guarantees in these


Genesco shall afford Berkshire Affiliates
the opportunity to include any or all of the
Genesco preferred stock received by them in
any "S-1" Registration of Genesco stock which
Genesco may file until October 1, 1972, at
the expense of Genesco. In addition, and
without limiting the foregoing, if a major-
ity in interest of the affiliates of Berk-
shire desire to sell any Genesco preferred
stock held by them prior to October 1, 1972,
and if in the opinion of Genesco's counsel
such...stock may not be sold without Regis-
tration, Genesco shall...effect one "S-1"
Registration...at its expense...In the event
any of the additional shares shall be earned
by Berkshire..., the date October 1 1972...
shall extend to October 1, 1974.F5 1

In this case, the number of such requests for registration is

limited to one, while the Berkshire sellers have the right

to "piggy-back" onto any number of "S-i" registrations which

Genesco might file prior to October 1, 1972, or two years

later if the earnout is successful. Because registration is

expensive, it is reasonable to expect some limitation on the

number of registration requests. For the same reason, it is

not uncommon for the acquiring corporation to require the

sellers to bear some of the costs of registration; the earnout

acquisition of Houston Electronics Corp. by the New Jersey

conglomerate, Walter Kidde & Co., Inc. in 1967 has this


During the period commencing with the
Closing of the Agreement and ending
February 1, 1974, Houston or its share-
holders entitled to Kidde shares on
liquidation of Houston have a right to
include not less than 10,000 of the
Kidde shares received in the transac-
tion in any Kidde Form S-1 registra-
tion statement covering Kidde Common
or Preference Shares that is filed with
the S.E.C. Houston or its shareholders
will be obligated to pay their propor-
tionate share of the registration ex-
penses in the event they include their
shares in such registration statement.16

The preceding discussion with respect to the Federal

securities laws has been concerned mainly with emphasizing

aspects of those statutes which need to be considered by

both the buyer and the seller who negotiate an earnout busi-

ness combination. The Securities and Exchange Commission

has also set up a system of reporting requirements which are

designed to provide full disclosure of financial information

about publicly held companies to investors. The Commission's

policies with regard to the accounting for earnout combina-

tions and their disclosure to investors will be discussed in

Chapter V.

Federal Tax Considerations

Although tax considerations should not be the motivating

force in promoting a business combination, such factors usually

are significant in determining both the advisability of an ac-

quisition and the method or form of the transaction. Both

parties to the agreement attempt to devise an arrangement with


the most beneficial tax results to each. In order to derive

a tax advantage, the acquiring company may be willing to pay

a premium while the sellers may be willing to accept a dis-

count. The area of Federal taxation, of course, is a compli-

cated one, and the tax aspects of business mergers or acqui-

sitions are particularly complex. It is not within the scope

of this study to treat tax problems as related to earnout

acquisitions in a detailed fashion. Rather, only those Federal

tax aspects which are highly visible in earnout combinations

will be discussed in this section.

Fundamentally, there are two general methods by which an

acquisition can be accomplished: it may be "taxable" or it

may be "tax-free," depending upon the form which the transac-

tion follows and the kind of payment received by the seller.

It is the tax position of the seller which is relevant here,

since the acquisition of property does not ordinarily result

in tax. Therefore, an acquisition may be either taxable or

nontaxable to the owners of the acquired company. In actu-

ality, the term "nontaxable" is incorrect: nontaxable trans-

actions involve the nonrecognition of gain or loss, and there-

fore serve to only delay or postpone taxes--not eliminate


In a taxable transaction, the seller will exchange his

stock or assets for the cash or obligations of the buyer. The

difference between the tax basis for the stock or assets he

Iives up and the market value of the consideration received

is gain or loss to the seller. Generally, the seller will

prefer to have any gain taxed at capital gain rates and if

part of his payment is deferred, then he may be allowed to

pay his tax on the installment method as he collects his pay-

ments. The buyer acquires a new tax basis for the assets he

receives in a taxable acquisition (but not in the case of a

tax-free transaction), and needs to allocate his purchase

price among the assets purchased. In an earnout transaction,

this allocation may be a tenuous one since the total purchase

price is not known with certainty at the time of the initial

payment. Some of the price paid--perhaps a substantial por-

tion--may have to be allocated to goodwill, which is not de-

ductible for tax purposes. The buyer will want to attribute

as much of his cost as possible to depreciable property and

as little as possible to goodwill so that most of his purchase

cost can be recovered as a valid deduction for tax purposes

over a period of years. The seller, however, will want to

allocate as much as possible to goodwill because of the depre-

ciation "recapture" provisions of the Internal Revenue Code.

Briefly, these rules provide for a recapture of post-1961

depreciation on certain business property involved in a sale

at a gain, of the corporate assets or of the stock of a cor-

poration which the buyer intends to liquidate. The rules

result in the taxation of all or part of the gain on the

property at the higher, ordinary income rates rather than at

the long-term capital gain rate.

Although there are various methods of planning business

combinations in a taxable transaction, with varying tax

consequences,17 in the majority of cases the owners of the

business to be sold will be interested in a nontaxable merger

in order to defer income taxes.18 This is particularly true
in potential earnout situations, where the stockholder-executives

of a young and vigorously growing company have appreciation in

the value of their investments in the business, but do not

have the cash or the inclination to pay a capital gains tax on

the disposition of their stock. In the nontaxable transaction,

the acquiring corporation will usually issue stock to the sel-

ler, who will then pay no tax on his gain until he sells or

disposes of his stock in a taxable transaction. If he doesn't

sell his stock during his lifetime, he can escape income taxa-

tion on the gain altogether. It has been said that, were it

not for the tax provisions which allow such tax-free acquisi-

tions of small and well-established growth companies by larger

corporations, relatively few such mergers would occur, since

the owner-executives would feel that they could not afford to

pay the necessary capital gains tax resulting from taxable

transactions and still carry the risk of stock market losses

on the shares of the buyer which they receive.19

If the acquisition of one corporation or its assets by

another corporation in exchange for the stock of the acquiring

corporation can qualify as a corporate reorganization within

the meaning of the Internal Revenue Code of 1954, then neither

the selling corporation nor its shareholders are taxed on the

acquisition.20 From a tax standpoint, the sellers are treated

as if the sale had not occurred since the shares they receive

then have the same tax basis as the securities or property

they exchanged. Earnout business combinations will hopefully

be planned so as to-qualify under one of these three nontaxable

forms of reorganization defined in the Code21:

1. The buying corporation acquires the
selling corporation through a statu-
tory merger or consolidation. This
is the so-called "A" reorganization.

2. The buyer issues voting stock in ex-
change for the outstanding stock of
the selling corporation. This is
the "B" reorganization ("stock-for-

3. The buyer issues voting stock in ex-
change for the assets of the selling
corporation. This is the "C" reor-
ganization ("stock-for-assets").

Various considerations (e.g., assumption of liabilities,

shareholders' meeting, legal paperwork) will dictate which

form a particular acquisition will most advantageously take,

but these considerations are not germane to the present discus-

sion. The relevant consideration is whether or not a given

earnout will be recognized as a tax-free reorganization by the

Internal Revenue Service in light of the contingent-payment

shares and the possible issuance of certificates of contingent


In one case, A and B corporations effected an "A" reorgani-

zation at a time when B was involved in litigation, the outcome

of which was not determinable at the time of the merger. Be-

cause of the potential liability which could result from the

litigation, A issued to B's stockholders shares of A's common

stock plus negotiable certificates of contingent interest

representing additional shares of A's common stock. The

certificates had no voting rights and, after the litigation

was resolved, each holder of a certificate was to exchange

the certificate for the appropriate number of shares of A's

common stock, plus cash equal to whatever dividends had been

declared on such common stock during the period while the

sellers were holding the certificates. In this case, in

Revenue Ruling 57-586, the Internal Revenue Service held that

the reorganization was not tax-free, in that the certificates

did not constitute stock, but instead constituted "other

property" or "boot" under Section 356 of the Code.22

In a 1960 ruling,23 the Eighth Circuit Court ruled that

certificates of contingent interest were to be deemed stock

for purposes of Section 354 of the Code with no recognition

of gain or loss upon their receipt. Section 354 provides

that there is no gain or loss where stock or securities of

one corporation are exchanged for stock or securities of

another corporation, a party to a plan of reorganization,

except where the principal amount of securities received ex-

ceeds the principal amount of the securities surrendered.24

The court determined that the certificates of contingent

interest were stock, in view of the overriding purpose of

tax-free corporate reorganizations to allow readjustments of

continuing interests, and in light of the practical problems

of the merger. The decision in this case therefore was in con-

flict with the Internal Revenue Service's position as it was

announced in Revenue Ruling 57-586.


The Tax Court, in 1964, held in James C. Hamrick25 that

the taxpayer's contractual right to receive additional stock,

contingent upon the earnings of the corporation exceeding a

specified amount, was the equivalent of "stock or securities"

within the meaning of the Code, so that the receipt of addi-

tional shares in later years pursuant to the original statu-

tory merger ("A") agreement would not result in recognizable

gain to him. The Tax Court, in this decision, relied to a

large extent on the 1960 Carlberg case.

The nature of contingent rights to receive additional

voting stock in the future was considered in Revenue Ruling

66-112, involving a "1B" ("stock-for-stock") exchange between

X corporation and Y corporation who equally owned the capital

stock of M corporation.26 Y was interested in acquiring X's

one-half interest in M, but because M was closely held it was

difficult to determine a fair value for the M shares. The

resultant earnout agreement provided for Y's acquisition of

X's interest in M in exchange for 40,000 shares of Y's voting

stock, plus a maximum of 20,000 additional shares over the

next four years if M's earnings exceeded a certain target.

The right to receive the earnout shares could not be assigned,

and only additional voting stock could be issued pursuant to

the earnout.

The question in the case was whether the "solely for

voting stock" requirement of Section 368 (a) (1) (B) of the

Code had been met. Whether this requirement was met or not

depended upon the treatment accorded the right to earnout


shares. If this right were considered "other property" as in

Revenue Ruling 57-586, then the reorganization would be deemed

a taxable one. Such was not the ruling, however; instead, the

right to receive the earnout shares was decided to satisfy

the "solely for voting stock" concept, thus preserving the

tax-free status of the reorganization. The decision was based

upon the fact that the right to the earnout shares was not

assi.onable and could be exchanged only for voting stock, and

the fact that only voting stock had been and could be issued

under the terms of the reorganization agreement.

Distinguishing the cases underlying Revenue Ruling 66-112,

Carlberg and Hamrick, as against that underlying Revenue

Ruling 57-586, was the fact that in the earlier decision, the

certificates representing the right to additional shares were

negotiable whereas in the other cases they were not. The ques-

tion was whether negotiable certificates of contingent interest

were merely evidence of the existing right to receive something

more than additional common stock. Since the issuance of

negotiable certificates created a transferable interest which

contained a dividend income element, it was determined that

they had been given something more than the right to receive

additional common stock, and therefore the certificates were

deemed "other property."27

Thus, Revenue Ruling 66-112 indicated that a "B" reor-

ganization's tax-free status would not be challenged provided

the earnout right was a nonassignable one. Presumably the

same conclusions would be reached in "A" and "C" reorganizations


if nonnegotiable rights were involved. The Ruling indicated,

however, that the facts of each earnout case would be care-

fully examined to "insure that bona fide business reasons

justify not issuing all of the stock immediately, and...that

stock issued as a bonus or compensation to the exchanging

shareholders is not treated as received in the exchange."28

In cases involving proposed reorganizations, it may be

prudent to request a ruling from the Commissioner of Internal

Revenue that the contemplated earnout transaction will be

tax-free. It is not uncommon for acquisition agreements to

have provision made for abandonment of the merger if satis-

factory rulings have not been obtained from the Internal Reve-

nue Service to the effect that no gains or losses will inure

to the parties to the reorganization.29 Specific guidelines

were set forth subsequent to Revenue Ruling 66-112 for the

issuance of advance rulings on proposed reorganizations in-

volving contingent shares. These guidelines are contained in

Revenue Procedure 67-13, which further amplified Revenue Pro-

cedure 66-34.30 The position of the Revenue Service, as

stated in Revenue Procedure 67-13, is that rulings will be

issued provided that:

(1) all of the stock will be issued within
five years from the date of the trans-
fer of assets in the case of an "A" or
"C" reorganization or within five years
from the date of the initial distribu-
tion in the case of a "B" reorganization;

(2) there is a valid business reason for not
issuing all of the stock immediately,
such as the difficulty in determining
the value of one or both of the corpora-
tions involved in the reorganization;

(3) the maximum number of shares which may
be issued in the exchange is stated;

(4) at least fifty per cent of the maximum
number of shares of each class of
stock which may be issued is issued in
the initial distribution;

(5) the agreement evidencing the right to
receive stock in the future prohibits
assignment (except by operation of
law), or, in the alternative, if the
agreement does not prohibit assign-
ments, the right must not be evidenced
by negotiable certificates of any kind
and must not be readily marketable; and

(6) such right can give rise to the receipt
of only additional stock of the acquir-
ing corporation or a corporation in
"control" thereof, as the case may be.
Stock issued as compensation, royalties
or any other consideration other than
in exchange for stock or assets will not
be considered to have been received in

It should be noted that these guidelines are for the

purpose of setting limitations for those proposed reorgani-

zations where a ruling from the I.R.S. is desired. Thus, a

given business combination may still be nontaxable even

though not all of the six criteria are met. For example, even

though the maximum number of additional shares that might be

issued under the earnout is not stated, as provided in the

third criterion, the reorganization might nonetheless be tax-

free, assuming that the terms of the formula to be used in
determining the earnout shares to be issued in the future

are very clearly given and fixed at the time of the reorgani-

zation. The combination might still be tax-free even though

less than 50% of the maximum number of shares which may be


issued are issued initially, given the conclusion in the pre-

ceding statement. Similar conclusions might be made with re-

gard to the arbitrary five-year limitation. Probably all, or

almost all, reorganizations would meet the second criterion.

The earlier cases and Revenue Ruling 66-112, earlier cited,

indicate that the fifth and sixth criteria would be mandatory

for a reorganization to escape taxation.

In addition to the problems in assuring that an earnout

agreement will be treated as a tax-free reorganization, there

is another tax pitfall which should not be overlooked: this

is the "unstated interest" problem. The Internal Revenue Code

provides for interest of at least 4% annually when property

is acquired on a deferred payment basis.32 If the agreement

does not provide for actual interest of at least 4% a year,

the Code provides that interest will be imputed by discounting

the future payments (due more than one year from the closing)

at the rate of 5% a year. The interest is not taken into

account until the earnout shares are actually issued, at

which time the fair market value of those shares is discounted

back to the effective date of the reorganization by use of the

appropriate present value factor in order to compute the im-

puted interest as the difference between the fair market
value of the shares and their discounted present value. The

unstated interest rule applies to both taxable and tax-free

earnout acquisitions.

Sellers who are anticipating only capital gains tax
treatment on any profit from the sale of their business


therefore should not overlook the imputed interest possibility,

since they will have ordinary income to the extent of any
imputed interest. One approach to the avoidance of the appli-

cation of the unstated interest rule is to have the buyer
offer to issue an additional number of shares of stock equiva-

lent to at least 4% of the number of earnout shares to be
issued under the terms of the agreement. This method was used
in Republic Corporation's acquisition of IKM Industries:

Republic further agrees to issue to IKM or
its Liquidating Agent on or prior to March
10, 1971 an additional number of shares of
its Common Stock equal to a percentage of
the number of contingent shares therefore
issued to IKM or its Liquidating Agent de-
termined at the rate of four percent (4%)
per annum from the Closing Date to the
date when such contingent shares shall have
been issued.33

In its acquisition of Graber Manufacturing Co., Inc. in
1967, Consolidated Foods Corporation hinged its liability to

issue additional 'imputed interest' shares to the sellers
upon the availability of a tax deduction for Consolidated.

The additional shares were to be worth the amount that Con-
solidated saved in taxes as a result of the deduction, thus:

If and to the extent that the Corporation
realizes a net reduction in its federal
income taxes resulting from any interest
deduction which may be available to it if
Section 483...is applicable to the future
delivery of shares of the Corporation's
common stock after the time of closing,
the Corporation will be required to issue
additional shares having value, determined
at the time of such future delivery, equal
to such net reduction in the Corporation's
federal income taxes, the number of which
cannot be determined at the present time....34


Another approach to the avoidance of imputed interest on

the sellers is to have the agreement provide that, of the

earnout shares issued, some are to be considered as represen-

ting interest. The Republic acquisition of Industrial Tech-

nology Corporation in 1968 utilized this alternative:

Included in the amount or value of any con-
tingent shares to be issued by Republic
pursuant to this Agreement is interest at
the rate of four percent (4%) which shall
be treated as and taxable for fe eral
income tax purposes as interest.i5

The third route to the avoidance of having interest im-

puted is to place all of the earnout shares in escrow upon

the effective date of the acquisition agreement, all or a

portion of such escrowed shares to be returned to the buyer

within a given time period if the seller's profits do not meet

specified targets. Since the seller is treated as having re-

ceived all payments due under the agreement as of the closing

date, Section 483 does not apply to the transfer of any of

the escrowed shares to the seller's shareholders.36 It is

necessary, however, for the seller's shareholders to have

voting and dividend rights during the escrow period. Although

the voting rights requirement applies to "B" and "C" reorgani-

zations, it is not mandatory under a type "A" reorganization.37

Further discussion on the use of escrowed shares will be found

in Chapter IV, in connection with the analysis of specific

earnout business combinations.


1. Securities Act of 1933, as amended to October 22, 1965.
2. Securities Exchange Act of 1934, as amended to July 29,

3. Section 2(3) of the Securities Act of 1933, as
amended to October 22, 1965.
4. general Rules and Regulations under the Securities Act
of 1933, Rule 133, Section (a).
5. general Rules and Regulations under the Securities Act
of 1933, Rule 133, Section (d) (3) (B).
6. Section 4(2) of the Securities Act of 1933, as
amended to October 22, 1965.
7. Ieorge E. McCarthy, Acquisitions and Mergers. New
York: The Ronald Press Co., 1963, p. 177.
8. Ibid.

9. Daniel C. Maclean III, "SEC Registration and Filing
Requirements for Mergers and Acquisitions,"
Mergers and Acquisitions, the Journal of Corporate
Venture (March-April, 1969), p. 55.
10. Ibid.
11. Fireside Securities, Proxy Statement dated August 17,
1968, p. 19.
12. 1enesco, Inc., Listing Application No. A-24965 to the
New York Stock Exchange, p. A-8.
13. Charles J. Hecht, "Earnouts," Mergers & Acquisitions,
the Journal of Corporate Venture (Summer, 1967),
p. 11.
14. Ibid.
15. ;enesco, Inc., loc. cit.
16. Walter Kidde & Co., Inc., Listing Application
No. A-25010 to the New York Stock Exchange, p. 1.
17. McCarthy, op. cit., for example, lists and discusses
six such possible methods, pp. 147-154.

18. Exceptions include cases where the seller would realize
a loss on the deal and estates holding property
owned by recent decedentb,,since the estate will
be interested in cash to pay death taxes, having
no capital gains tax to pay.
19. Hugh M. McNeill, "Certain Tax Aspects of Corporate
Acquisitions," Corporate Growth Through Merger and
Acquisition, Manag-ement Report 75. American
Management Association, 1963, p. 105.
20. Sections 354 and 361, Internal Revenue Code of 1954.
21. Section 368, Internal Revenue Code of 1954.
22. Revenue Ruling 57-586, C.B. 1957-2, 249.

23. Carlberg v. United States, 281 Fed. (2d) 507 (8th Cir.,

24. James P. Reeves, Tax Aspects of Corporate Mergers,
Exchanges, Redemptions, Liquidations and Reorgani-
zations. New York: Vantage Press, 1967, p. 89.
25. 43 T.C. 21 (1964).
26. Revenue Ruling 66-112, C.B. 1966-1, 69.
27. Ibid., 70.

28. Ibid.
29. See, for example, Section 15 of the merger agreement
between Fuqua Industries, Inc. and McDonough
Securities Co. in Fuqua's Proxy Statement of
October 2, 1967, p. 81.
30. Revenue Procedure 66-34, C.B. 1966-2, 1232;
Revenue Procedure 67-13, 0.B. 1967-1, 590.
31. Ibid., 590-1.
32. Section 483, Internal Revenue Code of 1954.
33. Republic Corporation, Listing Application No. A-24684
to the New York Stock Exchange, August 7, 1967,
Exhibit A., paragraph 3.1 (d).

34. Consolidated 2oods Corporation, Listing Application
No. A-24396 to the New York Stock Exchange,
June 6, 1967, p. 3.

35. Republic Corporation, Listing Application No. A-25751 to
the New York Stock Exchange, April 25, 1968, p. 4.
36. Income Tax Regulations, Section 1.483-1 (b) (6)
Example 8.
37. Samuel P. cunther, "Contingent Pay-Outs in Mergers
and Acquisitions," The Journal of Accountancy
(June, 1968), p. 39.



A stated objective of this research is to analyze the
attributes of the contingent payment form of business acqui-

sition. The present chapter is concerned with an examination
of the terms of particular earnout agreements that were
negotiated during the period of 1960 through 1968. Table 5

in Chapter II showed that corporations listed on the New York

Stock Exchange negotiated some four hundred earnout combina-

tions during that time. From these acquisitions, 265 (65%
of the total) agreements constitute the basis for the analysis

that follows in this chapter. Sixty-nine acquiring corpora-
tions (52% of the total of 133) are represented by these
agreements, including all ten of the corporations previously

identified as "frequent' acquirers. However, most of the 69
acquirers utilized the earnout approach to acquire only one

or two business entities. Therefore, the acquisitions of both
infrequent and frequent acquirers are represented. Agreements
negotiated in each of the nine years are represented, in-
cluding all of those for the first seven years--a time during
which earnouts were not commonly employed. Most of the agree-

ments studied, however, were consummated during the last two

years of the nine-year span, as would be expected, in view

of the increased incidence of earnout mergers indicated in

Table 5.

The particular combinations analyzed, then, include

transactions occurring throughout the nine-year period,

negotiated by buyers who seldom use the earnout approach as

well as those who normally do so. From the study of these

agreements, it is believed that fair representations of the

characteristics of earnout acquisitions will emerge.

The first part of the chapter is concerned with the dif-

ferentiation of the various kinds of agreements into specific

models. The remainder of the chapter deals with factors not

unique to any model--such as earnings goals, earnings period

duration and the kinds of payment media.

Hecht's Earnout Classifications

Hecht has defined earnouts as falling within at least

four categories: base-period, increment, cumulative, and

profit unit.1 No other writer has classified earnout acquisi-
tions. Hecht's "base-period" type is one where the contingent

payment is to be made annually, with shares valued at their

year-end market price, if actual earnings exceed those of

some prior base period. An "increment" earnout is based upon

yearly increases in actual earnings over the preceding earn-

out years (with the result that in the first earnout year, the

contingent payment would be computed upon the same bases under

both the base-period and increment definitions). A 'cumula-
tive" earnout is viewed as one which disregards yearly fluc-

tuations in the acquired company's earnings during the earnout

period. Instead, payment is dependent upon the cumulative
excess earnings of the seller, with a predetermined maximum

amount of issuable shares as part of the formula. Contingent

shares would not be issued until the end of the earnout pe-

riod, except for possible intermediate advances. The essence
of the "profit unit" earnout is that "additional stock payments
are exclusively based on the earnings of the new subsidiary.'2

For example, payment might be made on the basis of one addi-

tional share for each $20 of excess earnings.

In addition to these four types, Hecht lists the 'reverse"
earnout. A reverse earnout occurs if the acquired company's

earnings do not reach the earnings goal during the earnout
period, with the result that the purchase price is accordingly

reduced. Hecht, however, does not seem to view this type as
a "real" earnout since it 'is primarily concerned with the

down-side risks rather than the seller's participation in the

future growth of the acquiring company.3

The classification of earnout types of Hecht is both use-
ful and limited. It is useful in that he calls attention to
a number of the critical factors which should be considered
in negotiating such an agreement. These factors include time

of payment of additional shares, earnings goals to be achieved,
valuation of the earnout shares, and down-side risks, for


When considering specific agreements, however, his

classifications are not always mutually exclusive. In the

acquisition of Fordham-Bardell Shirt Corp. by the B.V.D.

Company, earnout shares were to be issued at the end of a

five-year period on the basis of

one additional share for each $2.00 of such
net earnings after taxes, in excess of
$250,000 (averaged out on a yearly basis
for the five-year period) up to an average
five-year net earnings of $375,000 or
62,500 shares, and then one more additional
share for each additional $8.00 of such
average net earnings in excess of t375,000,
without limit, during said period.

Cenco Instruments Corp. and Doerr Glass Company agreed that

earnout shares would be issued on or before September 1, 1970

by Cenco if the

Doerr Glass Company Division's cumulative
net earnings during the five-year period
from May 1, 1965 through April 30, 1970,
before any provision for Federal income
taxes, exceeds $673,000.00. In such
event, Cenco, for each full increment of
$19,200.00 by which such earnings exceed
the specified minimum, will deliver to
Doerr Glass Company and the Related Com-
panies, or their respective assignees,
an aggregate of 200 Cenco shares. Each
such increment of 200 additional shares
will be allocated among and distributed
to the six companies or their respective
assignees, on the basis of the relation-
ship of their respective net worths to
their com ined net worth as at January
31, 1965.'
From these two examples, it can be seen that the cumula-

tive and profit unit earnout designations do not necessarily

represent two separate types. In each of the acquisitions

above, the payment of additional shares is dependent upon the


cumulative earnings of the seller's business during the earn-

out period. These cumulative earnings, in the B.V.D.-Fordham

case, are considered on the basis of an annual average, while

in the Cenco-Doerr agreement, the cumulation is in the aggre-
gate over the earnout period. Further, the above agreements

provide for contingent payments on the basis of units of

profit. B.V.D. will pay on the basis of every two dollars of
profit up to a maximum of 62,500 shares, and thereafter on the
basis of an eight-dollar profit unit, with no maximum. Cen-

co's basis is a profit unit of $19,200 for each 200-share

payment (or $96 per share rounded down to blocks of 200
shares). No maximum is stated or implied by the terms of

Cenco's agreement.

Thus, earnout agreements may not necessarily fall within
the cumulative or the profit unit categories. If the above

two examples were to be classified via Hecht's approach, each

of them would fall within both categories.

Genesco, Inc. incorporated the increment approach with
the profit unit idea in its acquisition of Major Blouse Co.,

Inc. The agreement terms called for contingent shares to be
issued annually up to an aggregate maximum of 35,714 shares
if Major achieved yearly increases in actual earnings over
the preceding earnout years. The payout was on the basis of
a profit unit, as follows:

0.7143 of a share of Additional Stock for
each $3.00 by which the Adjusted Net Earn-
ings of the business of Major...for each
of the five Fiscal Years ended September
30, 1969 exceed $185,000 for the Fiscal

Year ending in 1965, $222 000 in the Fis-
cal Year ending in 1966, 4259,000 in the
Fiscal Year ending in 1967, $296,000 in
the Fiscal Year ending in 1968, and
$333,200 in the Fiscal Year ending in

To receive additional shares, Major was required to increase

its earnings each year by $37,000 over the preceding earnout

year. The agreement could be classed as both the incremental

and the profit unit type.

In an earnout with a three-year duration, Whittaker Cor-

poration combined the profit unit, the cumulative, and the

increment concepts into one agreement. In each year, the

profit unit was defined as 100 earnout shares for each $1,000

of earnings in excess of target, with the target for the first

year set at $700,000. To achieve additional payments, cumula-

tive earnings for the three years must exceed $2,400,000.

Thus, the earnings targets are incremental since there is a

net increase of $100,000 for the second period over the first,

and an increase of $150,000 for the third period over the


From the examples given, it is clear that because of the

overlapping of the categorizations which may exist when con-

sidering a given earnout agreement, the division of earnout

agreements into base-period, increment, cumulative, and profit

unit types is limited in usefulness. It is therefore con-

cluded that for purposes of this study the classifications

described by Hecht are not sufficient and that other criteria

must be found in order to adequately differentiate the various
kinds of earnout agreements.

Basic Earnout Models

From the study and analysis of the terms of agreement of
the selected earnout acquisitions, it is clear that contingent

payment purchase agreements contain much variation. Provisions
for the cumulation of earnings, for limits upon the amount of

the contingent payments, earnings definitions, profit goals,

timing of the payout, and others, are abundantly diverse.

Indeed, the multiplicity of elements and the formulations of
these elements into particular contracts may tend to obscure

their similarity.

The one indispensable factor (in addition to the survival
of the selling entity) which is common to the success of all
earnout acquisitions is the capability of the acquired entity

to generate profits during the earnout period of time, since

no contingent payments can be made unless the specified earn-
ings are achieved. The ability of a business enterprise to
earn a profit is, of course, an uncertain one,. with the un-

certainty increasing as the earnings goal for the selling
entity increases. Additional factors beyond earnings genera-

tion which may make prediction of the actual share payments
more difficult are sometimes found in earnout agreement formu-

lations. For example, the number of shares payable to the
sellers may depend not only upon their future profits which

are achieved in excess of an earnings target, but also upon

the market price of the equity security of the buyer at a

specific time which is several years distant from the date of


In this study, earnout agreements have been differenti-

ated into the following classes:

A. Those where the obligation of the buyer to make

contingent payments is dependent only upon the

ability of the seller to achieve profitable

operations. In this study, such agreements are

designated as "simple profit sharing" types.

B. Those where the buyer's earnout liability is

dependent upon the seller's ability to attain

specified earnings targets, rather than merely

achieve profitable operations.

C. Those where the amount of the earnout payment

depends upon the amount of the earnings of the

seller which are in excess of specified earn-

ings targets.

D. Those where the earnout payment depends upon

(1) the amount of the earnings of the seller

which are in excess of specified earnings tar-

gets and (2) the market value of the buyer's

equity security to be used as the medium of


Each of these classes of earnout agreements has the generation

of profits by the acquired entity as the prerequisite to any

contingent payment by the buyer. The first class has the
least amount of uncertainty: provided that the acquired

business earns profits, its former owners are entitled to re-

ceive specified earnout payments. For earnouts in the second

class, the business must not only be profitable, but its

profits must reach a certain minimum level before payment will

be made. Some earnouts depend upon the sum of the earnings

attained above a certain minimum level; these agreements

constitute the third category. The fourth kind of earnout

agreement is one where the number of earnout shares given in

payment is dependent not only upon excess earnings, but also

upon the fair market value of the security given in payment.

The groupings may be viewed as stages on a continuum which

generally proceeds from the uncomplicated to the more complex:

from agreements with a single determining variable (profit-

ability) to multiple-variable (excess profits, common stock

market prices) agreements. Each kind of earnout will now be

analyzed by utilizing particular terms of acquisition agree-


Simple Profit Sharing Earnouts

An early example of the use of a simple profit sharing

type of earnout is afforded by the October 5, 1960, acquisi-

tion of D. W. Onan and Sons, Inc. by Studebaker-Packard Cor-

poration. At the closing, Studebaker-Packard paid cash of

$6 million (which was subject to later adjustment, after an


audit had been completed of Onan's net worth as of August 31,
1960), and issued 324,325 shares of its common. stock. The

agreement provided for contingent payments, in cash, on April
15, 1961, *and annually thereafter...in respect to the earn-

ings, if any, of the Onan business until an aggregate of $3
million has been so paid.' The rate of payment was to be
one-third of Onan's net income before taxes for the first

three years, and then one-half of Onan's net income after
taxes for the remaining years. No time limit was specified;
apparently the earnout period would last until the maximum

payment of $3 million was made. In the year before its acqui-

sition by Studebaker, Onan had sales of almost $15 million and
before-tax earnings of slightly more than $2 million. At the

time of acquisition, Studebaker recognized the entire obliga-

tion (including the earnout payment, not yet earned) as

included in its purchase cost for accounting purposes. There
was apparently no uncertainty as to the eventual obligation to
make the earnout cash payments.

J. & H. Sales Company was acquired by Lehigh Valley In-
dustries, Inc. for payments of common stock, non-convertible

preferred stock, and cash. Contingent payments were provided
for in the event that J. & H. was profitable. These pay-
ments were to be made in cash at the rate of 50% of net
earnings before taxes for the four years 1966-1969, unless

such earnings proved to be $1.2 million or less, in which
case the earnout rate would be 40% instead of 50%. For
the years 1970-1972 the agreed rate was reduced to 26%,

probably because Lehigh Valley's Federal income tax carry-

forward loss appeared to be capable of being offset against

consolidated income only through the year 1969.9 No ceiling

was placed upon the total amount payable to the former owners

of J. & H., although the buyer acknowledged that the payments

might reach or exceed $3 million, based upon the assumption

that the business would continue to generate earnings at a

rate comparable to the level of profit earned during the

fiscal year ended in 1965.10

The proportion of profit which is to be allocated to

the former owners of the business need not be payable in cash.

In many cases, the medium of payment is the buyer's common

stock, valued at its fair market value as of a date, or

dates, close to its issuance, or on an averaged basis over

a specified period of time. For example, Republic Corpora-

tion and IKM Industries agreed that the fair market value of

the buyer's contingent shares

shall be deemed to be the average of the
daily market prices for the six (6) month
period commencing on May 1, 1970 and end-
ing on October 31, 1970. The market price
for each such trading day shall be the
last sale price on such day on the New
York Stock Exchange (or if there has been
no trading on such day, the average of the
bid and asked prices for such day as re-
ported by the Wall Street Journal).11

The aggregate fair market value of the earnout shares was to

equal the sum of (1) five times the first $200,000 of defined

net earnings during the two-year earnout, (2) two and one-half

times the next $200,000, and (3) one-half of all earnings in
excess of $400,000.12
A shorter period of time for determining the fair market
value of common shares to be issued annually contingent upon
earnings is found in the agreement of U. S. Industries, Inc.

and Talbott Knitting Mills, Inc. To determine the exact

number of earnout shares in this acquisition:

divide the pretax profits of the acquired
business for the specified period by the
average market value for a share of Special
Preference Stock... during the month preced-
ing the month in which the shares are to be
delivered to Talbott and (multiply) the re-
sulting figure by varying percentages ranging
from a high of approximately 29% in early
years t1 a low of approximately 26% in later

Upper limits upon the amount of stock which could be issued
contingently were established disregarding any pretax profits

in excess of a cumulative total of $6,650,000, and by restric-
tinF the market value of the earnout shares to a total of


In the 1966 acquisition of Electro-Air Cleaner Company,
Inc. by Emerson Electric Co., the buyer agreed to apply an

amount equal to 35% of the defined after-tax earnings of

Electro-Air to the purchase of shares of Emerson's common

stock in the open market "at then current prices and deliver
the shares so purchased to Electro-Air or its shareholders."14

Thus Emerson would be both expending cash and issuing shares
under any earnout payment. Cash payments will directly di-
minish corporate working capital while issuance of common

shares would not. It is not surprising therefore to find a

provision in the agreement which enables Emerson to substitute

unissued shares or treasury shares for shares newly purchased

for cash.

In addition to formulas which provide for profit sharing

by means of designated percentages of earnings through cash

payments or their equivalents in equity share market values,

some agreements provide for the contingent payment to be

translated to per-share terms by the use of "fixed divisors."

Such fixed divisors may be related to share market values

during some specified period or may be simply units of profit.

An example of the former is contained in the acquisition of

Tool Industries, Inc. by Gulf & Western Industries. The num-

ber of earnout shares is to be determined by

dividing 25% of the pre-tax earnings of
Tool for the period August 1, 1965 through
and including July 31, 1967 by $36.125,
the average closing price of the Common
Stock on the New York Stock Exchange over
a ten-day period 5 agreed upon during
the negotiations.

Use of a fixed divisor in profit-unit terms was made in

the acquisition of Merla Tool Corporation by Teledyne. Each

year for a three-year earnout period, Teledyne would deliver

its common stock on the basis of one additional share for each

$500 of net income before taxes earned during the preceding

twelve months.16 The profit unit divisor may be combined with
the fair market value per share to formulate the earnout pro-

vision. This was done by Fuqua in its purchase of Ward Mfg.,

Inc.17 Each $3 of net income after taxes up to $500,000


would result in the issuance of $1 worth of Fuqua common. On

earnings above $500,000, each $1 of earnings would result in

$2 worth of common shares. Thus, the divisors were $3 times

the market value of the common for the first $500,000 of earn-

ings, and $0.50 times the market value of the common for the
excess earnings, if any. Although this earnout requires only

profitability to insure payment, beyond earnings of $500,000

the payments will be a rate six times the initial payouts.

This should provide increased motivation for the seller-owners

to increase earnings.

It would seem reasonable to expect that in those acquisi-

tions where contingent payments will be made provided only

that the sellers generate profits that the recent history of

the business was most likely unprofitable, so that attainment

of the goal of profitability would represent an improvement

in the results of operations. This was not the case, however.

Of the total of twenty-seven acquisitions of the "profit

sharing" type, it was found that all of the acquired businesses

had been profitable in the period just prior to acquisition,

with only one exception. Sellers had only to continue oper-

ating their businesses profitably in order to receive addi-

tional compensation in the future.

In summary, in the profit sharing earnout the contingent
payment is equal to a specified fraction of all earned profit

and is most often payable in cash or its share equivalent in

terms of the approximate current market value of the equity

security given. In some cases the price per share is fixed


at a quoted value which would only coincidentally be equal to

the current market value. It is common to specify maximums

beyond which earnout payments will not be made. Some either

imply or state, however, that there is no payout limit. Stated

maximums are generally in terms of the number of shares which

may be issued in the aggregate or in terms of the total cash

which may be expended. The expectation under this type of

earnout agreement would be that future payments will be made

since these payments are dependent only upon the ability of

the acquired business to achieve profitable operations and

because almost all of the businesses studied were already

profitable before they were acquired.

Target-Attainment Earnouts

A second kind of earnout agreement requires that the ac-

quired business attain a designated profit target. If and

when the target is achieved, the contract specifies the amount

of cash, number of shares, or the value of the shares to be

issued to the former owners. Amounts of earnings which are

in excess of the stated targets do not influence the total

payout in this type of earnout; reaching the particular profit

goal is the determining factor. If the target is reached,

then the predetermined amount of the contingent payment is

required to be paid.

The 1963 combination of Fairmount Motor Products Co. into

Avnet included this kind of earnout. The agreement specified

a payment of $100,000 in cash to Fairmount on September 30,

1966 if the net earnings of the newly established Fairmount

Motor Products Division for the twelve months ending June

10, 1964 amounted to $400,000 or more. A further incentive

to increase earnings was provided by the promise of an addi-

tional sum of $150,000 in cash, payable on the same date, if

net earnings achieved a level of 425,000 or better. These

contingent payments, if earned, would be evidenced by Avnet's

non-interest bearing notes.18

In the earnout agreements selected for detailed analysis

in this study, the most common terms provided for payment in

shares. Sometimes the shares are issued out of escrow to the

sellers, or to the buyer, depending upon the attainment or

non-attainment of the profit target each year. In one earn-

out, the sellers agreed to put 1,500 of the shares issued to

them in escrow with the buyer's treasurer, the shares to come

out of escrow annually, dependent upon the seller's earnings.

If earnings of ,400,000 or more are realized in any of the

five earnout years, then 300 of the 1,500 shares would be

delivered to the sellers in each such year. For each year

where the earnings are less than )400,000, 300 of the 1,500

escrowed shares would revert to ownership by the buyer.19

It is not uncommon for the earnings target to differ from

one year to the next in earnouts with a duration of more than

one year. Where such differences exist, it is typical for

targets to be higher in later years, as compared with those

in earlier years. The corresponding contingent payments may


or may not be different, however. To illustrate, Ashland Oil's

acquisition of Southern Fiber Glass Products, Inc. provided


In the event that the combined pre-tax net
earnings of Southern and its subsidiaries
exceed $560,000 for 1966, $640,000 for
1967, or $800,000 for 1969, Ashland will
issue...Common Stock having a value equal
to $150,000, following the close of any
one of such years.

In this instance, the seller will strive to increase earnings

by :$80,000 per year. If the effort is successful, the annual

payment will be constant at $150,000. If the increase in one

year is not equal to at least $80,000 with no resulting con-

tingent payment that year, subsequent years may nevertheless

result in earnout payments provided the deficiency is compen-

sated for by increased future profits. A similar provision

is apparent in the acquisition of two candy companies by

Helme Products, Inc. In this case, however, the contingent

payment increases along with the increases in periodic earn-

ings. Helme agreed to issue additional shares as follows:

If net income of the two companies is $67,500
for the five months ending December 31, 1966:
5,000 shares; if net income is $357,500 for
the five months plus 1967: 25,000 shares
(less earnout shares previously issued); if
net income is $722,500 for the five months
plus 1967 and 1968: 45,000 shares (less
shares previously issued); if net income is
$1,161,250 for the five months plus 1967,
1968, and 1969: 68,750 shares (less shares
previously issued); if net income is $1,555,000
for the five months plus 1967, 1968, 1969 and
the seven months ending July 31, 1970: 95,000
shares (less shares previously issued). In
the event that the cumulative income at the
end of 1969 is $1,296,250, however the total
of 95,000 shares becomes issuable.21

Neither of the two companies acquired by Helme was prof-

itable before the combination took place. Acquisition of loss

companies is not usual under earnout agreements, however. In

most of the target-attainment earnout agreements, the profit

target is set at a higher level than current earnings, al-

though in some instances, current earnings at the time of ac-

quisition exceeded stated goals, thus increasing the likeli-

hood of earnout payments.

Notable in its employment of the target-attainment earn-

out is U. S. Industries, Inc. Unlike those of other acquirers,

the acquisition agreements of U. S. Industries commonly con-

tain more than one earnout component. One of the components

is frequently labeled as a "fixed deferred" payment and is

often of the target-attainment type. In its purchase of Con-

solidated Merchandising Corp., USI paid 44,867,000 in common

shares at the closing and agreed to issue up to another $5

million in shares on an earnout formula which provided for

payments in shares equal to stated percentages of the amounts

of earnings in excess of incremental profit goals. In addi-

tion, the agreement promised fixed dollar amounts in common

shares if other profit targets were met. Specifically, if net

income before taxes in 1968 reached $1.2 million or more, then

$985,221.80 would be paid; and, if 1969 earnings reached

$1.4 million or more, another $966,183.60 would be due.22

In some instances, the target is applicable to any one

of several income periods. In addition to an earnout provi-

sion insuring payments up to $10 million at the rate of