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Earnout business combinations

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Earnout business combinations
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Yeakel, John Albert, 1930-
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xi, 251 leaves. : 28 cm.

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Assets ( jstor )
Business structures ( jstor )
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Corporations ( jstor )
Issued capital ( jstor )
Net income ( jstor )
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Stock exchanges ( jstor )
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Accounting thesis Ph. D ( lcsh )
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Thesis -- University of Florida.
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Bibliography: leaves 244-249.
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Manuscript copy.
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Vita.

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Full Text










Earnout Business Combinations


By

JOHN ALBERT YEAKEL










A DISSERTATION PRESENTED TO THE GRADUATE COUNCIL OF
THE UNIVERSITY OF FLORIDA IN PARTIAL
FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF
DOCTOR OF PHILOSOPHY







UNIVERSITY OF FLORIDA
1971






























Dedicated

to

Deborah

































Copyright by

John Albert Yeakel

1971














ACKNOWLEDGMENTS


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.














TABLE OF CONTENTS


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


vii

ix
1

1
6

15
15
24
30

48

4.8
56

72

73
78
80
86
92
99

105
107
107
119
124
126
128
130
131
135








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 . . . . . . . .


143

144
146
148

153
156
156
156
157
157
160

162
166

169

175

178
186

197

198

203
210

221

242


250














LIST OF TABLES


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 .


vil


28

29


31

32


33

34


108


116


118


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


viii














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

EARNOUT BUSINESS COMBINATIONS
By

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
presented.

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.














CHAPTER I

INTRODUCTION AND PURPOSE OF THE STUDY

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






2

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






3

$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
4
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
corporation.5

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






5

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.






7

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






11

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-

mation.

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






13

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.








NOTES

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.














CHAPTER II

INCIDENCE AND BASIC CONSIDERATIONS


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
1
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,






16

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







17
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.






19
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


Assets
(millions)


Per cent


Horizontal

Vertical

Conglomerate


Total 1,083


Type


193
156


17.8

14.4

67.8

100.0


$ 7,099
5,782

26,629

$39,510


18.0

14.6


67.4

100.0


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
Mergers*

1,361
1,950
2,125
2,377
2,975
4,462
6,132


Increase over
Numerical


589
175
252
598
1,487
1,670


previous year
Per cent


43.3
9.0
11.9
25.2
50.0
37.4


*Merger announcements, net of cancellation.


Sources:


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


Year

1963
1964
1965
1966
1967
1968
1969












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.






23

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
11
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






25

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


196041966
1960-1966

1967-1968
1967-1968


Source: Listing applications to the New York Stock Exchange.


19
88

158
140


107


298

405


Total










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.






30
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
1960-1968

Number
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

Number
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
1960-1968


Year of
Acquisition

1960
1961
1962
196
1964
1965
1966
1967
1968


Number of
Profitable
Firms*
4
10
8
4
13
18

101


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


35.9
23.9
19.2
26.4
27.0
24.1
30.7
34.1
34.3


71.8
58.4
47.9
41.6
53.8
54.6
82.2
64.2
89.7


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




















Table 10

Age of the Firm at the Time of
Its Acquisition


Number of years
in Operation


Number
of Firms


Per cent


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


46 50

over 50

Total


40
52
37
24
29
13
10
10
7


239


16.7
21.8
15.5
10.0
12.2
5.4
4.2
4.2
3.0
1.2
1.8
100.0


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
Earnouts
14
18
9
3
12

56


*Shares were traded either
counter or American Stock


over-the-
Exchange.


Source: Listing applications to the
New York Stock Exchange.






35

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






36

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






39
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






40

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






43

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

rates.

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








NOTES

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.














CHAPTER III

LEGAL FACTORS


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






49

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,

however.

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






51

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
Act.

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






55

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

words:

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

provision:









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







57

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

them.

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-
stock").

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

interest.

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.






62

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






63

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






64

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
exchange.31

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






66

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






67

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






68

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.








NOTES

1. Securities Act of 1933, as amended to October 22, 1965.
2. Securities Exchange Act of 1934, as amended to July 29,
1968.

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.,
1960).

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.






71
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.













CHAPTER IV

ANALYSIS OF THE TERMS OF
EARNOUT BUSINESS COMBINATIONS

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






74
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

example.









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






76

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
1969.0

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

second.7

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

acquisition.

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

payment.

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-

ments.



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






81

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
08
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
years.1

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

$2,0000000.

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






85

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






86

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






88

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

acquisition of Southern Fiber Glass Products, Inc. provided

that:

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






89
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




Full Text
62
The Tax Court, in 1964, held in James C. Hamrick2^ 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 i960 Carlberg case.
The nature of contingent rights to receive additional
voting stock in the future was considered in Revenue Ruling
66-112, involving a "B" ("stock-for-stock") exchange between
X corporation and Y corporation who equally owned the capital
p Z
stock of M corporation. 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


114
the average annual earnings of Diamond earned during the
three-year earnout period in two payments (at the closing and
at the end of the earnout period). In this instance, the
market valuation of the initial shares is based upon an aver-
41
age price during a period of time before the closing.
Sometimes, the valuation of the initial shares for pur
poses of defining the earnings goal is based upon an average
market price much later than the closing. Kidde's acquisition
of the "Work-O-Lite Corporations" provides for a contingent
payment to be made in 1973 based upon earnings during 1969
through 1972. Kidde will pay two and one-half times the prof
its for those four years to the former owners, provided that
that amount exceeds the market value of the closing shares.
The closing shares are to be valued, however, at their average
closing prices for the first ten of the thirteen trading days
42
preceding March 31, 1973. Thus, unlike the Whittaker-Diamond
combination where the sellers already know the amount of the
earnings goal which they need to surpass, in the Kidde acquisi
tion the sellers cannot know during the earnout period if they
will receive contingent shares because their earnings goal is
predicated upon future market prices of Kidde securities. How
ever, the former owners are assured of having shares worth in
1973, at least two and one-half times their earnings for the
duration of the earnout. They could, of course, possess clos
ing shares worth more than that amount, in 1973.
It is possible that a number of other agreements contain
earnings goals that are, in reality, equivalent to an agreed


251
He is married, to the former Deborah Wendell Davis. He
is a member of the American Accounting Association, American
Institute of Certified Public Accountants, National Associa
tion of Accountants, Beta Gamma Sigma, Beta Alpha Psi, and
Phi Kappa Phi. He holds the CPA certificate from the Dis
trict of Columbia and has been the recipient of fellowships
from the Earhart Foundation, Haskins and Sells Foundation,
and the American Institute of Certified Public Accountants.


225
is large, negotiations will be more cumbersome than is the
case with a few owners. Should, the acquired company have
been publicly held with listing on a securities exchange,
additional problems may arise so that requirements of the
Federal securities laws are satisfied. A large number of
selling owners also means more record-keeping to assure that
contingent payments are made to those who are entitled to
them.
Parties to an earnout agreement should be cognizant of
relevant sections of the Federal securities laws. The buyer
will prefer to avoid the effort and cost required to file a
registration statement with the Securities and Exchange Com
mission covering any additional securities to be issued. To
avoid registration, the merger must qualify for exemption
under Rule 133 of the Rules and Regulations under the 1933 Act
or under Section 4(2) of the Securities Act of 1933. If the
securities are transferred under a statutory merger or a
"Type C" reorganization, then Rule 133 applies. If the secu
rities are transferred in a transaction "not involving any
public offering," then Section 4(2) is applicable. Both Rule
133 and Section 4(2) limit the freedom of the sellers to
dispose of the shares they receive from the buyer. The sel
lers should be aware of the possibility of their being "locked
into" their investment either by limitations on the number of
shares they are allowed to sell within specified time periods
(Rule 133) or by requirements that they hold the acquired se
curities for a "sufficient" period of time (Section 4(2)).


10
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


232
selling shareholder had to elect whether or not to partici
pate in a contingent payment scheme, but such earnout options
were evident only since 19&7. Whether or not the earnout
option approach to business acquisitions will be utilized
more frequently in the future for the purchase of publicly
owned enterprises remains to be seen.
It was found in this study that the business enterprises
acquired through earnout combinations usually have been small
firms whose mean volume of sales during the year just prior
to acquisition was $7,375 000. Only 5$ of these firms had
sales exceeding $25 million, and $0% had generated sales of
less than $5 million. Measured by total assets, acquired
firms averaged $3750000 at the time of acquisition. Ap
proximately one-half had assets of less than $2 million,
with only 6% showing assets exceeding $10 million. Except
for only about 3$ of their total number, firms have been
profitable enterprises prior to their acquisition. They were
not often newly founded businesses: approximately 36$ had
been in business more than twenty years, 61$ more than ten
years, with only 17$ having operated for five years or less.
The managers at the time of acquisition were commonly the
already-successful owner-founders who then continued in their
positions as the operating executives of the acquired entity.
In addition to the terms of merger and its legal implica
tions, the parties to an earnout must also give consideration
to the accounting form of the combination. This is so because
future earnings per share of the acquirer will depend upon the
combined effect of the accounting method, the earnout terms


117
by his most recent income data. Such data usually covered the
year preceding the date of acquisition and, where the data
were for periods of less than one year, the profit was an
nualized to enable comparison with the first period's earnings
goal.
Table 14 shows the results of this comparison of the
seller's recent earnings with his earnings goal for the initial
earnout period. Comparisons were possible for a total of 152
acquisitions. Three reasons account for the inability of the
writer to collate this information for all of the combinations.
In some cases no recent income statements were available. In
others, the profit goal is not given. For still others,
earnings definitions on the income statement and for the goal
are different and we cannot be sure if the two are comparable.
For example, while the earnings goal may be expressed in
after-tax form, the former entity was a partnershipwith its
resulting income statement showing no taxes on income as such.
As can be seen from Table 14, only about 28$ of the earn
outs tabulated contained earnings goals which were in excess
of the amount of profit being generated by the selling entity
near the time of its acquisition. In 25 cases the earnings
goal was quite obviously set to coincide with the amount of
the most recent profit figure. It is apparent from the data
in the table that the great majority of sellers were profitable
before their acquisition; only four were identifiable as loss
companies, in fact. The data suggest that for about 72$ of
the contingent payment acquisitions studied, some portion of


Table 11
Diversity of Ownership of Acquired Firms
Number of Number of
Individual Sellers Earnouts
1 14
2 18
3 9
4 3
5 to 48 12
Total known to be
privately held 58
Total known to be
publicly held* _8
Total verifiable 64
^Shares were traded either over-the-
counter or American Stock Exchange.
Source: Listing applications to the
New York Stock Exchange.


85
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


186
earnout obligations will be increasingly viewed as contingent
liabilities. The classification of earnout obligations as
contingent liabilities will be found in Chapter VI.
Examples of Informative Disclosure
The major user of the earnout form of acquisition, U.S.
Industries, Inc., discloses expected, estimated, and possible
maximum earnout obligations as well as payments made for suc
cessful earnoutsall in aggregate terms under the Capital
Stock footnote (but also referred to in the Contingent Liability
note):
The Company has contractual obligations,
as a result of acquisitions, to issue addi
tional shares of its convertible Special
Preference Stock and Common Stock from
1970 to 1977. The number of shares to be
issued will depend upon future earnings
of the acquired businesses and the market
price of the Company's Common Stock at the
approximate dates of issue. In 1969, the
Company issued 907,438 shares of Common
Stock and 44,775 shares of convertible
Special Preference Stock (convertible into
179,100 shares of Common Stock) pursuant
to these obligations. The minimum value
of shares to be issued subsequent to Decem
ber 31, 1969 will be approximately $47 mil
lion. If the earnings of these acquired
businesses continue equal to 1969 levels,
the value of the shares to be issued over
the eight year period would be approxi
mately $121 million and a maximum addi
tional number of shares equal in value to
approximately $220 million may be issued
for increased earnings. In addition, the
Company may be obligated to pay up to an
additional $6 million in cash and $500
thousand in non-convertible Special Pref
erence Stock during the years 1970-1975
under formulas based on profits of acquired
businesses.78


CHAPTER VI
THE CASE FOR EARNOUTS AS CONTINGENT LIABILITIES
Acquirers making use of the earnout concept have typi
cally viewed these transactions as giving rise to the recogni
tion of a contingentas opposed to an estimated or deferred-
liability. Of the total of 265 merger agreements analyzed in
this study, in only an insignificant number of cases (5) did
the buyer treat the future payments prescribed by the contract
as estimated or deferred liabilities. Even in cases where the
acquired entity had a history of profitable operations prior
to acquisition and where its earnings goal under the agree
ment was simply continued profitability, it was found that the
acquirer accounted for the earnout payments as contingent lia
bilities in virtually every instance. That is to say, no lia
bility appeared on the acquirer*s balance sheet to reflect
possible or probable future payments under the earnout. In
stead, footnote disclosure is the rule and the amount of such
disclosure varies widely, as was evidenced in the previous
chapter. The purpose of this chapter is to examine the cri
teria for inclusion of a given item as a contingent liability
and then to determine whether evidence supports the practice
of treating earnouts as contingent liabilities.
197


187
In its 1969 report, USI also estimated the number of shares
which might be issued in the future (assuming maintenance of
1969 earnings levels of earnout companies and the average
market price of common at year-end) under acquisition agree
ments, in order to compute common share equivalents and earn
ings per share. With this estimate of 4.3 million shares and
the knowledge that 20.1 million shares are outstanding, the
reader can gain some appreciation of the dilution which is
likely to occur.
The basic question of how much and what kinds of informa
tion should be disclosed for the reader's use is one that is
worthy of a considerable amount of empirical research effort,
and has not as yet been adequately answered. With reference
to earnout disclosures, in particular, we have no basis for
knowing what principles of disclosure would be optimal. The
writer presumes that the shareholder would be interested, at
minimum, in knowing whether earnouts are being utilized to
make acquisitions and the extent of any potential earnings
dilution caused thereby. He might also reasonably expect to
learn if the earnout acquisition was profitable enough to have
occasioned payments under the formula terms. Such payments
help to validate the soundness of acquisition policy and
managerial capability.
We have seen that in three out of four instances, the
annual report reader can be aware of the use of the earnout
concept by the corporation through its disclosure. It was
found in this study that the dilutive effect of contingent


203
Although it was found that writers on the subject of
contingent liabilities frequently are not precise as to the
meaning of the term, several characteristics seem to be basic
and are here summarized. A past and a future event are neces
sary to the notion of a contingent liability. There must be
an obligation which may arise, dependent upon the future event,
but stemming from the past event. The future event may change
the legal status or relationship between the parties, but it
may not be probable; if the future event is probable, the ob
ligation should be estimated and recorded as a liability
not disclosed as a contingent liability.
Are Earnout Obligations Contingent Liabilities?
There is no question but that an obligation payable under
an earnout agreement arises because of the existence of a past
eventthe purchase and sale of the acquired business entity.
Neither the legal status of the parties to the contract, terms
and timing of the contingent payment, nor the range of possible
payment values is in question. Two factors, however, are ap
propriate for discussion here: the existence of a future
event, and the probability that earnout payments may have to
be made.
The term "future event" is somewhat troublesome when
thought of in connection with earnouts. When used by writers
on the subject of contingent liabilities, the connotation is
usually clear-cut, even though the term is rarely defined.
The future event is a singular noteworthy happening, such as


205
not usually disclosed through the annual report to sharehold
ers. Changes in outstanding securities of the corporate ac
quirers included in this study are, however, required to be
disclosed (since 1965) through reports filed with the Securi
ties and Exchange Commission. Specifically, Item 2 of Form
10-K details such changes for each reporting year. Photo
static copies of this Item were requested from the Commission
for those years in which payment in the form of additional
securities would have been made, assuming achievement of the
earnings goal. The absence of any. issuance of shares implies
non-attainment of the specified goal.
For many of the earnout agreements analyzed, no payments
are yet appropriate because the earnings period has not yet
elapsed. This is to be expected inasmuch as the majority of
the agreements were consummated in the last two years covered
by the study, with an earnout duration of three to five years.
For these agreements, additional research is appropriate in
succeeding years to determine whether or not the acquisition
was an economic success.
Analysis of the changes in securities outstanding, as
reported in Item 2 of 10-K Forms, yielded evidence concerning
the economic success of 100 acquired companies, as indicated
in Table 20. At least 14# of these acquisitions were not
only successful enough to warrant payments in the form of
contingent shares as provided for by the terms of the con
tract, but performed well enough so as to qualify for the


213
There is some evidence from this study that the transla
tion of the earnout liability into a monetary amount can be
made. In five instances the acquirer recorded this obliga
tion in monetary terms on its balance sheet at the date of
acquisition. In several other cases, terms of the acquisition
were changed or equity shares were substituted for cash pay
ments when it became clear to the acquirer from its earnings
estimates that the maximum payment under the agreement would
be required in the future. Although all estimates of future
profitability involve uncertainty, such estimates may be less
prone to error in the case of earnouts because of certain
factors. One is that the duration of the earnout period
(Table 15) is frequently three years or less and rarely in
excess of five years. Thus the period of forecasting is often
relatively short. Another is that the acquired company is
usually profitable before acquisition (Table 9) and the earn
ings goal specified is usually not in excess of recent earnings
(Table 14). Further, the acquired companies in this study
often had a past history dating back a number of years; they
were not newly founded organizations Approximately $6% had
been in business more than twenty years; 61% had been in busi
ness more than ten years; 17% had been in business for five
years or less (Table 10). The writer assumes that generally
more reliable estimates can be made where the entity has a
backlog of past experience in its industry as opposed to the
case of a fledgling company.


134
of Soss Manufacturing Company, and used in its acquisition
program since 1964.-^
In two acquisition agreements, some of the regular con
tingent shares are required to be placed in escrow after such
time as the seller has earned them. To acquire Chicken De
light, Consolidated Foods negotiated an increasing excess-
fixed divisor earnout payable in 1966 and 1967, in shares of
its common stock. The agreement provides that one-half of
the additional shares issued in 1966 and in 1967 will be
placed in excrow until June, 1969 and. that some or all of
such shares may be forfeited if the average annual recurring
earnings of Chicken Delight from April 1, 1965 to March 31
1969 are less than the recurring earnings with respect to
which additional shares are issued in 1966 and 1967.In
this instance, shares already earned are required to be es
crowed to assure the buyer that the seller will maintain
earnings even beyond the usual earnings period. The escrow,
in effect, lengthens the duration of the earnout period for
an additional two years.
The successful earnings upon which release of escrowed
shares depend have been found to pertain to any of three dif
ferent time periods. First, the seller's unverified earnings
expectations of the period just prior to acquisition may be
the reason for the escrow. Shares may be escrowed during a
period which coincides with the earnout period. Thirdly,
earned contingent shares are sometimes escrowed for a period
of time beyond the usual earnout period. The purpose of


144
has been utilized in some combinations, but its incidence is
not frequent. In order to discuss the accounting implications
relating to earnout business combinations specifically, it is
necessary to first look briefly at the purchase and pooling
approaches to business combinations generally, with the atten
dant problem areas of the accounting for goodwill and earnings
per share computations.
Purchase Accounting
Under the purchase concept, a business combination is
treated as the acquisition of one company by another. The
buyer then records the assets acquired at cost, less whatever
liabilities are assumed. Cost is equal to the amount of cash
or its equivalent, which is paid, or the fair value of the
assets acquired, whichever is the more reasonably determin
able. Frequently however, there is a difference between cost
and the total of the fair market values of the acquired com
panys assets. The purchase method requires an acquiring
company to record its newly acquired tangible and identifiable
intangible assets, such as patents and trademarks, at their
fair market values. Any excess of the purchase cost over
these fair market values is customarily designated as good
will. Under the purchase method, the asset book values shown
in the records of the seller are often not relevant to the
accounting of the buyer.
Thus, if Company A has tangible assets with a book value
of $1 million and liabilities of $300*000, an appraisal of


CHAPTER II
INCIDENCE AND BASIC CONSIDERATIONS
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 1931We 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.^
The purpose of combining, allegedly, was to create monopolistic
corporate structures so that competition could be eliminated,
15


Table 16
Timing of the Contingent Payment(s)
As Specified in Earnout Agreements, 196O-I968
Frequency of Use
Time of Payment
1950
61
~~rZ2
L' i. CUUC
U.
iJ-W v.
"ZM"
>65 '
1 6
Ihl
Total
Percent
Annually, throughout
the duration of the
earnings period
3
5
3
3
8
8
29
27
63
149
59
At the end of the
earnout period of:
One year
1
1
2
4
4
13
25
10
More than one year
_1
_2
_2
-2
10
-5
16
_15
-21
Subtotal
4
8
5
7
13
20
38
47
111
253
100
Not stated
1
-5
4
1
1
6
14
-21
Total
5
13
9
7
14
20
39
53*
125*
285*
Totals exceed acquisition totals because some acquisition agreements contain more than
one payment arrangement.
Source: Listing applications to the New York Stock Exchange.


132
escrowed in order to secure the buyer against breach of
contract, undisclosed liabilities and the like. However,
these usual indemnifications to the buyer are not the subject
of the present discussion. We are here interested in those
escrow arrangements where release of the deposited shares is
dependent only upon earnout success.
The shares so deposited are usually taken from the total
of shares issued at the closing. Because of the tax implica
tions relative to tax-free reorganizations and possible im
puted interest (discussed in Chapter III), shareholders of
the escrowed shares (the former owners of the acquired busi
ness) generally retain the voting and dividend rights which
apply to these shares during the time they are escrowed. The
custodian may be either a third party, such as a bank, or the
acquiring corporation, acting as its own escrow agentthrough
its treasurer, for example. It was found that 24 (9$) of the
265 acquisitions contained an escrow arrangement.
One reason for escrowed shares is to assure the buyer
that the expected net income of the seller for its fiscal
period just before its acquisition will be attained. If it
is not, then the closing price can be adjusted downward. In
the March, 1968 agreement of Consolidated Foods to acquire
the Cant Shirt Companies, 126,596 shares were issued at the
closing, of which 28,625 were placed in escrow, to be released
according to the earnings of Gant for its fiscal year ended
June 29, 1968. Consolidated receives one share back for each
$7 that net income after taxes is less than $750000 (up to


TABLE OF CONTENTS
List of Tables
Abstract ix
Chapter I. Introduction and Purpose of the Study ... 1
An Early Earnout: The Gillette-Toni Merger
in 19^8 1
Purpose and Design of the Study 6
Chapter II. Incidence and Basic Considerations .... 15
The Merger Movement Background 15
The Increase in the Use of the Earnout 24
Advantages and Limitations of the
Earnout Form of Acquisition 30
Chapter III. Legal Factors 48
Federal Securities Laws Considerations 48
Federal Tax Considerations 56
Chapter IV. Analysis of the Terms of
Earnout Business Combinations 72
Hecht's Earnout Classifications 73
Basic Earnout Models 78
Simple Profit Sharing Earnouts 80
Target-Attainment Earnouts 86
Excess Earnings-Fixed Divisor Earnouts 92
Excess Earnings-Market Value Earnouts 99
Formulations Dependent upon the
amings of the Buyer 105
Frequency of Use of the Basic Earnout Models ... 107
Earnings Goals 107
The Definition of Earnings 119
Duration of the Earnings Period 124
Timing of Contingent Payments 126
Payment Media 128
Limitations on Contingent Payments 130
Escrow Provisions .... 131
Earnout Options 135
v


200
judgment to determine when a contingency be
comes sufficiently threatening to require
entry in the balance-sheet proper. More
over, a company is not called upon to pub
lish a specific amount of liability if by so
doing it would prejudice its own position in
controversy.
With the outbreak of World War II, more of the economic
activity in the United States was done by the rise of govern
ment contracts. As a result, additional uncertainties and con
tingencies arose with respect to possible price adjustments
due to renegotiation, additional taxes, and the interpretation
of government contracts and regulations issued by various
governmental agencies. The subject of contingent liabilities
assumed a "greater importance than ever before in the history
of the accounting profession,"' with a concomitant increase in
related articles written during the late 1940's and 1950's,
culminating with Accounting Research Bulletin No. 50 entitled
"Contingencies." In this Bulletin, a contingency was defined
as:
an existing condition, situation or set of
circumstances, involving a considerable de
gree of uncertainty, which may, through a
related future event, result in the acquisi
tion or loss of an asset, or the incurrence
or avoidance of a liability, usually with
the concurrence of a gain or loss. A commit
ment which is not dependent upon some signi
ficant intervening factor or decision should
not be described as a contingency.
The Bulletin further stated that "where the outcome is reason
ably foreseeable" recording should take place in the accounts
where a loss is expected.^ if the outcome is not predictable
enough to permit such recording, then the contingency should
be disclosed.10 That the Bulletin was not as definitionally


70
18. Exceptions include cases where the seller would realize
a loss on the deal and estates holding property
owned by recent decedent,.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, Management Report 75. American
Management Association, 1963, p. 105.
20. Sections 354 and 361, Internal Revenue Code of 195^*
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.,
I960).
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-I, 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 7-13, C.B. 1967-I, 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 Foods Corporation, Listing Application
No. A-24396 to the New York Stock Exchange,
June 6, 1967, p. 3.


96
per share is used unless current values are below this value.
For earnings in excess of a specified target, the selling
"stockholders shall receive one share for each $24 thereof,
unless the market value of the Company's shares are then less
than $24, in which event the number of shares shall be com-
27
puted at the lesser value." Such a provision benefiting
the seller in periods of market price decline is unusual,
however.
When the shares of the buyer's common are assigned a
fixed value and the market price of the stock rises, earnout
shares will be issued in larger number than would have been
true had the formula's denominator been variable rather than
fixed. This can put the buyer at a disadvantage in terms of
the seller's increase in proportional ownership. In several
of the acquisitions of one buyer, the agreements have been
devised so that an adjustment to the formula is made if the
buyer's shares rise in value above a specified price. The
earnout provisions of one such agreement follow:
On or prior to April 30, 1971, REPUBLIC
shall issue to AMTR0N...the following num
ber of shares (less earnout shares issued
in prior years):
(i) one (1) share of REPUBLIC Common
Stock, or
(ii) if it is less than one (1), that
fractional part of a share of
REPUBLIC Common Stock equal to
One Hundred Ten Dollars ($110.00)
in Fair Market Value of REPUBLIC
Common Stock (determined as at
April 25, 1971), whichever is the
smaller,
for each Thirteen and 20/100 ($13.20) by
which the average annual Net Earnings of the


158
seller's old book values were recorded, in five instances the
excess of the consideration given over those book values was
charged to patents, buildings, machinery, or equipment, and
subject therefore to later writeoff.
The most common disposition of such excess is to capital
ize it as "excess of cost over book values of assets acquired,"
without its being subject to amortization. In only ten out of
forty-five purchase combinations where the purchase price was
in excess of the net assets acquired was it the buyer's inten
tion to amortize such excess to income over future periods
(ranging as long as twenty-five years). Therefore, even
though there arose an excess of cost over the net assets ac
quired at the closing based only upon the initial payment,
there was usually no resulting reduction in future profits
caused by amortization of such goodwill. All of the earnout
acquisitions in which an intention to amortize was specified
took place before 1964. Current practice with respect to pur
chase earnout combinations is to not amortize the excess of
cost over assets acquired. Empirical studies indicate that
amortization of the goodwill which results from the accounting
for business combinations as purchase can have a material re-
18
ducing effect upon reported earnings. It is hardly surpris
ing then that merger-minded acquiring corporations will select
from among generally accepted accounting practices those which
will allow the most favorable earnings per share results.
From an income determination standpoint, therefore, there
is usually no difference between the pooled and the purchased


71
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. Gunther, "Contingent Pay-Outs in Mergers
and Acquisitions," The Journal of Accountancy
(June, 1968), p. 39.


196
43. This statement reflecting the position of the SEC with
respect to accounting for earnouts is taken from
personal correspondence received by the writer
from Andrew Barr, Chief Accountant, SEC, dated
March 23, 1970.
44. u.S. Securities and Exchange Commission, Securities Act
Release No. 4469. Washington, D.C.: Government
Printing Office, 1962, pp. 6-7.
45. Personal correspondence from Andrew Barr, Chief Accoun
tant, SEC, March 23, 1970.
46. Ibid.
47. Ibid.
48. W. R. Grace & Co., 1967 Annual Report, p. 30.
49. Lehigh Valley Industries, Inc., Annual Report for 1967.
P. 3.
50. City Investing Company, Annual Report April 30. 1968,
footnote 8, p. 30.
51. Brunswick Corporation, Annual Report 1965. p. 13.
52. Ibid.. p. 15.
53. Teledyne, Inc., Annual Report for the year ended
October 31. 1963. Note 1. p. 29.
54. Litton Industries, Inc., 1969 Annual Report. Note E,
P* 25.
55. Cenco Instruments Corporation, 1965 Annual Report.
"Commitments and contingent liabilities," p. 33
56. U.S. Industries, Inc., Annual Report 1969. Note E,
P. 38.
57. Genesco, Annual Report 1969. Financial Review, p. 32.
58. Lehigh Valley Industries, Inc., 1969 Annual Report.
Note 1, p. 18.




8
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-poolingpart-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 acquiring 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.


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
presented.
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.
xi


12
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.11
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
mation.
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 ]iabilities. This study is
concerned with the analysis of business combinations whose
agreements provide for additional payments that are dependent


94
of excess earnings is the numerator and the per-share earnings
equivalent is the denominator, the point here is that the de
nominator may increase year-by-year causing the number of
issuable shares to decrease correspondingly. At the same
time, the earnings target in the numerator may be set at in
creasing year-to-year bases, with the result that in order to
achieve the maximum number of shares issuable annually during
the earnout period, substantial increases in earnings may be
necessary.
These concepts are exemplified in the terms of acquisition
by Consolidated Foods of the Gant Shirt Companies in 1968.
For the first year of this four-year earnout, each earnout
share required §8 of excess earnings. Per-share equivalent
earnings increased to $9, $10, and $11 for the earnout years
of 1970, 1971 and 1972, respectively. The earnings target for
the 1969 fiscal year was defined as the lesser of $750,000 or
the actual net income after taxes for fiscal 1968. For 1970,
the target is the 1969 target plus $8 times the number of earn
out shares issued in 1969. Targets for fiscal 1971 and 1972
consist of the previous years target plus ^ and $10 times
the number of shares issued in the prior year. The agreement
also puts limits on the maximum number of shares that can be
issued in each year, but allows a limited number of previously
unearned shares to be carried forward to later years.In
this acquisition, the sellers must increase earnings approxi
mately over the preceding year in each of the earnout


198
The Meaning of Contingent Liabilities
The literature of accounting is not notable for defini
tional precision generally, and this is no less true in the
case of contingent liabilities in particular. For example,
an early (1927) edition of a leading textbook "defined" a con
tingent liability in the following manner:
A contingent liability exists when there is
no present debt but when a liability may
develop, usually as the result of an action
or default by an outsider. If there is
little probability that a liability and an
accompanying loss or expense will develop,
it is sufficient to disclose the contingent
liability by a balance sheet footnote. If
a liability and an accompanying loss or ex
pense are likely to develop, a liability
account...may be credited, with (usually)
an offsetting debit to an expense account.
Although the preceding quotation is far from being precise, it
was nevertheless carried forward to the current (1970) edition
2
of the text, verbatim.
In a slight variation of the above, it has been common to
define a contingent liability as one which is "not an actual
liability at the time, but which may become a real liability
3
at a future date, dependent upon some future event." The
vagueness of such an explanation can hardly help to render the
task of the accountant or auditor easy with respect to deter
mination of the existence of specific contingent liabilities.
Writers in accounting have commented upon the lack of
attention given to contingent liabilities. In 1939, for
example, one author noted that "despite the importance of the
subject of contingent liabilities, there appears to be a


152
During the 1960's, the incidence of business combina
tions has increased substantially, and the adoption of the
pooling method has continued and increased in usage as an
alternative to the purchase method despite these conclusions.
Outspoken critics of the pooling method contend that it is
used by management, with the approval of the independent
auditors for the acquiring entity, to delude shareholders
into believing that their corporation is benefiting greatly
from certain acquisitions, while in fact their shares are
being diluted through nonrecognition of purchased asset
values and suppressed goodwill that should be amortized to
14
reduce inflated earnings per share computations. Some be
lieve that although the pooling approach has been abused in
the past, such abuses could be largely eliminated if the
criteria for applying the method were clearly redefined.
The purchase-pooling controversy continued unabatedintensi
fied, in factduring 1970.
Attempts in the past by the accounting profession to
define the pooling concept via broad criteria to apply to
particular business combinations have not met with success.
The Institute's Accounting Research Bulletin No. 40, entitled
"Business Combinations," published in September, 1950, was
the first official attempt to differentiate between these two
types of business combinations and to indicate the nature of
the accounting treatment appropriate to each type. The cri
teria set forth that were indicative of a pooling were four
in number: the continuity of substantially all of the equity


150
corporate assets were disbursed. Total profits should thus
continue to be computed on the basis of the same depreciated
historical costs as were shown on the books of the constituent
entities before the combination. The new entity is seen as
the vehicle for the sharing of business risks and resources
by the owners, now on a combined basis; the ownership groups
have only been restructured. The medium of exchange is seen
as critical by those who endorse the pooling concept: they
assert that the "weakness in the purchase theory results from
o
ascribing the same qualities to stock and assets." Because
of the adverse effect on combined earnings from amortization
of the goodwill that usually results if the purchase method
is used, pooling advocates often stress its income statement
implications. One concluded that "it is probably the effect
on net income, more than any other, that has demonstrated
the weakness of the purchase theory."1^ Perhaps more di
rectly to the point, another writer concludes that "the real
and underlying issue is seldom discussed: whether the cor
porate management can avoid the creation of goodwill and the
necessity for amortization thereof through the income state
ment ."11
In addition to differing viewpoints as to the basic
nature of a business combination, there are frequently other
problem areas. For example, most earnout acquisitions in
volve small, closely held companies whose fair value is often
not clearly evident. The agreement restricting the former
owner's ability to sell the shares he has received from the


168
The listing application description of the Beatrice ac
quisition states that in the event additional common shares
or additional cash payments are issued under the earnout
provision, these payments will be accounted for in a "similar
manner" to the accounting for the closing payments. J Thus,
the specific accounting treatment proposed for any such earn
out shares is not clearly stated, at least to this writer.
None of the other acquirers gave any indication of their ex
pected accounting for earnout shares which might be issued
under partial pooling agreements.
Fundamentally, the distinction between the opposed pur
chase and pooling concepts is in the view one has of the basic
nature of a business combination. A given combination, be it
an earnout or other type, clearly cannot have a dual basic
nature. We must conclude that the part-purchase, part-pooling
idea is without logical foundation. When applied to the earn
out type of combination, its difficulties are perhaps even
clearer. VJere this partial pooling concept allowed to con
tinue in practice, one solution might be to require estimates,
where possible, at the time of acquisition of the probable
contingent payment, so that the proportions may be less likely
to need revision later when the payments are actually made.
The more logical solution, however, is the elimination of the
concept from practice entirely. In fact, a recent opinion of
the Accounting Principles Board has concluded that the part-
purchase, part-pooling practice is no longer acceptable.


190
One acquirer, Lehigh Valley Industries, is exceptional
in this regard because its disclosure of earnout activities
has been more complete than any other acquirer through the use
of extended footnotes in its annual reports for the past five
years. These notes identify for the shareholder not only the
specific companies acquired by earnout agreements, but also
inform him of the amounts which have already been earned, the
amounts which might still have to be paid, the medium of pay
ment, and the duration of the earnout period. Presumably be
cause of the growing number and length of these footnotes, the
1969 annual report portrayed this basic information in the
form of a schedule, a portion of which is presented below as
an illustration of what the writer believes to be a concise
and adequate method of disclosure of an acquirer's record
c'O
with respect to earnout acquisitions.
Acquired in 1967:
Riverside Mfg
Industries, Inc.
Cash
4^,2 subordinated
convertible
debentures
Dori Shoe Company, Inc.
Cumulative,
Convertible,
Preferred Stock:
series "C"
series "D"
Amounts
paid as of
acquisition
#2,251,200
# 998,800
60,000 shs.
80,000 shs.
Amounts
paid since
acquisition
$ 2,900
$747,100
Remaining
maximum
contingent
shares
40,000 shs.
(cont'd on next page)


40
prospective sellers who believe their own growth claims from
22
those who do not.
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


11
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 i960 through
1968 will be studied in depth. The earlier year was selected
so that study could be made of earnout combinations not only
during 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


67
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 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 Poods 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


245
Beaton, C. D. "Contingent LiabilitiesSo-called," The
Accountant (August 21, 1965), PP. 237-239.
Black, William M. "Certain Phases of Merger Accounting,"
The Journal of Accountancy (March, 1947), PP. 214-220.
Blough, Carman G., ed. "Contingent Liability" (Current
Accounting Problems), The Journal of Accountancy
(December, 1947), PP. ^00-501.
Briloff, Abraham J. "Dirty Pooling," The Accounting Review
(July, 1967), PP. 489-496.
Brink, Victor Z., ed. "Contingent Liabilities" (Auditing
Practice Forum), The Journal of Accountancy (December,
1946), pp. 523-52^:
Byrne, Harlan. "Merger Come-Ons," The Wall Street Journal,
June 6, 1969.
Carlberg v. United States. 281 Fed. (2d) 507 (8th Cir.,
I960).
Carswell, Howard J. News release from W. T. Grimm & Co.,
October 2, 1969.
Catlett, Goerge H. and Norman 0. Olson. "Accounting for
Goodwill," Accounting Research Study No. 10. New York:
American Institute of Certified Public Accountants, 1968.
Chan, Stephen. "Procedures in Auditing Accounts Payable and
Contingent Liabilities," New York Certified Public
Accountant (April, 1945), pp. 165-168.
"The Contingent Payout," Mergers & Acquisitions Newsletter.
Main Lafrentz & Co. (August, 1969).
Copeland, Ronald M. and Joseph F. Wojdak. "Valuation of
Unrecorded Goodwill in Merger-Minded Firms," Financial
Analysts Journal (September-October, 1969), pp. 57-62.
Corporation Annual Reports (Form 10-K) for 1963-69 fiscal
years filed with the Securities and Exchange Commission.
Corporation Annual Reports to Shareholders for 1963-69
fiscal years.
Dettmer, Robert G. "Reasons for Mergers and Acquisitions,"
Corporate Growth Through Merger and Acquisition.
Management Heport 75. American Management Association,
9S3.


61
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
22
property" or "boot" under Section 356 of the Code.
In a I960 ruling,2-^ the Eighth Circuit Court ruled that
certificates of contingent interest were to be deemed stock
for purposes of Section 35^ of the Code with no recognition
of gain or loss upon their receipt. Section 35^- 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-
24
ceeds the principal amount of the securities surrendered.
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.


174
transferred, to common stockholders or returned to the cor
poration at the time the contingency is resolved.Thus,
earnout combinations, including escrowed earnouts, must hence
forth be treated as purchases, if the combination is initiated
after October 31, 1970.-^ This treatment will be in contrast
to the current and past tendency to use pooling, a tendency
evidenced by the data presented earlier in this chapter.
Although the Board concluded that "amounts of contingent
consideration which are determinable at the date of acquisi
tion should be included in determining the cost of an acquired
company and recorded at that date,"-^ it stated that "contin
gent consideration should usually be recorded when the contin
gency is resolved and consideration is issued or becomes
issuable."39 it further concluded that "consideration which
is issued or issuable at the expiration of the contingency
period or which is held in escrow pending the outcome of the
contingency should be disclosed but not recorded as a lia
bility or shown as outstanding securities unless the outcome
of the contingency is determinable beyond reasonable doubt.
With respect to the prescribed accounting for contingent
earnout payments specifically, the Board concluded that "when
the contingency Qbased upon maintaining or achieving specified
earnings levels in future periods] is resolved and additional
consideration is distributable, the acquiring corporation
should record the current fair value of the consideration
issuable as additional cost of the acquired company. The ad
ditional costs of affected assets, usually goodwill, should


185
Table 19
Earnout Disclosure in Shareholder Annual Reports
Number of reports with no disclosure 28
Reports containing some means of disclosure 82
Total reports examined 110
Number of
Means of Disclosure Instances
Within the text of the report 2
In the body of a financial statement 10
By footnotes concerning:
Capital stock 59
Commitments and contingent liabilities 16
Principles of preparation/consolidation 12
Earnings per share 9
Earnout acquisitions 9
Events subsequent to the
balance sheet date _6 111
Total 123*
Total is greater than 82 since more than one means of
disclosure may be used in a particular report.
Source: Annual reports of earnout acquirers for fiscal
years ended during 1960-69.


87
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.
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
19
escrowed shares would revert to ownership by the buyer.
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


136
Girard, shareholders on voting on the Agree
ment will be given an option of receiving a
total consideration of #5.50 worth of the
Company's Common Shares for each Girard
share held, or initial consideration of
#3.50 worth of the Company's Common Shares
for each Girard share plus additional con
sideration provided certain average annual
net after tax earnings were attained by
Girard-Del (Kidde's subsidiary) for the
five fiscal years ending June 30, 1973 or
at the election of the shareholders for
four fiscal years ending June 30, 1972....
Such election must be made by March 31
1972.52
It is not clear from the above description pertaining to
the Girard acquisition whether or not a majority vote of the
shareholders is to apply to all. In cases where the individ
ual shareholder may decide if he is to be paid in full at the
closing or participate in an earnout, the implementation of
the terms of the agreement is made a good deal more detailed
and troublesome for the buyer. The seller, in the Girard case
specifically, is faced with the difficult decision of whether
or not the prospect of receiving an unknown value in shares
of Kidde's stock over the next four or five years is at least
equal to a present value of $2.00 for each Girard share held.
Earnout options may be formulated for those shareholders
who are not part of the "owner-manager" group. The acquisi
tion of Gloray Knitting Mills, Inc. by U. S. Industries, Inc.
makes such provisions and is interesting in that not two, but
three options are available. Gloray, whose shares were listed


Table 13
Earnings Goals of the Acquired Business
Ivhich Must 3e Met Before Contingent Payments Are Made
Goal
1. The business must attain a
fixed, minimum level of
earnings during the earnout
period
2. The business must attain
increasing levels of earn
ings during the earnout
period
3. The business must generate
earnings in excess of a mar
ket value of the shares
issued at the closing
Total
From agreements effected in;
I960 '61 *62 *63 *64 '65 '66 '67'*g Total
1 3 5 5 8 10 15 22 53 122
2 1 3 12 13 21 52
1 5 5 6 8 13 17 36 80 181
Percent
67.4
28.7
100.0
Source: Listing applications to the New York Stock Exchange


242
the estimated obligation and acquired assets as suggested
here and thereby gave visibility to the estimates made by
management of future profitableness. It is contended in this
study that such reflection of the results of management's
evaluation of an acquired enterprise is consonant with a true
purchase accounting concept and is in the interests of satis
fying the need of investors and others for relevant financial
statements based on current values whenever practicable. The
findings of this research are in contradiction to the conclu
sions contained in APB Opinion No. 16 relative to the appro
priate accounting for earnout acquisitions.
Significance of the Research
The results of this study should prove useful to several
groups of individuals. Because virtually no research effort
has been expended thus far on the subject of earnout business
combinations, there is a resulting void in the related litera
tures of accounting and finance. Prospective buyers and sel
lers of business enterprises will be interested in Chapters
II, III, and IV in particular where the usefulness, limita
tions, incidence, legal factors and contract terms relative
to earnouts were analyzed. The study is significant for
members of the accounting profession, since a major conclu
sion reached was that changes in the practice of accounting
for earnout combinations are appropriate. Chapters V and VI
are especially relevant to the accountant's need for continu
ing examination of the accounting and disclosure practices of


192
Some examples of concise and informative disclosure
practices have been presented. It is suggested that by the
use of supplementary schedules an efficient and useful means
of information presentation can be achieved. In particular,
the schedule by Senesco to detail potential dilution from all
sources and the schedule by Lehigh Valley to indicate the
success and current status of individual earnout acquisitions
are recommended. The inclusion of both of these types of
schedules in the annual report of the acquirer would do much
to inform the shareholder in a clear and concise manner.


167
will be recorded...and will not be amor
tized until such time as there is evidence
of a decline in value.22*
Had the purchase method been chosen to account for the trans
action in its entirety, the intangible would likely have been
$7.2 million ($9.9 less $2.7 million) instead of $2.6 million.
Additional contingent payments following such an initial
accounting choice pose difficulties. Such earnout payments
presumably might be added to the pooling portion (no additional
intangible), or to the purchase portion (increasing the in
tangible), or allocated to both. Should Beatrice issue earn
out shares worth another $6.4 million, the question is whether
this amount is additional pooling consideration or partly an
increase in the intangible. If it is looked at as additional
pooling since payment is not in cash, then the question arises
as to whether or not the original intangible is subject to
change inasmuch as the aggregate payments now are in the pro
portion of about 21% cash and 79% stock. In other words, con
tingent payments could result in changes in the original pro
portions considered pooled and purchased. The goodwill intan
gible, accordingly, may be subject to either upward or downward
revision on a retroactive basis, and this may be significant
enough in amount to warrant revision of past years'earnings,
assuming goodwill amortization. Even if no amortization is
assumed, the percentage change should necessitate a smaller
increase in the buyer's earnings in the year of acquisition
since a smaller proportion of the seller's profits would have
been included since the date of acquisition. >


155
opposed to that of purchase, by a better than six to one
margin. Over all, only 17# of the earnouts were accounted
for as purchases. With one exception, all of the frequent
earnout acquirers showed a strong preference for the pooling
approach (only about 12% of their earnouts were deemed pur
chases). The exception was Lehigh Valley, which utilized
pooling only once in accounting for seven earnouts, even
though only two of the seven included cash or debentures as
part of the payment media.
The infrequency of purchase accounting for earnout acqui
sitions helps to confirm the erosion of the pooling criteria,
already noted. Because businesses acquired through contingent
payments are typically closely held, with the owner-managers
remaining in their executive positions after the merger, the
continuity of equity interests and of management criteria would
be met. In this study, all of the acquirers are large corpo
rations listed on the New York Stock Exchange, whereas the
majority of the sellers, clearly, are not large. It was found
that total assets of the sellers averaged approximately
$3,750,000 at the time of acquisition, with about 47# of the
sellers showing assets of less than $2 million. Only 6# had
assets in excess of $10 million. Annual sales volume averaged
$7,379*000, with 50# generating sales of less than $5 million.
Only 5# had sales exceeding $25 million. If relative equality
of size of the constituents is viewed as a necessary criterion
for use of the pooling approach, then few earnout acquisitions
would qualify.


224
the business after it has been acquired. There is strong
motivation toward operating the acquired entity profitably
inasmuch as the owners who stand to receive contingent pay
ments are also the operating managers. It was found that the
selling owner-managers were also commonly the founders of the
business; this further strengthens the motivation factor.
The determination of a fair purchase price is normally
difficult, and especially so in the case of the small, young,
owner-manager operated enterprise. An earnout agreement
represents a logical means of adjusting the difference between
the amount the buyer is willing to pay and the amount the
seller would prefer to receive. It is especially desirable
in situations where the earning power of the acquired business
has not yet been established. Also important is the fact that
an earnout represents a favorable means of financing the ac
quisition. At least in part, the purchase can be financed
from the income derived from the operations of the acquired
company over the period of the deferred payments.
Earnout acquisitions can have limitations as well as
advantages. The acquirer must be able to operate the acquired
business as an autonomous unit or else its product line must
be sufficiently distinguishable from that of the parent in
order to permit the degree of separation that is needed to
account for the earnout results. Since the agreement is
hinged upon the future profit performance of the absorbed
company, the definition of earnings is critical and needs to
be as precise as possible. If the number of selling individuals


31
Table 8
Size of Firms Acquired Through Earnouts
1960-1968
Sales Volume*
Number
of Firms
Per cent
under $1,000,000
$ 1,000,000 $ 4,999,999
34
13.5
93
36.9
| 5,000,000 $ 9,999,999
66
26.2
$10,000,000 $14,999,999
26
10.3
$15,000,000 $19,999,999
12
4.7
$20,000,000 $24,999,999
10
4.0
$25,000,000 and over
11
4.4
Total
2 52
100.0
Total Assets
Number
of Firms
Per cent
under $1,000,000
74
28.9
$ 1,000,000 $1,999,999
48
18.7
$ 2,000,000 $2,999,999
32
12.5
$ 3,000,000 $3,999,999
$ 4,000,000 $4,999,999
34
13.3
11
4.3
$ 5,000,000 $5,999,999
14
5.5
$ 6,000,000 $6,999,999
12
4.7
$ 7,000,000 $7,999,999
7
2.7
$ 8,000,000 $8,999,999
5
2.0
$ 9,000,000 $9,999,999
3
1.2
$10,000,000 and over
16
6.2
Total
256
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.


84
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 as agreed upon during
the negotiations.16
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.1^1 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. Each $3 of net income after taxes up to $500,000


Ill
there is no improvement in profits, the seller receives no
additional payment. A variety of approaches to the specifi
cation of this improvement is observable. For example, in
each earnout fiscal year in which profits are increased by
$50,000 over the preceding year, an additional 1,000 common
shares may be issued. Such a provision might be modified to
state that the highest earnings achieved in any one of the
preceding earnout years is to be used in calculating the
$50,000 increase. The modification would thus insure that
the sellers could not receive additional shares as a result
of merely regaining their earnings record after having suf
fered lower earnings the previous year. In a 198 agreement,
the earnings goal for each of the four years of the earnout
was to better the earnings of the immediately preceding year,
but with a constant dollar amount as the lower limit on each
year's goal.
It is not unusual for the goal of the first earnout year
to be fixed at a level equivalent to the results of the pre
ceding year, with the increased succeeding earnout years'
goals stated to include cumulative elements. For example,
in its acquisition of Imperial Oil and Grease Company,
Beatrice's earnout payments depend upon these earnings goals-^
For earnout year #1: $375,000 (the ap
proximate earnings level before the year
of acquisition).
For earnout year #2: the greater of (A)
actual earnings for earnout year //l, or
(B) $375,000 plus the excess of $375,000
over actual earnings for earnout year #1.
For earnout year #3: the greater of (A)
actual earnings for earnout year #2, or


181
Sometimes, disclosure is made in the body of one of the
financial statements presented. For example, on its balance
sheet for April 30 1968, City Investing included a separate
caption in the shareholders' equity section for "Certificates
of Contingent Interest," although with no indication of any
dollar value for this account on the statement. However, a
footnote explained that:
Certificates of contingent interest have
been issued to former stockholders of Hayes
International Corporation and American
Electric, Inc. representing contingent in
terests in additional shares of common
stock of City. The required number of
shares to be issued pursuant to certifi
cates of contingent interest and, in the
case of Motel 6, Inc., by agreement, will
be determined by earnings during periods up
to five and one-half years and by the mar
ket price of the common stock of City at
the settlement date. Assuming arbitrarily,
that the earnings, as defined, of Hayes,
American and Motel 6 continue for the earn
ings periods at the same level as the earn
ings to April 30, 1968, and that the
average market price, as defined, for City's
common stock is the same as the market
price in April 28, 1968 ($65.25 per share),
the maximum number of shares of City's com
mon stock that can be issued is 71,592.50
Information about earnout acquisitions may also be con
tained in financial statements of changes in capital stock
and in capital surplus. Disclosure in such statements is
generally related to the issuance of some or all of the con
tingent shares which were earned as a result of an economi
cally successful combination. Brunswick Corporation's Con
solidated Statement of Capital Surplus for the year ended
December 31, 1965, includes a reconciling item of $167,000


101
shares were to be valued at the average of their daily closing
prices on the New York Stock Exchange during twelve calendar
weeks preceding the week of February 1, 1965. During the year
of 1959, Western's earnings were approximately $1,166,000
30
substantially above the $450,000 earnings goal.
The majority of the disclosed rates, however, were not
above ten. Approximately one half of them were negotiated at
five or under. Only ten per cent were at factors ranging
from eleven to fifteen, while roughly one-third had rates not
in excess of one.
Since the valuation of the buyer's shares at a variable
market value will determine the precise number of earnout
shares to be issued, the methods used to approach that valua
tion are of interest to the parties to the acquisition. In
several earnout combinations, the Brunswick Corporation has
offered earnout shares which are to be valued at the average
of their high and low prices on the New York Stock Exchange
on the fourth or fifth trading day prior to the particular
delivery date of the contingent payment. Valuation on the
basis of prices taking place on a solitary trading day is not
common, however. The possible danger of obtaining a price
which is not representative of the value of the buyer's shares
is more likely when valuation is restricted to transactions
occurring during such a narrow range of time. Consequently,
most of the agreements provide for some wider basis of averag
ing share prices. Averages used are not weighted by trading
volume.


202
With respect to the nature of a contingent liability, he fur
ther states that:
A true contingent liability exists against
a particular person when, under the agree
ments in force at a particular point of
time, no direct liability rests upon that
person, but future events may change the
legal status of the parties. 5
Koehler, in his A Dictionary for Accountants, defines a
contingent liability as:
An obligation, relating to a past transac
tion or other event or condition, that may
arise in consequence of a future event now
deemed possible but not probable. If prob
able, the obligation is not contingent but
real (ordinarily, a current liability), and
recognition in the accounts is required,
notwithstanding that its amount must be es
timated in whole or in part.
Writers agree that determination of the probability of
the event's occurring may be made upon the basis of related
experience. Thus, a favorable experience with respect to con
tingent assessments levied by mutual insurance companies was
the basis for deciding not to require financial statement re
flection of the contingency, per Statement on Auditing Pro
cedure No. 7.1^ Where appliance and auto dealers, for example,
.guarantee a product, experience normally demonstrates that the
18
liability is real and not contingent. The difference between
an estimated liability and a contingent liability, according
to Hendriksen, is that a liability has a positive most probable
value even though this must be estimated; a contingent liabil
ity will probably not result in a specific obligation, but
there is a chance that a specific obligation may arise if an
event or events occur.


102
In one earnout transaction where contingent shares were
dependent upon excess profits over a five-year period, valua
tion is to be made by use of the average of the closing
prices per share for the buyer's common on the last five busi
ness days of the earnout period. An unusually wide basis of
averaging share prices was employed in the acquisition of
Morgan Yacht Corporation by Beatrice Foods, where Beatrice
agreed to issue shares in 1971 valued at the average of the
closing prices of its common on the New York Stock Exchange
31
for each of the trading days during the entire earnout year.
Valuation may be based upon prices which will occur after the
end of the earnout period, as well as on prices within the
period. An acquisition by Kidde provided for dividing the ex
cess earnings for the earnout period by the daily means of the
high and low and opening and closing prices on the New York
Stock Exchange for the first ten trading days following the
32
end of the formula period. U. S. Industries frequently de
termines the number of its issuable earnout shares on the
basis of average closing prices during the month preceding
the month of delivery. These few examples serve to illustrate
that the determination of share market values may vary widely,
from using a single day as the basis, to use of an entire
year. The price measurement period may fall either within or
without the earnout period.
Although not characteristically the case, minimum and
maximum share values are sometimes prescribed:


220
16. Eric L. Kohler, A Dictionary for Accountants, 3rd ed.
Englewood. Cliffs, New Jersey: Prentice-Hall,
Inc., 19^3, P* 123.
17. Carman G. Blough, ed., "Contingent Liability," (Current
Accounting Problems), Journal of Accountancy
(December, 1947), p. 501.
18. Victor Z. Brink, ed., ojd. cit., p. 524.
19. Eldon S. Hendriksen, Accounting Theory. Homewood,
Illinois: Richard D. Irwin, Inc., 1965, p. 361.
20. J. B. C. Woods, op. cit. p. 471.
21. Rufus Wixon, ed., Accountants1 Handbook. New York:
The Ronald Press Company, I960, Section 20, p. 36.
22. Accounting Principles Board, "Basic Concepts and
Accounting Principles Underlying Financial State
ments of Business Enterprises," Statement No. 4 of
the Accounting Principles Board. New York: Ameri
can Institute of Certified Public Accountants,
1970, p. 50.
23. Hendriksen, op. cit., p. 357.
24. See, for example, Maurice Moonitz, The Changing Concept
of Liabilities." The Journal of Accountancy (May,
i960), pp. 41-46.
25. Stephen Chan, "Procedures in Auditing Accounts Payable
and Contingent Liabilities," New York Certified
Public Accountant (April, 19457, p. 167.
26. For a discussion of the problem of evaluating companies
involved in business combinations and the importance
of the disclosure of management's basis for decision
to combine, see S. R. Sapienza, "Business Combi
nations and Enterprise Evaluation." Journal of
Accounting Research (Spring, 1964), pp. 5O-66.
27.
Ibid.. p. 63.


41
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 195 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 other aspects of
Beckman's operations.... 3
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


133
17,857 shares) and one share for each $6 that such earnings
are under $625,000.Thus, as much as 22.6$ of the initial
purchase payment may revert to the buyer if Gant's earnings
should prove to be in the neighborhood of $560,000 rather
than $750,000
More often, shares are put into escrow to assure that the
seller's earnings during future, rather than recent or current,
periods will be up to a certain minimum level. In addition to
such escrowed earnout shares, the agreement may also provide
for issuance of shares according to one of the earnout models
set forth earlier in this chapter. Another acquisition by
Consolidated Foods is illustrative. To acquire the B. P. John
Furniture Company, Consolidated issued 90,909 common shares
at the closing, and agreed to issue contingent shares (up to
a maximum of 52,402) based upon increasing excess earnings for
three years, using a fixed divisor. Of the closing shares,
20,202 are escrowed to assure that the average annual earnings
of John over the next five years are not less than $360,000.
In the event that they are under that minimum level, the es
crowed shares will revert to Consolidated at the rate of one
share for every $3.60 of such deficiency. Accordingly, the
buyer by this formula has provided for a total purchase price
ranging from a minimum of 70,707 to a maximum of 143,311
49
shares. 7 This kind of merger approach which includes downside
protection to the buyer, along with upside benefit to the sel
ler, is similar to that developed by Harold Marko, president


241
at levels that were no higher than earnings generated, near the
time of acquisition. Also significant is the fact that the
owner-founders who were responsible for their company's past
performance remained as its operating executives after acqui
sition, but with the additional financial resources of the
buyer now available to their company.
It is concluded that earnout obligations should not be
accorded mere footnote disclosure as are contingent liabili
ties. Such disclosure is inadequate for an estimated lia
bility. If the probability exists that at least some portion
of the maximum contingent payment will likely be made, it is
appropriate for the acquirer to estimate the total of such
future payments and to reflect this estimated liability in
the accounting entry needed to record the acquisition. To
omit such liabilities and also correspondingly understate the
values of acquired assets seems unrealistic in view of the
payment experience revealed by this research.
The accounting that is recommended as appropriate from
this study has rarely occurred in practice, perhaps because
of confusion regarding the nature of earnout obligations con
ceptually or because of the difficulties inherent in the
measurement of the amount of such liabilities. This analysis
keeps separate the distinction between the obligation itself
and its measurement and suggests that the uncertainty gener
ally surrounding estimates of future profits is at the root
of the problem of accounting for earnout obligations. In
only five instances was it found that the acquirer recorded


173
was apparent from the divergent practices used to account for
the combinations analyzed in this study, and described earlier
in this chapter.
In August, 1970, the Accounting Principles Board reaf
firmed its acceptance of both the purchase and the pooling
methods of accounting for business combinations, but con
cluded that the two methods are not alternatives in accounting
for a given combination.^ Amid much publicity in the finan
cial press for almost a year prior to the publication of APB
No. 16,^5 the guidelines pertaining to poolings were restric
ted, but not as much as many critics of pooling had advocated.
In particular, proposals to limit poolings to mergers in which
the surviving company would be no more than three times, or
nine times, the size of its merger partner were not accepted
by the Board. Also not accepted were proposals to abolish the
pooling method altogether. However, the part-purchase, part
pooling practice is no longer acceptable, as already noted.
Among the several conditions required by APB No. 16 for
application of the pooling of interests method is one that
states that the combination is resolved at the date the plan
is consummated and no provisions of the plan relating to the
issue of securities or other consideration are pending. This
condition means that (1) the combined corporation does not
agree to contingently issue additional shares of stock or
distribute other consideration at a later date to the former
stockholders of a combining company or (2) the combined cor
poration does not issue or distribute to an escrow agent com
mon stock or other consideration which is to be either


ACKNOWLEDGMENTS
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.
iv


Table 15. Duration of the Earnings Period 125
Table 16. Timing of the Contingent Payment(s)
as Specified in Earnout Agreements,
1960-1968 127
Table 17. Payment Media Specified in Earnout
Transactions, 196O-I968 129
Table 18. Method of Accounting for Earnout
Combinations, 1960-1968 15^
Table 19. Earnout Disclosure in
Shareholder Annual Reports 185
Table 20. Economic Success of Earnout
Acquisitions 206
Table 21. Classification of Successful
Acquisitions by Type of Earnout 208
viii


6
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 196?, one author referred
O
to the earnout as the "newest type of merger financing."
Apparently, business combinations of the contingent payment
variety have not been a subject of much interest until recently.


223
however that earnouts are becoming more frequent because of
certain advantages they possess over other forms of acquisi
tion.
The earnout approach helps to assure the acquirer that
he is not overpaying for the business acquired. This is
especially important during inflationary periods when asking
prices are high. If the medium of payment is cash, an earnout
arrangement will limit the payout of assets initially. If
the medium of payment is common stock, the dilution of primary
earnings per share will be limited at the closing in compari
son to the acquisition where the entire purchase price is made
in shares at the closing. (Although it was not the case at
the time of negotiation of the earnouts studied in this re
search, generally accepted accounting principles now require
disclosure of potential earnings per share dilution by con
tingent shares via the income statement.)
Earnout agreements can be particularly attractive to
growth-minded conglomerates since only a portion of the total
shares are issued initially, thus helping to maintain or in
crease primary earnings per share in the short run. The earn
out acquisition proposal can act as a screen to eliminate those
sellers who exaggerate their own growth claims; in order to
be paid the contingent payments, the seller must actually
prove his claim by producing the requisite profits.
A primary factor in the use of contingent payment plans
is the retention and motivation of management. Earnout agree
ments require that the selling management remain to operate


23
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 13^ during the
7
first six months of 1968.
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
G-rimm &
Co. figures and those
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.
Mo 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.1 This


179
acquirer's annual reports might suspect that future obliga
tions are indeed of the earnout variety, judging from the
phrasing of a segment of the yearly footnote concerning
capital stock; for example:
The agreements for two acquisitions made in
1967 provide for payments in stock in 1969
and 1972, the amounts to be determined in
accordance with prescribed formulas. ^'8
Disclosures such as this one which refer to the existence of
earnout obligations, although without specificity, were found
in fourteen of the remaining one-fourth(28) of the reports
which did not clearly disclose the use of the earnout con
cept. One in eight (14) reports made no mention, however
indirect, of the existence of an earnout acquisition or its
related contingent payment. In some cases, this lack of
disclosure may be attributed to the relative insignificance
of the acquisition and/or contingent payment when compared
with the size of the acquiring organization. In general, we
may conclude that acquirers do disclose the fact that they
are utilizing the contingent payment approach to acquisitions.
However, it was not commonly found that the acquired com
pany was identified by name as having been merged by the earn
out technique. Only five of the twenty-one acquirers made a
practice of revealing the identities of the acquired organi
zations. The others frequently disclosed the names of com
panies that were acquired during the year, but did not indicate
that they were acquired through an earnout agreement, and did


141
31. Beatrice Foods Co., Listing Application No. A-26839
to the New York Stock Exchange, November 26, 1968,
p. 1.
32. Walter Kidde & Co., Inc., Listing Application No.
A-25378 to the New York Stock Exchange, January 31,
1968, p. 1.
33. International Telephone & Telegraph Corp., Listing
Application No. A-19757 to the New York Stock
Exchange, June 14, 1961, p. 1.
34. United States Rubber Company, Listing Application
No. A-22428 to the New York Stock Exchange, April
19, 1965, P. 1.
35. Neptune Meter Company, Listing Application No. A-23533
to the New York Stock Exchange, July 7, 1966, p. 1.
36. Rexall Drug & Chemical Co., Listing Application
No. A-22281 to the New York Stock Exchange,
February 9, 1965, p. 1.
37. Republic Corp., Listing Application No. A-25912 to the
New York Stock Exchange, May 24, 1968, p. 1.
38. Beatrice Foods Co., Listing Application No. A-24729 to
the New York Stock Exchange, August 28, 1967, p. 1.
39. Consolidated Foods Corporation, Listing Application
No. A-25097 to the New York Stock Exchange,
December 7, 1967, p. 1.
40. The B. F. Goodrich Co., Listing Application No.
A-19442 to the New York Stock Exchange, January 23,
1961, p. 1.
41. Whittaker Corporation, Listing Application No. A-26674
to the New York Stock Exchange, November 4, 1968,
p. 1.
42. Walter L. Kidde & Co., Inc., Listing Application No.
A-26445 to the New York Stock Exchange, September
16, 1968, p. 1.
43. Genesco, Inc. Prospectus dated August 17, 1962, p. 3,
and included as part of Listing Application
No. A-20607 to the New York Stock Exchange.
44. Loral Electronics Corporation, Listing Application
No. A-20877 to the New York Stock Exchange, March
6, 1963, P. 3.


250
BIOGRAPHICAL SKETCH
John Albert Yeakel was born December 25, 1930, in Center
Valley, Pennsylvania. In 1948 he was graduated from Allen
town High School in Allentown, Pennsylvania. From 1948 until
1952 he was employed in various positions with the Union Bank
and Trust Company of Bethlehem, Pennsylvania, and with the
Merchants National Bank of Quakertown, Pennsylvania. He
served with the U.S. Army as a pharmacy technician from 1952
until 1954. In September, 1954, he entered The Pennsylvania
State University and was awarded the degree, Bachelor of
Science, in June, 1957. From that time until January, i960,
he was employed as a staff accountant with Peat, Marwick,
Mitchell & Co., Certified Public Accountants. In i960 he en
rolled in the Graduate School of The Pennsylvania State Uni
versity and was awarded the degree, Master of Science, with
a major in finance, in August, 1962. He was a member of the
accounting faculty at The Pennsylvania State University from
1961 until 1963. In January, 1964, he enrolled in the
Graduate School of the University of Florida. From 1965
until the present time he has been an Assistant Professor,
School of Business and Administrative Sciences, at the Uni
versity of New Mexico.


47
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, 191, 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. Gunther, "Contingent Pay-Outs in Mergers and
Acquisitions," The Journal of Accountancy (June,
1968), p. 33.


216
at the closing. No reasons are specified for this conclusion,
but the writer reasons that there might be two. One is that
earnout payments were viewed as contingent liabilities deserv
ing footnote disclosure with no formal recording until such
time as the contingency is resolved. Another is that, while
earnout payments might be considered to be contingent liabili
ties or even actual liabilities, the estimation of their
probable value is too hazardous.
A view of earnout obligations as contingent liabilities
is not supported by the analysis in this study. Indications
from the study are that estimates of the acquirers obligation
should be made, since 88 of the 100 companies studied met the
earnout payment conditions. Some factors have been noted
which suggest that the uncertainty factor involved in making
estimates of the acquirer's liability is not overpowering.
Managements can and often do evaluate a company in very speci
fic ways.2^ These economic evaluations can form the basis for
more realistic asset and liability valuations. Under gener
ally accepted accounting principles earnout acquirers are, in
effect, estimating their liabilities under these agreements
at zero. Whatever error is inherent in estimating this lia
bility, the error is likely to be much less than the current
zero estimate. The conclusion here does not mean however that
there are no situations where the uncertainties are so great
that a specific estimate cannot be made. Presumably, one of
the reasons for the use of the earnout approach in certain
cases is that the evaluation of the absorbed enterprise was


56
During the period commencing with the
Closing of the Agreement and ending
February 1, 197^, 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-l 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


105
shares in the securities marketplace may also directly affect
their welfare.
Formulations Dependent Upon
the Earnings of the Buyer
In three agreements of the total analyzed in this re
search, it was found that in addition to the future earnings
of the seller the future earnings of the buyer are an essential
determinant of the number of contingent shares which may be
come payable.
The terms of the acquisition of General Services Company
by Neptune Meter Company illustrate one method by which the
earnings of the buyer may help to determine how many common
shares the former shareholders of the seller will receive at
the end of the earnings period. At that time, up to a maxi
mum of 71,500 common shares are issuable, the specific number
to be equal to:
the product obtained by multiplying 29,148
times the fraction, of which the average
earnings per share, as defined..., of the
Capital Stock of General for the fiscal
years ended December 31, 1968 and 1969 and
the first nine months of the year 1970 shall
be the numerator, and the average consoli
dated earnings per share, as defined..., of
the Common Stock of Neptune for the fiscal
years ended December 31, 1968 and 1969 and
the first nine months of the year 1970 shall
be the denominator.35
Another approach is to incorporate price-earnings ratios
into the agreement terms. To compute the number of contingent
shares in the Rexall-Thompson merger:


209
In Chapter I it was hypothesized that the profitability
experience of the selling entities would indicate that at the
closing date the treatment of earnout contingent payments as
contingent liabilities is inappropriate. That hypothesis is
now accepted, based upon the evidence just presented.
Perhaps the evidence merely confirms just what one would
expect, based upon three relevant factors. One is that the
acquired companies studied usually had profitable operations
before they were acquired. Analysis of the data in Table 9
shows that their performances for the fiscal year immediately
prior to acquisition averaged approximately 32# on the basis
of before-tax return on assets. On the basis of return on
owners* equity, their before-tax performances averaged 75#
In computing both measures, it was found that the more recent
acquisitions involved the purchase of companies that were
generally more profitable than were those bought in earlier
years. This fact suggests that the more recently acquired
companies may be even more likely to achieve their earnings
goals. The second relevant factor which would point toward
earnout success is that for approximately 72# of the agree
ments studied, the earnings goal was set in such a way that
it did not exceed earnings being generated by the selling
entity near the time of its acquisition (see Table 14). Most
significant is the fact that earnout agreements typically re
quire that the owner-founders who were responsible for the
company's past performance will remain as its operating
!


153
interests, continuity of management, similar or complementary
business activities, and the relatively equal size of the con
stituent companies.1^ The criterion of similar or complemen
tary business activities was dropped upon publication of the
next Bulletin (No. 48) on business combinations in 1957 It
may be noted that increasing diversification of business was
taking place in the country at this time, with the criteria
for distinguishing purchases from poolings increasingly coming
to be regarded as inadequate. With the erosion of the dis
tinguishing criteria, it was concluded in 1968 that "almost
any business combination in which voting stock is issued as a
major portion of the consideration, as opposed to cash, bonds,
or other property, can now be accounted for either as a pool-
17
ing of interests or as a purchase."
The Choice of Purchase or Pooling
Accounting for Earnouts
As in all other business combinations, an initial choice
between purchase and pooling is made by the acquirer with
respect to earnout acquisitions. This choice then determines
the subsequent accounting for any contingent payments made.
Table 18 indicates the accounting treatment accorded to earn
out combinations analyzed in this study.
1
The data show that during the first four years of this
period, neither the purchase nor the pooling method was favored.
Acquirers showed a clear preference for pooling in 1964, how
ever, and the pooling choice was thereafter evident, as


249
Wilcox, Edward B. "Business Combinations: An Analysis of
Mergers, Purchases, and Related Accounting Procedure,"
The Journal of Accountancy (February, 1950), PP* 102-107.
Wintrub, Warren G., ed. Planning Business Combinations.
Lybrand, Ross Bros. & Montgomery, 19&8.
Wixon, Rufus, ed. Accountants' Handbook. New York: The
Ronald Press Company, i960.
Woods, J. B. C. "Auditing Procedures; LiabilitiesDirect
and Contingent," New York Certified Public Accountant
(August, 1950), pp. 467-474.
Wyatt, Arthur R. "A Critical Study of Accounting for Business
Combinations," Accounting Research Study No. 5* New
York: American Institute of Certified Public
Accountants, 1963.


135
escrowing shares with release provisions in earnout terms
seems to be either (l).to help to render the corporate reor
ganization as tax-free, (2) to avoid the imputation of interest,
or (3) to provide the buyer with an acquisition formula which
will help to reduce the risk of overpayment by the possible
return of shares in the event that minimum earnings levels
are not attained or maintained.
Earnout Options
Of the total of 265 earnout business combinations that
were studied, six were found to contain options whereby the
selling shareholders were obliged to choose to participate or
not to participate in a contingent payment scheme. Table 11
illustrated the fact that earnouts are often used to acquire
companies that are closely held, often having only one or just
a few owners. Although it may be more troublesome to negoti
ate and implement in the case of publicly held corporations,
the earnout may still be the acquisition vehicle. All six
agreements containing options were negotiated during the last
half of 1967 or during 1968. This fact may indicate that the
earnout method will be utilized more frequently for the pur
chase of publicly owned corporations in the future. Additional
research is necessary, of course, to determine whether or not
such a development materializes.
Whether used in the case of closely held or publicly held
companies, the earnout option gives each seller a reasonable
choice. Such an option was made available by Kidde in its
agreement with Girard Industries Corporation in late 1968:


162
In such an instance, the accounting for earnout payments
should parallel that for preferred dividends, and no increase
in asset costs is appropriate.
In most instances, however, the agreement is not of the
profit sharing type and the fair value of the business ac
quired is probably not agreed upon. The buyer and seller
agree to base the selling price of the business to be acquired
in part on its subsequent earnings, and the consideration
given at the closing is in the nature of a down payment to
ward the total purchase price, assuming that the earnout is
at least partially successful. Should no further payments be
made beyond the initial payment, the closing payment becomes
the total purchase cost. In any event, both the initial down
payment and any subsequent earnout payments make up the total
consideration agreed upon as the cost of the seller's busi
ness. For accounting purposes, the aggregate payments made
should be reflected in the cost of the net assets acquired,
if the cost principle of accounting is to be followed. It
may be noted that a portion of subsequent payments need not
be capitalized, coinciding with the actual or imputed interest
which is involved with the privilege given to the buyer of
paying on an installment, or deferred basis. This interest
component should, of course, be expensed.
Contingent Payments Recorded as if Already Earned
Where the anticipated accounting treatment for any fu
ture earnout payments was specified by the buyer, it has been
noted that the usual practice is to charge an intangible


238
through the capital stock footnote. They were disclosed less
frequently as part of the contingent liability or the princi
ples of consolidation notes. Disclosure by footnote has re
sulted in inadequate disclosure on financial statements.
The dilutive effect of contingent shares was not disclosed
to any noticeable degree until 1968 and later. The new dis
closure requirements of APB Opinion No. 15 were apparently
much needed. In general, shareholders have been given only
fragmentary information regarding earnouts by the use of vague
and tedious footnotes to the financial statements. Where the
acquirer has negotiated many earnout acquisitions, the notes
tended to be even more general. Knowledge of the economic
success of an acquired company was almost never made available
to the shareholder via the annual report. It is suggested
that by means of supplementary schedules the potential dilu
tion arising through the use of earnout shares and the resul
tant successes (and failures) of the absorbed entity may be
conveniently and usefully presented. With this information
available to him, the investor will be in a better position
to evaluate the soundness of his company's acquisition policy
and the capability of the company's management.
Although recent Opinions of the Accounting Principles
Board were concerned with the derivation and disclosure of
per share earnings, little attention has been focused upon
basic accounting for contingent payments. The Securities and
Exchange Commission has established no general policy relating
to such payments; instead, it reviews individual earnout


142
45. McGraw-Hill, Inc., Listing Application No. A-23680 to
the New York Stock Exchange, September 7, 1966, p. 1.
46. Republic Corporation, Listing Application No. A-24684
to the New York Stock Exchange, August 7, 1967, p. 4.
47. Consolidated Poods Corporation, Listing Application
No. A-24396 to the New York Stock Exchange, June 6,
1967, p. 1.
48. Consolidated Foods Corporation, Listing Application
No. A-25715 to the New York Stock Exchange, April
23, 1968, p. 1.
49. Consolidated Foods Corporation, Listing Application
No. A-26810 to the New York Stock Exchange,
December 5 1968, p. 1.
50. See "Marko's Minimum Risk Merger Method," in Mergers
and Acquisitions, the Journal of Corporate Venture
(Winter, 1967), pp. 55-57.
51. Consolidated Foods Corporation, Listing Application
No. A-22326 to the New York Stock Exchange, June 1,
1965, P. 2.
52. Walter L. Kidde & Co., Inc., Listing Application
No. A-26928 to the New York Stock Exchange,
November 20, 1968, p. 1.
. U.S. Industries, Inc., Listing Application No. A-25859
to the New York Stock Exchange, May 20, 1968,
pp. 1-2.
53


248
Revenue Ruling 57-586, C.B. 1957-2, 249.
Revenue Ruling 66-112, C.B. 1966-1, 69.
Sanders, Thomas Henry, Henry Rand Hatfield, and Underhill
Moore. A Statement of Accounting Principles. New
York: American Institute of Accountants, 1938.
Sapienza, S. R. "Business Combinations and Enterprise
Evaluation," Journal of Accounting Research (Spring,
1964), pp. 50-66.
U.S. Internal Revenue Code of 195^, Sections 35^, 361, 368,
and 483.
U.S. Securities and Exchange Commission. General Rules
and Regulations Under the Securities Act of 1933. As
in Effect November 1t 1968. Washington, D. C.7
Government Printing Office.
. General Rules and Regulations Under the Securities
Exchange Act of 1934, As in Effect October 16. 198.
Washington, D. C.: Government Printing Office.
. Securities Act of 1933. As Amended to October 22.
1965. Washington, D. C.: Government Printing
Office.
. Securities Act Release No. 4469. Washington, D.C.:
Government Printing Office, 1962.
. Securities Exchange Act of 1934, As Amended to
July 29. 1968. Washington, D. C.: Government Printing
Office.
Walker, J. B., Jr., and Neil Kirkpatrick. "Financing the
Acquisition," Corporate Growth Through Merger and
Acquisition, Management Report 75. American Management
Association, 1963.
The Wall Street Journal (1969: February 24; July 1;
September 24; October 31; December 3 8).
. (1970: January 1, 15; February 19, 27; March 2, 11;
May 8, 14; June 15, 24, 29; July 6, 29; August 3).
. (1971: January 6).
Werntz, William W. "Corporate Consolidations, Reorganizations
and Mergers." The New York Certified Public Accountant
(July, 1964), pp. 379-387.


Chapter V. Accounting and. Disclosure Aspects
of Earnout Combinations
Purchase Accounting
Pooling of Interests Accounting
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
Chapter VI. The Case for Earnouts As
Contingent Liabilities
The Meaning of Contingent Liabilities
Are Earnout Obligations Contingent
Liabilities?
Implications from the Evidence
Chapter VII. Summary of Findings
Significance of the Research
Bibliography
Biographical Sketch
143
144
146
148
i53
156
156
156
157
i57
160
162
166
169
175
178
186
197
198
203
210
221
242
244
250
vi


139
NOTES
1. Charles J. Hecht, "Earnouts," Mergers & Acquisitions,
the Journal of Corporate Venture (Summer, 1967),
pP7
2. Ibid.. p. 7.
3. Ibid., p. 8.
4. The B.V.D. Company, Listing Application No. A-22290 to
the New York Stock Exchange, March 1, 1965, p. 1.
5. Cenco Instruments Corporation, Listing Application
No. A-22359 to the New York Stock Exchange, March 18,
1965, P. 4.
6. Oenesco, Inc., Listing Application No. A-22220 to the
New York Stock Exchange, January 20, 1965, p. 1.
7. Whittaker Corporation, Listing Application No. A-24506
to the New York Stock Exchange, June 23, 1967, p. 1.
8. Studebaker-Packard Corporation, Listing Application
No. A-I92O8 to the New York Stock Exchange, October
8, I960, p. 1.
9. Lehigh Valley Industries, Inc., Annual Report 1968.
Note 11, p. 19.
10. Lehigh Valley Industries, Inc., Listing Application
No. A-23021 to the New York Stock Exchange, January
11,1966, p. 1.
11. Republic Corporation, Listing Application No. A-24684
to the New York Stock Exchange, August 7, 1967, p. 4.
12. Ibid.
13. U.S. Industries, Inc., Listing Application No. A-24019
to the New York Stock Exchange, December 13,
1966, p. 1.
14. Emerson Electric Co., Listing Application No. A-23695
to the New York Stock Exchange, September 26,
1966, p. 1.
15. Culf & Western Industries, Inc., Listing Application
No. A-22757 to the New York Stock Exchange,
September 13, 1965, p. 1.


195
27. American Institute of Certified Public Accountants,
Reporting the Results of Operations: Accounting
Principles Board Opinion No. 9. New York: Ameri
can Institute of Certified Public Accountants,
1966, paragraph 32.
28. Ibid., paragraph 43.
29. Ibid.
30. American Institute of Certified Public Accountants,
Earnings per Share: Accounting Principles Board
Opinion No. If?. New York: American Institute
of Certified Public Accountants, 1969, paragraph 9.
31. Ibid., Appendix D, Definition of terms; paragraph 41.
32. Ibid.. footnote 2.
33. Ibid., paragraph 62.
34. Business Combinations: Accounting Principles Board
Opinion No, 16. op. cit.. paragraphs 42 and 43.
35. See, for example, related articles in The Wall Street
Journal on September 24, 1969; October 31, 1969;
December 3, 1969; December 8, 1969; February 19,
1970; February 27, 1970; March 2, 1970; May 8,
1970; May 14, 1970; June 15, 1970; June 24, 1970;
June 29, 1970; July 6, 1970; July 29, 1970; and
August 3, 1970.
36. Business Combinations: Accounting Principles Board
Opinion No, 16. op. cit.. paragraph 47.
37. Ibid., paragraph 97.
38. Business Combinations: Accounting Principles Board
Opinion No. 16. op. cit., paragraph 78.
39. Ibid.. paragraph 79.
40. Ibid., paragraph 78.
41. Ibid.. paragraph 80.
42. American Institute of Certified Public Accountants,
Intangible Assets: Accounting Principles Board
Opinion No. 17. New York: American Institute of
Certified Public Accountants, 1970, paragraph 9.


60
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
21
forms of reorganization defined in the Code :
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-
stock").
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
interest.
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


l60
income over the "reasonable period" of time, then the purchase,
per se, will be reflected partly as an increase in earnings.
No mention is made of possible amortization of any unallocated
excess of cost over net assets purchased however, assuming
that earnout payments are made. This inconsistent accounting
treatment with regard to any unallocated excess resulting from
the purchase ensures that the buyer's earnings are not dimin
ished, but perhaps even increased. Amortization of such a
credit balance to income is justified by some accountants as
20
being consistent with the "bargain purchase" idea. How
ever, such arbitrary and periodic increases in income as a
result of merely making a purchase are conceptually at odds
with the accounting notion of realization, which states that
income is to be recognized during the period in which it is
earned.
Earnout Payments
It was found that for more than one-half of the purchase
acquisitions studied, the buyer did not specify the antici
pated accounting treatment with regard to any future earnout
payments. Earnout payments are to be charged to an intangible
account such as goodwill in one-third of the acquisitions. In
only three of the forty-six acquisitions is the earnout pay
ment to be charged to a tangible property account or to an
intangible with a limited period of existence, such as pat
ents. The valuation basis used for earnout shares is almost
always their fair market value per share, measured near their
dates of issuance. In a few acquisitions, however, the basis


214
Fundamentally, the recording of the buyer's obligation
under an earnout agreement cannot be divorced from the central
question of the evaluation of the enterprise being acquired.
Both parties to the combination determine their limits with
respect to a purchase price in the evaluation process and
then negotiate in the bargaining process to the finally deter
mined terms. There is no question but that enterprise evalua
tion is a very complex problem and not within the scope of
this research. Many factors are considered by the affected
managements in an effort to determine price, although it is
usual for these influences (and the price) to remain undis-
26
closed. The agreed upon value, however, can then be the
basis for recording and allocating the costs of the net assets
acquired (including goodwill) with the earnout obligation also
recorded at the closing. Conceptually, the amount of the lia
bility should be the present value of the estimated earnout
payments based upon forecasts of earnings during the earnout
period and formulations agreed upon from the merger agree
ment. The recording of the acquisition should not conceal
the agreed evaluation of the selling company made by the par
ties, as so often occurs under the so-called purchase ac
counting approach where the old book values of the acquired
company are used along with only the initial payment made at
the closing. Current values consonant with a true purchase
accounting concept are appropriate if the statement user is
to receive full disclosure regarding the acquirer's investment.
In an earlier chapter it was found that a purchase con
cept that included appraisals or current market values was


103
The number of shares, if any, to be issued
pursuant to the Certificates of Contingent
Interest will be determined by the average
market price for ITT Capital Stock in the
first two months of each year preceding
each delivery date (but at no more than
$100 a share and no less than $25 a share).
Thus, if all earnings goals are achieved
the minimum number of shares which will be
issuable under the Certificates is 80,000
shares and the maximum is 320,000 shares,
for an overall maximum under the entire
Jennings Agreement of 490,213 shares.33
Setting such limits is a way of protecting both the buyer and
the seller. The buyer benefits from the floor of $25 per
share while the seller benefits from the $100 ceiling. If the
buyer's common stock should decline below the $25 per share
limitation, it will prevent the seller from enjoying some of
the advantage of a substantial drop in the share price. The
buyer is thus protected from excess dilution. Should the
stock of the buyer rise in price substantially beyond the
$100 ceiling, the seller may receive a much greater number of
shares than otherwise. If the rise in the buyer's shares are
a reflection of his increased earnings per share which have
been substantially influenced by the seller's increased earn
ings achievements, then the seller's position with respect to
the existence of the ceiling may be viewed as having been
treated with more equitableness.
An interesting method of formulating a floor for the
valuation of issuable earnout shares was contained in the
agreement of U. S. Rubber and William Heller, Inc. which pro
vided that:


37
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
1192,000; 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
v/ould 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....1?
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


98
goals. For one of the acquisitions, earnout shares are to be
issued at the rate of 1,000 shares for each $16,125 of excess
profits. For another, 9 shares are to be issued for each
$250 of excess, and the third provides for 1 additional share
for each $50. Whatever capitalization rates to be applied to
excess earnings, and whatever fixed values per share of
Oenesco's common shares the parties to the agreements may have
had in mind are obscured by the terms of the agreements. Con
ceptually, this type of earnout might be viewed as one where
the capitalization rate is an integral component of the numera
tor and the value per share is basic to the denominator.
However, since both of these factors are fixed at the time of
agreement and since the formula is in the nature of a fraction,
the distinction between the two may become blurred through
arithmetic manipulation and the way in which the resultant
formulation in phrased.
Throughout the discussion of this earnout model, payment
has been assumed to be in terms of shares of the buyer's stock.
Although this assumption is in fact valid except for two of
the acquisitions studied, there is no compelling reason for
one to expect that it should be so for earnout business combi
nations generally. The sample of acquisitions studied here is
likely to be biased toward selection of those mergers where
stock is the medium of payment rather than cash, inasmuch as
the data were taken from New York Stock Exchange listing appli
cations. With regard to the exceptions just noted, one earnout


81
audit had been completed of Onan's net worth as of August 31
i960), and issued 324,325 shares of its common stock. The
agreement provided for contingent payments, in cash, on April
15, 196I, "and annually thereafter...in respect to the earn
ings, if any, of the Onan business until an aggregate of $3
8
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 $0% 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 k0% instead of 50%. For
the years 1970-1972 the agreed rate was reduced to 26^,


79
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
acquisition.
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
payment.
Each of these classes of earnout agreements has the generation
of profits by the acquired entity as the prerequisite to any


42
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


Copyright by
John Albert Yeakel
1971


64
if normegotiable 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
28
shareholders is not treated as received in the exchange."
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.^^ Specific guidelines
viere 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.-^ 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;


14
NOTES
1. "Gillette Begins to Diversify," Business Jeek (January
10, 1948), p. 44.
2. Ibid.. p. 46.
3. Gillette 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. & Montgomery, 1968, p. 79.
11. Section 13 is concerned with periodical and other
reports required for securities registered on a
national securities exchange.


218
If the medium of payment is cash, no problem of accounting
classification of the obligation exists. If the earnout is
payable in shares, or if the acquirer has the option to fulfill
the obligation by the use of either shares or cash, then how
should the estimated amounts be shown? While a decision by
the parties to the acquisition to utilize shares in lieu of
cash, or convertible debentures in lieu of shares, for example,
may very well have an impact on the aggregate amount of con
tingent payments, such preferences of the parties do not change
the basic nature of the obligation. The liability and the
payment medium used to discharge that liability are held to
be separate and distinct issues.
The findings of this research are in contradiction to
the opinion in APB No. 16 relative to the appropriate account
ing for earnout acquisitions. The Board apparently viewed
earnout payments as contingent liabilities instead of esti
mated liabilities. We conclude that in the application of the
purchase method of accounting for an earnout acquisition the
resulting liability should be estimated and recorded. The
result should be a balance sheet containing more current
(relevant) values.


55
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
words:
Genesco shall afford Berkshire Affiliates
the opportunity to include any or all of the
Genesco preferred stock received by them in
any "S-l11 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-l"
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, 197^. 5
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-l" 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
provision:


119
the earnout will become payable if the acquired business can
simply continue to generate earnings at its current level.
Given the probability of such a continuation, implications
arise as to the appropriate accounting for earnout business
combinations. These implications will be taken up in the dis
cussion in Chapter VI.
The Definition of Earnings
The earnout agreement requires the measurement of achieved
earnings and their comparison with the specified earnings goal
in order to determine the appropriateness of any contingent
payment. This measurement should be assured by a clearly de
fined statement in the agreement of what is meant by "earnings."
Because of the imprecision which attends the accounting con
cept of earnings, a statement to the effect that earnings will
be determined in accordance with generally accepted principles
of accounting may not, in itself, prove mutually satisfactory
to the merger parties in most cases. Therefore, specific
items which could become troublesome in future measurements
are usually spelled out in some detail at the time the merger
is consummated. In Genesco's agreement with Flagg-Utica,
three such items were identified:
"Net profits" means the net profits of the
business as now constituted of Flagg-Utica
and its subsidiaries, determined in accor
dance with generally accepted accounting
principles, treating as expenses (i) taxes
of all kinds, (ii) any interest charged by


177
those acquisitions studied where such accounting treatment
was disclosed. Thus, the recording of the liabilityor,
presumably, the recording of contingent shares as additions
to capital surplusis acceptable but not mandatory.
However, if contingent payments based upon maintenance
of an earnings level (as contrasted with achieving increased
earnings) are to be made in capital shares, the SEC has re
quired the additional shares to be considered as outstanding
in the computation of primary earnings per share when the
level is being maintained. This is in accordance with para
graph 62 of APB Opinion No. 15.^ Although the SEC has the
power to unilaterally prescribe the accounting methods for
use in reflecting business combinations, it appears that in
earnout situationsas in other areas as wellthe Commission
is not demanding any more than is required by the Accounting
Principles Board.


i6l
selected is the fair market value of the shares at the time
of the issuance of the closing shares, rather than at the
time of the issuance of the earnout shares.
A contingent payment which results from a simple sharing
of profits earned subsequent to the acquisition might be shown
on the purchaser's income statement as an income deduction
(similar to Federal income taxes), or as a distribution of
retained earnings (similar to dividends). The rationale for
such accounting treatment is that the payment did not depend
upon achieving an earnings target which was in excess of a
normal return on the investment, and that therefore no good
will (in the traditional sense of superior earnings) could
result. Assuming valuation of the acquired assets at their
fair market value at the date of acquisition, to increase the
buyer's investment cost upon payment of the agreed upon share
of the earnings would then seem to be inappropriate. It has
been noted in an earlier chapter, however, that earnout agree
ments are frequently the result of the inability of the buyer
and seller to determine the fair value of the seller's busi
ness. Therefore, the preceding assumption would be invalid
since the value of the acquired assets at the acquisition
date has not been agreed upon. If the fair value of the busi
ness is known and recorded at date of acquisition and the
agreement is of the profit sharing type, contingent payments
to the former owners are of the order of dividends on pre
ferred shares. One segment of the surviving company's share
holders has a priority on certain earnings of the enterprise.


I certify that I have read this study and that in my
opinion it conforms to acceptable standards of scholarly
presentation and is fully adequate, in scope and quality, as
a dissertation for the degree of Doctor of Philosophy.
Milliard E. Stone
Professor of Accounting
I certify that I have read this study and that in my
opinion it conforms to acceptable standards of scholarly
presentation and is fully adequate, in scope and quality, as
a dissertation for the degree of Doctor of Philosophy.
4.cT<
bhn B. McPerrin
rofessor of Finance
I certify that I have read this study and that in my
opinion it conforms to acceptable standards of scholarly
presentation and is fully adequate, in scope and quality, as
a dissertation for the degree of Doctor of Philosophy.
I certify that I have read this study and that in my
opinion it conforms to acceptable standards of scholarly
presentation and is fully adequate, in scope and quality, as
a dissertation for the degree of Doctor of Philosophy.
radbury
Professor of Economics


130
Limitations on Contingent Payments
It is to be expected that a corporate acquirer using an
open-ended purchase contract such as the earnout will place
limitations on future contingent payments. In this way, asset
severance can be kept within tolerable limits and the issuance
of equity securities will not unduly dilute the earnings or
equity position of existing shareholders. The agreements
studied were found to contain various limitations upon both
the aggregate contingent payments that could be made and upon
the amounts that could be paid for a specific fiscal period's
earnings.
In 96% of the transactions, the buyer had set some kind
of a maximum on the aggregate amount he was willing to pay.
In 70% of such instances, the type of limitation was in terms
of the total number of shares which could be issued in the
future. Another 20% specified an aggregate fair market value
at the time of issuance of the earnout securities as the upper
limit. The remaining 10% designated ceilings in terms of both
the number of issuable shares and their fair market value or
in other ways. One agreement specified an upper limit for
the price-earnings ratio utilized in the earnout formula, thus
effectively setting a maximum on the total contingent payout.
Ten of the transactions (k%) either stated or implied that
there was no limitation on the aggregate amount of the earnout
payments. This does not mean, however, that the buyer has an


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 federal
income tax purposes as interest.35
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.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.3?
Further discussion on the use of escrowed shares will be found
in Chapter IV, in connection with the analysis of specific
earnout business combinations.


99
was to be paid in cash, while the second utilized debentures
which are convertible into shares of common stock.
The essence of the excess earnings-fixed divisor earnout
model is that contingent payments under the acquisition agree
ment are dependent upon the amounts of the excesses of actual
earnings over specified earnings targets. It is only the
degree by which the business earnings surpass the goal which
determines the magnitude of the earnout payment. In some
cases, the excess earnings are multiplied by a given capitali
zation rate. In any event, the excess earnings are divided by
a number having a fixed value. This fixed value divisor may
be the value per share of the common stock by the buyer at
the time of the agreement. In a few agreements, the capitali
zation factor or the divisor was subject to limited change
under certain conditions relative to the future market price
of the buyer's shares. In the usual case, however, the fixed
nature of the divisor may result in either advantage or disad
vantage to the buyer and seller, since the market value of the
acquirer's shares is not considered in computing the number of
earnout shares issuable upon the achieving of profits in ex
cess of defined goals.
Excess Earnings-Market Value Earnouts
In contrast to the preceding earnout model, this type of
earnout utilizes a future market value of the buyer's stock
instead of a fixed divisor in its formula. The number of


92
Excess Earnings-Fixed Divisor Earnouts
In order to receive contingent payments according to this
earnout model, the sellers must operate the acquired business
so that profits earned are in excess of a specified earnings
target. Eurther, it is the magnitude of this excess which
determines the quantity of the buyer's shares which are re
ceived. A small amount of excess earnings will mean a small
number of earnout shares; larger excess profits will result
in correspondingly greater numbers of shares. The quantity
of contingent payment shares is not dependent upon their cur
rent market value at the time of issuance; instead, excess
earnings are translated into share quantities by the use of
a divisor whose value is fixed at the time of acquisition.
Consolidated Foods Corp. employed this type of earnout
to acquire Chicken Delight, Inc., in 1965. At the closing,
48,936 common shares were issued by Consolidated. Delight's
sellers were entitled to receive earnout shares in 1966 and
in 1967 based upon the earnings for their fiscal years ended
March 31 The terms provided that Consolidated would issue,
in 1966, one additional share of common for each $6 2/3 by
which the recurring earnings of the Delight companies ex
ceeded the recurring earnings for the prior fiscal year
or '>260,584.16, whichever was lower, but not more than
30,000 such shares. The 1967 earnout shares were based upon
earnings achieved in excess of 1966 earnings and at the same


18
Table 1
Acquisitions of Manufacturing and Mining Firms With
Assets of .'$10 Million or More, 1948-1967
Year
Number of
Acquisitions
Assets
(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
I960
62
1,710
1961
59
2,129
1962
72
2,194
1963
68
2,889
1964
91
2,798
195
93
3,900
1966
101
4,078
1967
166
6.172
Total 1,083 $39,510
Source:
Federal Trade Commission, Large
Mergers in Manufacturing and Mining
1945-1967, May 1968, p. 8.


82
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.^ 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 1965.1^
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).H
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


Table 15
Duration of the Earnings Period
Duration
Number
of Agreements
(in years)
?0
1?61
1?62
126J
1?64
i
1?66
1967
198
Total
Percent
1
1
l
2
4
3
5
16
6.0
2
1
1
3
6
10
24
45
17.0
3
1
4
1
2
2
3
7
17
27
64
24.2
4
1
1
1
2
5
7
9
26
9.8
5
1
5
5
3
8
9
12
9
38
90
34.0
6
2
1
1
3
7
2.6
7
1
1
2
4
1.5
10, or more
1
l
1
2
5
1.9
Not stated
1
.
1
.
-
6
8
-J-,0
Total
5
13
9
7
14
20
39
49
109
265
100.0
Source: Listing applications to the New York Stock Exchange


25
to 10.1# of total merger activity.^ 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
14
a major factor in total merger activity."
Examination of listing applications to the New York Stock
Exchange by the writer revealed that, during the years i960
through 1968, listed companies negotiated 405 earnout-type
combinations, as shown in Table 5. Prom this table, it can be
seen that the number of earnouts totaled 20 or less annually
during i960 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
4l alone. Note that these data exclude most cash earnouts.


Table 4
Transaction Comparison by Years
126
1966
122
1968
Cash Transactions
1436 (67#)
1438
(60%)
1077
(36%)
1314
(29%)
Stock Transactions
604 (29$)
820
(35%)
1783
(60%)
2762
(62%)
Combination Cash & Stock
&JJ&1
119
( 5%1
115
( m
386
(. 911
Total
2125 (100.^)
2377
O
O
2975
(100%)
4462
V?.
0
0
H
Source: W. T. Grimm & Co., 1968 Merger Summary, p. 2


100
variables is increased therefore to two: the amount of excess
earnings during the earnout period, and the market value of
the earnout shares. In the preceding model, the only variable
was the magnitude of the excess earnings. Determination of
the exact number of shares to be issued at the end of an earn
out period is made by dividing the capitalized earnings of the
seller in excess of the earnings goal by a fair market value
per share of the buyer's stock.
Capitalization rates are more readily identified in the
numerators of this earnout type than vas the case in the
fixed divisor type. Where both the capitalization rate and
the divisor are fixed, the identification of the two can be
obscured by cancellation or otherwise, as has already been
noted. With excess earnings-market value formulas, the de
nominator is variable and the capitalization rate fixed.
Statement of the earnout formula, therefore, will include in
the numerator the rate of capitalization to apply to the earn
ings excess.
Examination of the terms of agreement of the mergers
negotiated by this type of earnout revealed a considerable
range of capitalization rates. The highest rate encountered
was in the acquisition of Western Geophysical Company of
America by Litton Industries in i960. The buyer in this case
agreed to issue an amount of its common stock equivalent to
twenty times the excess over $450,000 of the average annual
consolidated earnings after taxes of Western during the five-
year period commencing February 1, i960. The earnout


237
factor in maintaining and increasing earnings with concomitant
support of share market values and acquisition activity.
Jhere the prospective buyer and seller are unable to agree
on the value of the enterprise, it would seem that the earn
out approach should still be an attractive one which will
result either in pooled acquisitions having very short earn
out durations or in purchased acquisitions with terms such
as were found in this study. The writer concludes that addi
tional research should be productive in determining the signi
ficance of the pooling of interests method as a contributing
cause of the increased use of the earnout in recent years.
The extent and means of disclosure of earnout combinations
to shareholders of the acquiring corporation was analyzed
through the examination of 110 annual reports issued for fis
cal years ended during 196O-I969. It was found that acquirers
usually disclosed the fact that they were utilizing the earn
out approach for acquisitions, but the identities of the
companies so acquired were not usually revealed. Neither was
disclosure usually made of closing payments, accounting prin
ciples applied or earnings definitions. No instance was
found where the earnout formula or the earnings goal was
published. It was found that the duration of the earnout
period and the estimated or the maximum remaining contingent
liability were frequently disclosed.
The most common means of disclosure has been through the
use of footnotes to the financial statements, but these notes
vary widely with respect to both the quantity and the quality
of their content. Most acquirers chose to disclose earnouts


210
executives after acquisition, but with the additional financial
resources of the buyer now available to the enterprise.
Implications from the Evidence
Prom the preceding evidence, it was concluded that earn
out obligations should not be accorded mere footnote disclosure
as are contingent obligations. The discussion in Chapter V
emphasized the fact that the disclosure of earnout commitments
by means of footnotes has resulted in inadequate disclosure.
Because earnout obligations do not appear to be contingent lia
bilities in most cases, they should not be so treated for dis
closure purposes. If it seems that at least some portion of
the contingent payment will be required, an estimate of that
amount should be made and an entry formulated to record the
liability. In addition, supplementary details concerning the
earnout agreement might be footnoted. A quotation from Woods
on the subject of contingent liabilities is pertinent:
Where it is believed that the contingency
...will result in some actual liability
(whether to the maximum extent or not...)
it is not sufficient merely to describe
the situation in a footnote; some appro
priate provision should be made for the
estimated liability.20
Based upon the payment experience presented in Table 20, it
seems unreasonable to believe that most contingencies created
through earnout agreements will not result in liability amounts
that should be recorded.
The fact that such recording has rarely occurred may be
caused by confusion as to whether or not earnout obligations


24
analysis estimates the merger universe at 300000 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.11
In its 1968 Merger Summary. Grimm & Co. counted 305 earn-
out transactions as compared with 114 in 1967. Thus, while
total merger activity during 1968 increased $0% 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&% 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


Accounting Principles Board Opinions
Relating to Accounting for Earnouts"
169
Accounting prescriptions concerning earnout arrangements
were not specified by the American Institute of Certified Pub
lic Accountants until its issuance in December, 1966, of Ac
counting Principles Board Opinion No. 9, Reporting the Results
of Operations. In the section entitled "Computation and Re
porting of Earnings Per Share," the Board strongly recommended
that earnings per share be disclosed in the statement of in
come. The reporting format specified was designed not only to
"increase the usefulness of the reports of results of opera
tions of business entities," but also to "help to eliminate
the tendency of many users to place undue emphasis on one
27
amount reported as earnings per share." Accordingly, per
share data should disclose amounts for income before extraor
dinary items, extraordinary items (if any), and net income in
cluding such items. In addition, the Board required disclosure
of potential material dilution of earnings per share caused by
contingencies such as are found in earnout agreements:
Under certain circumstances, earnings per
share may be subject to dilution in the
future if existing contingencies permitting
issuance of common shares eventuate. Such
circumstances include contingent changes
resulting from the existence of (a) out
standing senior stock or debt which is con
vertible into common shares, (b) outstanding
stock options, warrants or similar agree
ments and (c) agreements for the issuance
of common shares for little or no considera
tion upon the satisfaction of certain con
ditions (e.g., the attainment of specified
levels of earnings following a business
combination). If such potential dilution


233
and the tax approach utilized. Stock market prices in turn
frequently reflect the impact of per share earnings. Since
acquisition-minded corporations are concerned with the market
values attributed to their equity securities because of their
possible use in financing additional future acquisitions, the
choice of the accounting method is often significant.
The pooling method assumes no revaluation of assets at
the time of merger and therefore no amortizable goodwill
emerges. Future aggregate earnings will be unaffected, al
though per share earnings of the continuing shareholders may
be diluted, depending on the relationship between the shares
issued and issuable in the future and the profit contributions
of the merger entities. The purchase method implies asset
revaluation with goodwill as the usual result. Its amortiza
tion to future income can materially affect per share earn
ings. The establishment and maintenance of criteria for
distinguishing purchases from poolings has been unsuccessful
in the past and is still the subject of much controversy
centering on distinctly different views regarding the basic
nature of a business combination.
It was found that during the early 1960's neither the
purchase nor the pooling method was favored to account for
earnout acquisitions. However, in 1964 and thereafter the
pooling approach was preferred by a better than six to one
ratio. Overall, only 17% of the earnouts studied were ac
counted for as purchases. It is probable that the avoidance
of the problem of asset evaluation and any dampening effect
of goodwill amortization on earnings explains this preference


LIST OF TABLES
Table 1. Acquisitions of Manufacturing and
Mining Firms with Assets of
$10 Million or More, 1948-1967 18
Table 2. Acquisitions of Manufacturing and
Mining Firms with Assets of
$10 Million or More, by Type of
Acquisition, 1948-1967 20
Table 3. Annual Merger Activity, 1963-1969 21
Table 4. Transaction Comparison by Years 22
Table 5. Incidence of Earnout Use During 1960-1968,
by Corporations Listed on the New York
Stock Exchange 26
Table 6. Distribution of Earnouts by
"Frequent" and "Infrequent" Users 28
Table 7. The Ten Corporations Using
Earnouts Most Frequently 29
Table 8. Size of Firms Acquired Through
Earnouts, 1960-1968 31
Table 9. Profitability of Firms Acquired
Through Earnouts, 1960-1968 ......... 32
Table 10. Age of the Firm at the Time of
Its Acquisition 33
Table 11. Diversity of Ownership of
Acquired Firms ..... 34
Table 12. Basic Earnout Models Utilized in
1960-1968 Business Combinations 108
Table 13. Earnings Goals of the Acquired Business
Which Must Be Met Before Contingent
Payments Are Made 116
Table 14. Earnings Goals and Current
Profitability of the Acquired Company .... 118
vii


73
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. Prom 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 modelsuch 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


165
When one examines the attendant circumstances surrounding
those acquisitions where the earnout was accounted for as if
already earned, rather than as a contingent liability, no one
common factor appears to be present which would explain the
acquirer's preference for such an accounting prior to the earn
ing of the contingent payments. Presumably, the forecasts of
the management of the acquirer were such that future earnout
payments appeared to be very probable. Such probability esti
mates were then reflected in the recording of either an esti
mated liability (other long-term debt) or an addition to
owners' equity (paid-in surplus) at the time of acquisition,
rather than the usual delay until such time as recorded earn
ings assured payment of the earnout obligation. A result of
this accounting choice is that assets of the acquirer are not
undervalued during the earnout period and, accordingly, no
later adjustments need to be made to goodwill or other asset
accounts. The preceding statement assumes, of course, that
management's earnout probability estimates prove to be rea
sonably close to actual payment experience.
Some might argue that this accounting for earnout pay
ments as if they were already earned injects an unwarranted
pro forma element into the statement of financial condition.
However, if the probability of payment is strong enough, such
treatment may be justified on the basis of providing for all
foreseeable costs.2^


Table 6
Time Period
1960-1966
1960-1966
1967-1968
1967-1968
Distribution of Earnouts
by "Frequent" and "Infrequent" Users
Number of buyers using
earnouts for:
Six or more
acquisitions
Less than six
acquisitions
Number
of earnouts
3
62
19
88
107
10
83
158
140
298
Total
405
Source: Listing applications to the New York Stock Exchange


CHAPTER I
INTRODUCTION AND PURPOSE OP THE STUDY
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. Por 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
1


183
payable in the future, the shareholder's potential earnings
dilution might be greater than he suspects if the reserved
shares represent an estimated (probable) number, rather than
a maximum. Litton Industries, for example, utilizes such an
estimated approach, as may be seen in the following note:
Under certain acquisition agreements
capital stock may be issued as additional
consideration for businesses acquired.
The number of shares to be issued is de
pendent, among other things, upon future
earnings of acquired businesses and
future market value of Litton stock.
Based upon current estimates, the maximum
number which could be issued as addi
tional consideration is approximately
50,000 common, shares and 26,000 prefer
ence shares.5^
An example of more specific disclosure with respect to
earnout duration and potential dilution follows. In this
case the acquirer (Cenco Instruments) makes no attempt to esti
mate probable earnout shares issuable, but does state the
maximum number of shares which might be issued for one of the
acquisitions. Actually, there was no ceiling on the number of
shares issuable for the other two acquisitions (Phoenix and
Doerr), but this fact is not mentioned in the note:
The company may be required to issue
additional shares of its common stock
under the acquisition agreements with
respect to several companies (Phoenix in
1964 year; Doerr and Lab Holding in 1965
year) based on the earnings of these com
panies from the dates of acquisition
through April 30, 1966, 1970 and 1972,
respectively. The number of such shares
to be issued, if any, is not presently
determinate. In the case of Lab Holding,
the maximum-number of shares to be issued
is 19,184.75


Table 17
Payment Media Specified in Earnout Transactions,
1960-1968
Frequency of Use
Medium Specified:
i960
~nr
nr
1A1
*o7
Total
For payment at the closing:
Cash
2
1
2
3
3
2
2
2
1
18
Straight preferred stock
1
1
1
2
2
7
Convertible preferred stock
1
5
15
8
29
Common stock
5
13
9
7
12
18
35
38
101
238
Notes, debentures, or warrants
2
1
Total*
7
15
11
13
16
20
43
58
112
295
For the contingent payment(s):
-if- -if-
Cash
2
2
2
1
1
2
2
12
Straight preferred stock
1
2
3
Convertible preferred stock
4
11
6
21
Common stock
3
13
7
5
13
19
33
38
100
231
Notes, debentures, or warrants

2
1
1
Total*
5
13
9
9
14
20
39
53
108
270
Totals may be greater than the total numbers of transactions because some
transactions involve more than one medium of payment.
**In one transaction, the buyer has the option to issue common in lieu of cash.
Source: Listing applications to the New York Stock Exchange.
ro
vO


49
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." The 193^ 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
193A 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 193^.
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


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 i960 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
x


CHAPTER V
ACCOUNTING AND DISCLOSURE ASPECTS
OF EARNOUT COMBINATIONS
It was evident from the discussion of the three important
merger movements in Chapter II that business combinations have
been a major economic phenomenon in the United States. The
accounting for the entity which results from each such combi
nation has been the subject for a great deal of debate and
disagreement among accountants, financial executives, and
other interested persons. A dozen years ago, George 0. May
wrote that "the problem which the profession now faces resem
bles in some respects that which embarrassed accountants sixty
years ago when the great era of consolidations began."1 Dur
ing the increased merger activity of the past decade, one finds
that accountants are still embarrassed by their lack of a solu
tion to the problems of accounting for the surviving corpora
tion in a business combination. Indeed, they seem to come up
with too many acceptable "solutions," and then have to spend
a .good deal of effort trying to narrow the resulting areas of
difference.
Currently, there are two very different concepts of ac
counting for business combinations, and both are considered
acceptable. These two concepts are commonly known as "pooling
of interests" accounting and "purchase" accounting. Addi
tionally, a third approach"part-purchase, part-pooling"--
143


35
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


13
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.


32
Table 9
Profitability of Firms Acquired Through Earnouts
1960-1968
Year of
Acquisition
Number of
Profitable
Firms*
Return,
Assets
as a Per cent of:
Owners' Equity
I960
4
35.9
71.8
1961
10
23.9
58.4
1962
8
19.2
47.9
1963
4
26.4
41.6
1964
13
27.0
53.8
1965
18
24.1
54.6
1966
38
30.7
82.2
1967
46
34.1
64.2
1968
101
34.3
89.7
*In addition to these firms, a total of 11 were
unprofitable during the fiscal period prior to
acquisition.
^Reported net income before taxes for the fiscal
period prior to acquisition; annualized where
necessary.
Source: Listing applications to the New York Stock
Exchange.


208
Table 21
Classification of Successful
Acquisitions by Type of Earnout
Earnout Model
Number of
Successful
Acquisitions
Simple profit-sharing
14
Target-attainment
21
Excess eamings-fixed divisor
30
Excess earnings-market
value
11
Unable to classify
12
Total
88


53
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
shares by him in violation of the Securities
Act.11
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


180
no relating for the reader of any remaining contingent obliga
tion to particular acquisitions. Details such as closing
dates, initial payments at the closing, accounting principles
applied to earnout acquisitions, and the definition of earn
ings under the acquisition agreement are occasionally, but not
usually, disclosed. No instance was found where the specific
earnout formula or the earnings goal of the acquired company
was published in an annual report. Those aspects of earnout
agreements which are the most likely to be disclosed include
the duration of the earnout period and the estimated or the
maximum remaining contingent liability.
Analysis was made of the means of disclosure employed in
those reports where earnout utilization was clearly visible.
No instances were found of earnout disclosure via the medium
of the letter of the president to the shareholders. In rare
cases, the text of the report may contain information with
respect to earnout agreements, such as the following descrip
tion under "New Acquisitions":
The acquisition of the Dori Companies of
Lynn, Massachusetts and Lewiston, Maine in
late December marked Lehigh's initial entry
into the shoe industry. The companies were
acquired for approximately $3.5 million in
two new series of 4f per cent cumulative,
convertible, preferred stock and an addi
tional $1 million in these shares based on
future earnings. Dori manufactures high-
style women's footwear and operates plants
in Lynn, Massachusetts and Lewiston, Maine.
The company earned about $1 million pre
tax on sales volume of $14 million last
year. ^


74
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
2
are exclusively based on the earnings of the new subsidiary."
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.
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
example.


148
equity securities are exchanged, the acquirer may account for
the acquisition as a purchase, as a matter of current practice.
The Purchase-Pooling Controversy
With respect to accounting, the principal merger problems,
perhaps for the entire period from the beginning of the cen
tury to the present time, have been in the accounting for
assets and surplus. During approximately the past twenty
years, the accounting problems associated with business combi
nations have become evident in the purchase versus pooling
dichotomy. Since the effect of the two methods on the sur
viving corporation's asset valuation, income determination
and capital accounts would often be significantly different
for a particular combination, it is not surprising that a
great deal of interest in merger accounting has been generated,
7
especially during the recent wave of mergers taking place.
It is not within the scope of this study to examine the
purchase-pooling arguments in depth. Such an effort would be
a major endeavor in itself, and the results of two such re-
O
lated efforts have been published by the AICPA. In addition,
numerous articles on the subject of the accounting for busi
ness combinations have appeared in the accounting literature.
Only a brief summary of the basic viewpoints is attempted
here.
Those who support pooling and those who advocate purchase
accounting have distinctly different views with regard to the


17
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 190*s, the third
merger movement became characterized by the large number of
conglomerate business combinations effected, as compared 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."^ 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


16
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.^ 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
Ll
prices. 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.^ The basic pur
pose seems to be to create and bring together logical industrial


164
Shares will be issued at a value of $30 per
share, which was the approximate market
value of outstanding Purex stock on the date
of the approval of the issuance of said
shares by the Purex Board of Directors.
Purex's paid-in surplus account has been
credited with $150,000; and as the Contigent
Shares are issued, the par value of $1 for
each share issued will be credited to the
paid-in surplus account. An independent ap
praisal of the Corporation's assets is being
made, and an amount equal to the appraised
value, net of liabilities assumed, will be
assigned to the assets taken over by Purex....
The difference between this net appraised
value amount and $73355^ will be assigned
to goodwill; Purex has no immediate plans
to amortize this goodwill.22
In the Studebaker-Onan merger, setting up the future
earnout payments as a liability of the buyer at the closing
date does not seem unreasonable: there was neither an earn
ings target to be attained nor a stated time limitation
beyond which earnout payments could not be made. In addition,
the acquired company was generating net profits of almost one
million dollars annually at the time of acquisition. The
question seemed to be not so much i£ an earnout payment would
be made, as when the buyer would incur the obligation. In
the Purex-Wallace instance, again there was no earnings
goalthe terms were on the basis of profit sharing. A time
limitation, however, was part of the agreement. In still
another acquisition by Purex involving the recording of an
estimated liability, both a time limit and an earnings goal
were specified. Accordingly, more uncertainty was introduced
into the probability that future earnout payments would be
made.


52
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
O
the exemption unavailable. If stock is taken pursuant to
this exemption, it can only be taken for "investment11 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-
g
ficient period of time is normally three years. 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.*^ 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


147
assets at the values given them on the seller's books, no
matter how distant those amounts may be from current market
values. Following the example suggested above, under the
pooling concept neither the $2 million fair value of the
acquired tangible assets nor the $3 million representing the
fair market value of the equity shares issued by the acquirer
is deemed to be relevant to the accounting for the surviving
entity: The assets would be accounted for at $1 million.
Since the assets and liabilities acquired are carried
forward at their old book values, no goodwill arises when a
combination is interpreted to be a pooling, and therefore no
diminution in future per share earnings resulting from any
amortization of goodwill can arise, as may be the case under
purchase accounting. Earnings of the now-combined companies
are added together for the entire fiscal period in which the
pooling has occurred. Additionally, the income of the con
stituent companies for past periods is also combined and re
stated as income of the surviving corporation. By way of
contrast, the purchase method embodies the inclusion of the
income of the acquired company as part of the income of the
acquiring corporation only from the date of acquisition, with
no restating of past periods.
Pooling of interests accounting is applicable only to
those combinations which are effected by means of stock is
suances and not to those effected primarily by use of cash,
since the issuance of stock permits the continuity of owner
ship that characterizes pooling. However, even in cases where


243
business entities. The study calls attention to the necessity
for accounting principles to be solidly grounded in the eco
nomic realities of the situation and shows that in the case of
earnouts this grounding has not yet occurred. In the past it
has been common for financial analysts to have to devote much
time to the recasting of corporate financial statements into
more meaningful amounts and forms because of the inadequate
accounting and disclosure permitted by the accounting profes
sion. This study is illustrative of how one very significant
event in the life of a businessthe earnout mergerhas been
treated inadequately from an accounting standpoint, thus re
quiring the analyst to continue his recasting efforts. This
inadequate accounting has also allowed the use of the earnout
approach to business combinations as a means to avoid coming
to grips with the fundamental problem of enterprise evalua
tion. Prom the writer's efforts in this study, it appears
that continued empirical research would be appropriate and
fruitful in the earnout area in addition to research in re
lated areas such as actual and contingent liability conceptu
alization and approaches to the measurement of enterprise
evaluation and its disclosure.


106
multiply one-fifth of the average net earn
ings for the calendar years 1968 and 1969
of the acquiring subsidiary times the price
earnings ratio of Rexall stock as deter
mined by reference to the average price of
Rexall stock on December 31, 1969 and the
per share net earnings of Rexall for the
year ending December 31, 1969.3k
The formula included a minimum and maximum price earnings
ratio which may be taken into account in computing the number
of additional shares. Thus, the number of shares to be issued
in this case is contingent upon three factors: future earn
ings of the seller, future earnings of the buyer, and the
future market price of the buyer's common stock.
Because these three agreements were basically dependent
upon the buyer's earnings, in addition to those of the seller,
in order for contingent payments to be made, they are not
regarded as ordinary earnout agreements and are not included
in the frequency table that follows. Earnout agreements are
viewed here as merger contracts where the essential factor is
the capability of the selling entity to generate profits during
a specified time period. Thus, the single extant variable
remains within the control of the sellers. The introduction
of factors such as the buyer's price earnings ratio at a
future time should be decidedly less appealing to prospective
selling shareholders inasmuch as elements outside their con
trol may counterbalance their successful efforts to achieve
specified earnings goals. Because of this, it is not surpris
ing that such agreements are rarely found.
1
i
i


112
(B) $375*000 plus the excess of $750,000
over actual earnings for earnout years
#1 and #2, or (C) actual earnings for
earnout year #1 plus the excess of
actual earnings for earnout year #2 over
$375,000.
Consolidated Foods typically emphasizes earnings improve
ments in its agreements, as illustrated in the terms of ac
quisition of Hollywood Brands in 1967.^ Earnout ("going for
ward") shares are issuable in 1968, 1969, and 1970 at the
rates of one share for each $7, $8, and $9, respectively, of
actual earnings over yearly earnings goals ("base earnings").
No more than 20,000 shares may be issued in each of the three
years, except for additional "imputed interest" shares. Earn
ings goals are incrementally structured: base earnings for
the 1968 earnout are $1,000,000; for the 1969 earnout, base
earnings consist of $1,000,000 plus $7 times the number of
1988 earnout shares; for the 1970 earnout, base earnings con
sist of the prior year's base earnings plus $8 times the num
ber of 1969 earnout shares. Should the earnings goal for the
1968 going forward shares not be met, up to a maximum of
10,000 of such shares may be carried to 1969 to be earned at
the $8 rate.
Incremental earnings goals may also be defined by refer
ence to the buyer's return on his investment in the seller.
The Rayco Mfg. Co. was purchased under such an earnout deal
whereby Goodrich would issue 10,000 additional shares for each
calendar year in which the net income after taxes of Rayco


50
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.^ 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,
however.
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,1 '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


20
Table 2
Acquisitions of Manufacturing and Mining Firms With
Assets of $10 Million or More, by Type of Acquisition, 1948-1967
Type
Number
Per cent
Assets
(millions)
Per cent
Horizontal
193
17.8
$ 7,099
18.0
Vertical
156
14.4
5,782
14.6
Conglomerate
m
67.8
26.629
67.4
Total
1,083
100.0
$39,510
100.0
Source: Federal
. Trade
Commission,
Large Mergers
in Manu-
facturing and Mining 1948-
-1967. May1968
, P. 9.


45
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 Manhattan 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.^


217
too uncertain for other modes of acquisition to be employed.
In addition to the particular business conditions that affect
a specific firm, the general economic conditions that affect
all firms may play a significant role with respect to the un
certainties of estimating future profits and resulting earnout
obligations. Por example, the depressed economic situation
that became evident during 1970 and 1971 was widespread and
caused a considerable amount of adjustment in business opera
tions. Such recessions may have a very serious effect upon
management's ability to estimate the amounts of future earn
out payments. At the extreme, general economic conditions
might result in so much uncertainty that a reasonable estimate
cannot be made currently. In the more usual case, however,
it is believed that general economic conditions would not
prevent management from making an estimate that is more real
istic than the current zero estimate.
With respect to the specific accounts required to imple
ment the accounting recommended by this analysis, it is ex
pected that a long term estimated liability should normally
result, in addition to increased amounts of goodwill (to be
amortized in accordance with APB No. 17). Current portions
of such long term obligations should be segregated for bal
ance sheet classification purposes. In several previously
analyzed acquisitions, the acquirers increased the owners*
equity segment of the balance sheet by adding the anticipated
earnout obligations to paid-in surplusapparently because the
earnout was to be payable in equity shares rather than cash.


Table 7
The Ten Corporations Using Earnouts Most Frequently
Corporation
U. S. Industries, Inc.
Consolidated Foods Corp.
Republic Corp.
Whittaker Corp.
Genesco, Inc.
Walter Kidde & Co., Inc.
Teledyne, Inc.
Beatrice Foods Co.
Fuqua Industries, Inc.
Lehigh Valley Industries, Inc.
Number of earnout acquisitions
1967-1968
1960-1966
Total
40
1
41
19
6
25
22
0
22
18
0
18
8
7
15
15
0
15
10
3
13
9
l
10
11
0
ll
6
_1
_2
158
19
177
Total
Source: Listing applications to the New York Stock Exchange


76
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


157
Accounting for Purchase Earnout Combinations
Initial Payments
Under the purchase approach, the buyer should value the
acquired assets at their cost, based upon the fair value of
the assets or the fair value of the consideration given, which
ever is more clearly determinable. Measuring the current ap
praisal value of such assets is frequently costly and trouble
some and, probably because an exchange price for shares given
is readily available, it was found in this study that the fair
value of the initial consideration given was the usual basis
used by the buyer. The accounting to be utilized in the event
earnout shares are issued is less frequently specified.
In each purchase combination, except one, the value of
the initial consideration given was in excess of the net as
sets acquired. Although the purchase concept implies asset
valuation on a current basis, it was found that in most cases
the valuation basis actually employed was the old book value
of the seller. Of the thirty-one instances where the valua
tion basis was clearly stated, only nine indicated use of an
appraisal or current market value. The remaining twenty-two
acquisitions were recorded by use of the seller's book values.
Since old book values are typically in amounts that are below
current costs, it is probable that the tangible assets ac
quired are undervalued in most purchase earnout combinations.
A corresponding overvaluation will then be foundusually in
a goodwill or other intangible asset account. Where the


215
applied in only nine of the mergers studied in this research.
The purchase concept typically utilized included the acquired
assets at the seller's book values. More often, the acquirer
treated the acquisition as a pooling., which meant that no
recognition of enterprise evaluation was effected in the fi
nancial statements and, of course, no obligation was recorded
to reflect future earnout payments. To a large degree this
treatment may have been a consequence of tax rules that re
quire the bringing forward of book values of the absorbed
company in a tax-free reorganization and do not permit deduc
tions for intangible goodwill. Thus the use of the pooling
concept proved expedient even though not productive with
respect to more relevant valuation of assets and estimation
of liabilities.
APB No. 16 specifies that earnout transactions can no
longer qualify as poolings; acquisitions initiated after
October 31 1970, must be treated as purchases. However,
earnouts may still be tax-free reorganizations according to
tax rules. Consequently, we may expect to see current and
future earnout acquisitions where acquirers record assets at
fair market values for accounting purposes but carry forward
old book values for tax purposes. This does not necessarily
mean that the enterprise evaluation agreed upon by the parties
will be given accounting recognition inasmuch as APB No. 16
also states that any additional cost (usually goodwill) repre
sented by subsequent earnout payments should usually be rec
ognized in the balance sheet at the time of payment, anfl not


86
at a quoted value which would only coincidentally be equal to
the current market value. It is common to specify mximums
beyond which earnout payments will not be made. Some either
imply or state, however, that there is no payout limit. Stated
mximums 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


23^
for pooling. Although the purchase concept implies asset
valuation on a current basis, it was found that two-thirds
of the purchase acquisitions studied were recorded by use of
the seller's old book values. Since old book values are typi
cally below current costs, it is probable that the tangible
assets acquired were undervalued in most purchase earnout
combinations. A corresponding overvaluation then usually oc
curs in a goodwill account. It was found that practice with
respect to purchase earnouts is to not amortize this goodwill.
Therefore, from an income determination standpoint (although
not from a balance sheet approach) there has been usually no
difference between the pooled and the purchased earnout com
bination. Acquirers have obviously selected those accounting
principles that result in the most favorable earnings per
share.
Under the pooling approach, contingent shares when issued
increase the par or stated value in the capital stock account
while decreasing capital surplus. Contingent shares issued
in a purchase agreement have been usually charged to an in
tangible account that is not subsequently amortized to earn
ings. The valuation basis used for earnout shares has almost
always been their fair market value measured near their dates
of issuance.
It is significant that in five of the agreements studied
the acquirer accounted for the contingent payments at the
closing by either setting up an estimated long-term liability
or increasing owners' equity. A result of this choice to ac
count for the acquirer's evaluation of the absorbed enterprise


110
to be the break-even point, as has already been indicated.
The levels of future earnings for those where such goals were
specified to be in excess of the break-even point can be viewed
as falling within three distinct groups.
The first group comprises those earnings goals which are
set at some fixed, minimum level. In each period during the
years of the earnout, the business must meet or exceed a
profit target, but the target is not a changing one. For
example, the acquired business may be required to earn profits
in excess of $500,000 after taxes in each year of a five-year
earnout in order for the sellers to receive annual distribu
tions of the buyer's common shares. The $500,000 future earn
ings goal may have been based upon earnings achieved during
the last year prior to the merger, or perhaps upon some kind
of an average of past earnings during preceding years, or
upon other calculations or projections. It is not usually
possible for an outsider to learn the method by which the goal
was derived. In some cases, however, it may safely be assumed
that the profit of the latest year prior to the merger was
selected as the record to be improved upon, because the stated
goal is identical to the results of recent operations. For
this first group, the essential attribute is a specified, un
changing minimum dollar amount of earnings as the goal.
A second kind of earnings goal is one which emphasizes
improvement of earnings during the earnout period. To receive
contingent payments under this arrangement, the business must
record increasing levels of profit at successive stages. If


199
paucity of written material on it."*4 Even as late as 1965,
another writer stated that "the meaning of the expression
'contingent liabilities' and what comes within the scope of
the expression seem to be obscure matters in accounting
theory. In the earlier editions of accounting textbooks
little or no reference appears to have been made to the sub
ject. Later editions of such textbooks deal with the matter,
but one gets the impression that the whole question has not
been sufficiently examined.
Listings of items that have been classified as contin
gent liabilities commonly include pending litigation, pro
tested tax claims, discounted notes receivable, guarantees of
letters of credit, purchase commitments, other guaranty agree
ments, and disputed claims of various types. Contingent lia
bilities such as these are typically disclosed by footnote
until such time as they are deemed to be "actual" liabilities
In their pioneering study in 1938 Sanders, Hatfield, and
Moore pointed to the probability of future liability and to
the ability to estimate its amount, as deciding factors in
distinguishing contingent from recorded liabilities:
Contingent liabilities, such as those in
connection with pending lawsuits or guaran
tees of various kinds, are rarely shown in
the body of the balance-sheet. It is, how
ever, good practice to call attention to
the existence of material contingencies
either parenthetically or in a footnote.
If the amount which will probably fall due,
as for instance in the case of the liabil
ity to redeem trading stamps, can be esti
mated, that amount should appear in the
balance-sheet not as a contingent but as an
actual liability. It is a matter for nice


206
Table 20
Economic Success of Earnout Acquisitions
Evidence
Number of
Acquisitions
Earnout period has elapsed:
Contingent payments have been made,
up to the contract maximum lk
Contingent payments have been made,
but not necessarily at the
maximum level 23
No contingent payments were made
because earnings goal was not reached 6
Earnout period is not yet ended:
Some annual contingent payments have
been made; additional payments may
be made in the future 51
No contingent payments have been made
thus far; future earnings may
necessitate earnout payments,
however 6
Total verifiable acquisitions 100
Source: Item 2 of Form 10-K reports filed by acquiring
corporations with the Securities and Exchange
Commission.


27
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 197 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
196O-I966, 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 1968.1^ 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


188
shares was not disclosed to any noticeable degree until the
issuance of annual reports for 1968 and later. Of course, dis
closure of a maximum (or estimated) number of contingent shares
payable during the earnout period, in some cases, can give im
portant clues as to the magnitude of potential dilution. But,
where the agreement terms require increased future earnings
before contingent shares may be issued, there may be no poten
tial dilution. In fact, per share earnings may increase. Ad
ditionally, only about one in three reports which disclose the
use of earnouts also discloses such mximums. Thus the user
of the financial report has usually been unable to determine
whether dilution is likely. Apparently the APB's new disclo
sure requirements regarding earnings dilution were badly
needed.
It was found, commencing with several annual reports in
1968, that footnote disclosure was made by some acquirers con
cerning the dilutive effects of earnout acquisitions. Such
disclosure varied from a statement to the effect that none (or
no material dilution) will occur, to specific computations of
the effect of dilution on a common share basis. In most in
stances, the effect of the possible earnout was not differen
tiated from the total effect of all other dilutive factors
(such as stock options and convertible securities), so that the
reader was unable to perceive the impact of the earnouts on per
share earnings. Of all earnout acquirers studied, Genesco
undoubtedly provides the most concise and informative disclo
sure. The following is its presentation of the potential re
duction in per share earnings because of the factors enumerated


7
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.^ The study will investigate the forms which
the earnout has taken during the period from i960 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.


76
must be found in order to adequately differentiate the various
kinds of earnout agreements.
Basic Earnout Models
Prom 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


140
16.
17.
18.
19.
20.
21.
22.
23.
24.
25.
26.
27.
28.
29.
30.
Teledyne, Inc., Listing Application No. A-24676 to the
New York Stock Exchange, August 3, 1967, P. 1.
Fuqua Industries, Inc., Listing Application No. A-26913
to the New York Stock Exchange, November 11, 1968,
p. 1.
Avnet Electronics Corp., Listing Application No. A-21046
to the New York Stock Exchange, April 26, 1963, p. 2.
Beatrice Foods Co., Listing Application No. A-21709 to
the New York Stock Exchange, April 30, 1964, p. 1.
Ashland Oil & Refining Co., Listing Application No.
A-23097 to the New York Stock Exchange, February 14,
1966, p. 1.
Helme Products, Inc., Listing Application No. A-23573
to the New York Stock Exchange, July 26, 1966, p. 2.
U. S. Industries, Inc., Listing Application No. A-26111
to the New York Stock Exchange, July 17, 1968, p. 1.
U. S. Industries, Inc., Listing Application No. A-26423
to the New York Stock Exchange, September 4, 1968,
p. 1.
Consolidated Foods, Corp., Listing Application No.
A-22326 to the New York Stock Exchange, June 1, 1965,
p. 1.
Consolidated Foods, Corp., Listing Application No.
A-25715 to the New York Stock Exchange, April 23,
1968, p. 1.
Purex Corporation, Ltd., Listing Application No. A-21656
to the New York Stock Exchange, April 1, 1964, p. 1.
The B.V.D. Company, Inc., Listing Application No.
A-2338O to the New York Stock Exchange, April 26,
1966, p. 1.
Republic Corporation, Listing Application No. A-259H
to the New York Stock Exchange, May 21, 1968, p. 4.
W. R. Grace 5-, Co., Listing Application No. A-21127 to
the New York Stock Exchange, June 7, 1963, p. 1.
Litton Industries, Inc., Listing Application No. A-18948
to the New York Stock Exchange, May 4, i960, p. 1.


207
maximum amount possible. For the 43 acquisitions where the
earnout period has elapsed, only six failed entirely to meet
their earnings goals.
Eighty-eight of these 100 mergers may be viewed as having
been successful, at least to some degree, with the possibility
that an additional six may yet prove capable of meeting future
earnings goals. In Chapter IV earnout business combinations
were differentiated into four mutually exclusive classes
(Table 12). On the basis of that classification, it may be
reasonable to suppose that there would be differences in suc
cessfulness that are evident among these models. In particu
lar, one might expect much greater success for those acquisi
tions where the earnings goal was simple profitability. The
writer's classification of the 88 successful acquisitions by
type of earnout is shown in Table 21. The data show that all
of the earnout models are represented among the successful
acquisitions. However, no conclusions are possible here with
respect to the evidence of greater success for one model over
another. It appears that the number of verifiable acquisitions
as compared to the total acquisitions studied is too small for
reliable conclusions to be drawn.
From Table 20, however, the evidence is clear that expe
rience showed that, in the great majority of these cases, the
attainment of earnings goals by the selling company was the
rule, and not the exception. We conclude that the economic
success of the acquired company, as measured by the incidence
of earnout payments made, appears to be a probable result, and
not merely one that is possible.


204
the default by the maker of a note or an unfavorable court
ruling. With respect to earnout agreements, where payment is
to be made, the future event would have to be thought of as
the achievement of the earnings goal of the acquired entity
for the specified period of time. Of course, a wide variety
of numerous transactions (or events) forms the basis for de
termining whether or not the earnings goal has been net. In
other words, when applied to earnout contingent payments, the
"future event" needs to be thought of in a broader sense from
that usually encountered in the accounting literature related
to contingent liabilities. Although accountants are probably
not accustomed to such an interpretation, there seems to be
no compelling reason why the concept might not be thus broadly
construed. Earnout obligations are therefore not excluded by
the writer from the contingent liability concept because of
the future event criterion.
Given that achievement of the earnings goal specified in
the earnout agreement satisfies the notion of a future event,
the probability of such achievement still remains to be in
vestigated. If attainment of the goal is probable, then the
earnout obligation does not fall within the criteria estab
lished for identification of contingent liabilities.
This segment of the study consists of a search for evi
dence that the acquired entity was economically successful
enough to warrant the payment of contingent amounts, in accor
dance with the terms of the agreement. It has already been
noted that the economic success of the acquired business is


63
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
assignable 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.
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


138
Election No. 3 is open to shareholders, other than the
Dunitz family, and provides that up to 100,000 shares of
Gloray common stock may be exchanged for Series H Preferred,
if the shareholders so desire. Each share of common receives
$15 worth of the new non-convertible Series H, which has an
agreed value of $100 for purposes of the exchange. Should
shareholders desire to exchange more than 100,000 shares, those
so desiring would receive a pro rata amount with Series A
53
stock as a substitute for any shortage of Series H stock. v
Increasing the number of options as in the Gloray acqui
sition, of course, does not necessarily mean that the selling
individual's choice is the easier because of it. In this
situation, for example, he must decide whether the possible
earnout shares are worth their indicated value of $5 to #6
per share when compared to the alternative of receiving con
vertible shares. The rightness of his choice among the three
elections will become evident only in the future years. In
teresting research could be done concerning the results of
alternative choices with respect to earnout options available
to selling shareholders. With the large variety of ownership
and debt securities already being issued by some corporations,
it is clear that more earnout agreements containing earnout
options, as well as an increased number of options within a
specific agreement, are very possibly likely to be evident
in the future.


Part-Purchase, Part-Pooling
Pour acquisitions of the total studied were found to have
been accounted for partly by purchase and partly by pooling.
Each of these transactions was effected by payments at the
closing through the use of cash (and, in one case, debentures)
and common stock. The acquisition is treated as a purchase to
the extent of the cash (and debentures) outlay and as a pool
ing to the extent of the value of the shares issued, upon
comparing each to the total current value of the cash and
securities.
Application of this hybrid method may be seen in the ac
quisition by Beatrice Foods of three steel companies. At the
closing, Beatrice's outlay consisted of $3-5 million in cash
and '$6.4 million in current value of common shares. Net tan
gible assets acquired had a book value of $2.7 million. The
acquisition was deemed a 35# purchase and a 65# pooling, rep
resenting the approximate proportions of cash and stock issued
at date of acquisition. Some results of this unusual account
ing choice follow:
The excess of the stated value of the...
shares of Beatrice's common stock to be
initially issued over the pooled portion
of the stated capital of the Companies
will be charged to capital surplus. The
assets, liabilities and pooled portion of
the retained earnings of the Companies
will be carried forward into the consoli
dated statements of Beatrice. The intan
gible asset of approximately $2.6 million
arising in this transaction and represent
ing excess ofTthe $3.5 million cash] cost
over the 05#] Purchase portion of the net
tangible assets acquired [[$2.7 million]


182
which is labeled "Common stock issued for companies acquired
in prior years (16,302 shares)(Note 13)."^1 In a very un
usual presentation, Note 13 then identifies the successful
earnouts:
The Company issued 16,302 additional
shares of common stock in 1965 in connec
tion with the acquisitions of Biological
Research, Inc. in 1961 and Ortho Chemical
Corporation in 1962. The acquisition
agreement for Ortho Chemical Corporation
provides that additional shares of com
mon stock may be issued in the years 1966-
1968, depending on operating results of
the successor company.
Disclosure of earnouts in shareholder reports is most
commonly made through the use of footnotes to the financial
statements, and these notes vary widely with reference to the
amount of information given. An example of a non-specific
footnote is afforded by Teledyne Inc. in its note entitled
"Mergers and acquisitions" in the 1963 report:
Since October yi, 1962, the company issued
common and series A preferred stock in
exchange for all of the outstanding capi
tal stock or net assets of several com
panies. These transactions have been
accounted for as poolings of interests,
and the results of operations of these
companies for the year ended October 31>
1963, have been included in the consoli
dated statement of income. Depending upon
future income of certain of these compa
nies and the market value of the company's
common stock, additional common stock may
be issued. A total of 58,33^ shares have
been reserved for this purpose.53
The above note provides no information as to how many or which
acquisitions were earnouts. Neither is the duration of the
earnout period noted. Although the 58,33^ reserved shares
may represent the maximum possible number of contingent shares


19
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 find Acquisitions, the Journal of
Corporate Venture. Grimm St 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


240
Since earnout payments arise because of the purchase and
sale of a particular business entity, no question exists with
respect to the existence of a past event. It was concluded
that the achievement of the specified earnings goal by the
acquired business could be viewed, in a broad sense, as a
future event. However, earnouts failed in the definition of
contingent liabilities with respect to the prospect that pay
ments will be made in the future. Evidence of whether or not
the acquired entity was successful enough to warrant the pay
ment of contingent amounts was obtained through disclosures
made by acquirers to the SEC and reported in Item 2 of Form
10-K. This Item details changes in outstanding securities and
thus includes issuances of contingent payment shares.
Evidence pertaining to 100 earnout acquisitions was ob
tainable. It was found that 88 of these acquisitions have
proved economically successful in meeting earnings goals and
one or more earnout payments were subsequently made. Six of
the 100 were unsuccessful altogether, and another six might
yet achieve future earnings goals even though they were unable
to do so thus far. The view of earnout obligations as contin
gent liabilities therefore was rejected in view of this expe
rience record showing that the attainment of profit goals by
the selling company was the rule and not the exception. Sev
eral factors help to account for the excellent record shown
by acquired entities in achieving stated profit goals. One is
that the entity was profitable before it was acquired in almost
every case. Another is that earnings goals were frequently set


151
buyer may render the quoted market price of those shares unre
liable as a measure of the cost of the acquired company.
Direct valuation of the worth of the seller's business is
often difficult because of the existence of intangible and
other assets which do not have discernible market prices.
Where a new security is issued to acquire the seller, no mar
ket price may be available, or the available quoted price may
be unreliableperhaps because its market is thin.
Opponents of the pooling method believe that the under
lying economic essence of the transaction is not recorded
because the current fair values upon which the bargaining was
based are ignored in favor of past costs. One conclusion of
Wyatt in his 1963 study of business combinations was that:
No basis exists in principle for a con
tinuation of what is presently known as
"pooling of interests" accounting i_f the
business combination involves an exchange
of assets and/or equities between inde
pendent parties.12
In 1966, the American Accounting Association stated, through
a committee report, that the pooling technique of not recog
nizing new exchange values for assets acquired is "perhaps
the classic case of quantifiability and verifiability warring
with relevance." J The reasoning was that when a single
machine is purchased, the machine's book value in the seller's
records is irrelevant for the purchaser's records, and that
this irrelevance is equally true when a company is merged or
purchased. It was recommended that pooling of interests ac
counting be disallowed.


69
MOTES
1. Securities Act of 1933, as amended to October 22, 1965.
2. Securities Exchange Act of 1934, as amended to July 29,
1968.
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. George 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-Apr11, 19o9), p. 55*
10. Ibid.
11. Fireside Securities, Proxy Statement dated August 17,
1968, p. 19.
12. Genesco, 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, 19&7),
p. 11.
14. Ibid.
15. Genesco, Inc., loc. cit.
16. Walter Kidde 8c Co., Inc., Listing Application
No. A-25OIO to the New York Stock Exchange, p. 1.
17. McCarthy, op. cit.t for example, lists and discusses
six such possible methods, pp. 147-154.


115
market value of the closing shares, but this fact remains
unknown because the goal is stated simply in terms of a
dollar amount. In any event, those agreements which dis
closed the earnings goals in terms of closing-shares value
are not numerous, as is evident from Table 13. This table
details the incidence of each of the three kinds of earnings
goals (other than simple profitability) which were identifi
able for the acquisitions studied.
About 29$ of these earnings goals were of the incremental
type. Seven of the two hundred and nine goals were in terms
of a market valuation of shares issued at the closing. The
most frequently found earnings goals are specified at a fixed,
minimum level. This type comprises about 68) of the total.
Although about 12% of the mergers analyzed required
only profitable operations in order for contingent payments
to become payable, it should not be inferred that these were
businesses whose operations had been unprofitable before ac
quisition took place. In fact, in only one merger where
the earnings goal was profitability was the seller found to
be operating at a loss at the time of acquisition. Finan
cial data of the sellers were examined for all of the mergers
considered in this study in order to determine the relation
ships of earnings goals to current levels of operations. Some
earnouts, of course, have varying earnings tarp;ets for succes
sive earnout years. In such cases, the earnout goal which was
compared with current operations was that for the first earn
out period. Current operations of the seller were represented


123
earnings." From general usage and from the context in which
the phrase "net earnings" was used in described transactions,
the writer assumes that in most, if not all, of these 41
cases the earnings definition is after-tax. Thus, more than
one-third of the agreements use earnings before taxes while
almost two-thirds consider after-tax profits to define earn
ings. Even without the preceding assumption, it is clear
that most earnout agreements rely on net income after taxes
as the preferred definition. In two cases, before-tax earn
ings were used for part of the earnout period, and after-tax
earnings for the remaining portion. Additionally, many of
those in the before-tax category provide for application of a
percentage which approximates 50:'o. This may, in effect, tend
to reduce the before-tax figure to an after-tax residual.
Whether or not this is, in fact, the purpose is not known.
In sum, it has been found that earnings are usually de
fined according to generally accepted principles of accoun
ting, but with some important modifications. These modifica
tions pertain to such items as federal taxes, capital expendi
tures, interest on intracorporate capital invested, research
and development, overhead and management fees and capital
gains and losses. In drawing up an earnout agreement of mer
ger, each modification must be considered and satisfactorily
negotiated by buyer and seller inasmuch as the resultant
definition of earnings is a material factor in determining
future contingent payments.


126
Timing; of Contingent Payments
Earnout agreements of more than one year's duration
provide for contingent payments to be made either at the end
of the earnings period or else on a periodical basis during
the period. The most common approach is to provide for an
annual computation as of the end of a fiscal year with proxi
mate payment of any amount due the former owners. The timing
of earnout payments is not dependent upon the basic earnout
model utilized or upon the duration of the earnings period.
Table 16 indicates the timing arrangements used in the acqui
sitions studied.
It is apparent from the table that for every case where
the former owners must wait until the end of the life of the
earnout to receive payment there are two others where payment
is made annually. Earnout agreements with earnings periods
of only one year might be added to either of the other two
categories, depending upon one's viewpoint, although they are
shown separately here. The selling owners of the acquired
business should tend to prefer annual contingent payments,
thus avoiding the possibility of becoming "locked-in" over
the earnout period. For earnouts of only two or three years,
however, this possibility may not be significant where the
disposition of the shares received is hampered in any event
by the restrictions of the Securities and Exchange Commission,
already referred to in Chapter III.
i
I


131
unlimited, obligation, since in every such case, the duration
of the earnout period was limited, and this fact provides for
some degree of control.
In 37 transactions (14$), mximums were agreed upon
which would limit the amount which could be paid during each
individual period of an earnout lasting two or more earnings
periods. One way this is done is to divide evenly the aggre
gate number of shares which may be issued by the number of
earnings periods in the agreement. In other cases, the mxi
mums are not identical in amount each year. Where the earn
ings goals are cumulative in design, the annual possible pay
ments may also be structured in a cumulative fashion. Annual
mximums may also be set up to allow carry-overs of portions
of maximum unearned shares from a prior year. In this way,
the former owners are given some opportunity currently to
make up for a poor prior year. For example, in an acquisition
where the yearly maximum number of earnout shares was set at
25,000, provision was made so that 15,000 of the maximum from
the first year, if not earned, would carry forward to the
second year. Such carry-forwards were not cumulative beyond
one year, however.^
Escrow Provisions
An acquisition agreement may require that a portion of
the purchase price is placed in escrow until certain earnings
goals are achieved. It is common in agreements to have shares


Table 12 (cont'd)
Model
l?60 '61
*62
164 165
166 '67
68
Total
Percent
Data inadequate to assure
proper classification
2
l
2
2
4
1
8
9
31
60

Total
5
13
9
6
14
19
38
50*
122*
276*
Total exceeds the number of acquisitions involved because of agreements
utilizing more than one model.
Source: Listing applications to the New York Stock Exchange.
o
NO


229
In some cases, the excess earnings were multiplied times a
given capitalization rate but in all cases the excess earnings
were divided by a fixed value to determine the earnout pay
ment. The fixed value was sometimes related to a value per
share of the buyer's common--for example, its value at the
time the parties reached agreement. Since the market value
at the time of contingent payment of the buyer's common is
not considered, the fixed nature of the divisor may result in
either advantage or disadvantage to the buyer and seller. To
avoid such possible advantage and disadvantage, the divisor
can be specified to be the market value of the earnout shares
at a time reasonably close to their issuance. This model is
termed an "excess earnings-market value" earnout. It has two
variables (excess earnings and per share market value) and
its use places the former owners of the business in the posi
tion of receiving contingent shares that are the cash equi
valent of the capitalized excess earnings as defined in the
earnout formula.
Of the agreements analyzed in this study, 12.5/6 were
simple profit sharing, 18% were target attainment, 38,& were
excess eamings-fixed divisor, and 31.5/6 were the excess
earnings-market value type. All four models were utilized
throughout the 196O-I968 time period with no apparent trends
in their frequency of use. It was found, however, that some
of the earnout acquirers have apparent preferences for a
given model to the exclusion of others. No conclusions are
possible here to explain such individual preferences. Before
formulating an earnout agreement, each party must forecast


Table 10
Age
of the Firm at the Time
Its Acquisition
of
Number of years
Number
in Operation
of Firms
Per cent
0 -
5
40
16.7
6 -
10
52
21.8
11 -
15
37
15.5
16 -
20
24
10.0
21 -
25
29
12.2
26 -
30
13
5.4
31 -
ll
10
4.2
36 -
10
4.2
41 -
45
7
3.0
46 -
50
3
1.2
over
50
14
Si.8
Total
239
100.0
Source:
Listing applications to
York Stock Exchange.
the New


154
Table 18
Method of Accounting for Earnout Combinations,
1960-1968
Year
Purchases
Poolings
Part-purchase,
part-pooling
Unknown
Total
I960
3
2
5
1961
4
9
13
1962
4
5
9
1963
5*
l
1
7
1964
3
11
14
1965
4
15
1
20
1966
3*
35
1
39
1967
3*
45
1
49
1968
17
86
2
4
122
Total
46
209
4
6
265
Includes a business combination originally accounted for as a
pooling, but later changed to a purchase.
Source: Listing applications to the New York Stock Exchange


30
technique, however, has not taken place until the latter part
of the i960 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 fr*om 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


246
Eggleston, DeWitt Carl. "Contingent Liabilities and Fire
Losses," in Modem Accounting Theory and Practice,
Volume 1. New York: John Wiley & Sons, Inc., 1930*
Federal Trade Commission. Large Mergers in Manufacturing
and Mining 1948-1967. Washington, D. C.: Federal
Trade Commission, 1968.
Finney, H. A. Principles of Accounting, Volume 1. New
York: Prentice-Hall, Inc., 1927.
Fireside Securities. Proxy Statement dated August 17, 1968.
Fuqua Industries, Inc. Proxy Statement dated October 2,
1967.
Getz, Joseph. "The Difference Between Contingent Liabilities
and Material Commitments," New York Certified Public
Accountant (March, 1939), pp. 57-261.
"Gillette Begins to Diversify," Business Week (January 10,
1948), pp. 44-46.
Gillette Safety Razor Company. Annual Reports to Stock
holders, 1949-1953.
Grimm, W. T., & Co. 1968 Merger Summary. Chicago: W. T.
Grimm & Co., 1969.
Gunther, Samuel P. "Contingent Pay-Outs in Mergers and
Acquisitions," The Journal of Accountancy (June, 1968),
pp. 33-40.
Hamrick, James C. 43 T.C. 21, 1964.
Hecht, Charles J. "Earnouts," Mergers and Acquisitions, the
Journal of Corporate Venture (Summer. 1967). pp. 2-12.
Hendriksen, Eldon S. Accounting Theory. Homewood, Illinois:
Richard D. Irwin, Inc., 1965.
Johnson, Glenn L. and James A. Gentry, Jr. Finney and
Miller*s Principles of Accounting, Introductory, 7th. ed.
Englewood Cliffs, New Jersey: Prentice-Hall, Inc.,
1970.
Kohler, Eric L. A Dictionary for Accountants, 3rd ed.
Englewood Cliffs, New Jersey: Prentice-Hall, Inc.,
1963.
Kripke, Homer. "A Good Look at Goodwill in Corporate
Acquisitions," The Banking Law Journal (December. 1961).
pp. 1028-1040. '


201
precise as might be hoped for was evident in the qualification
to the assent of one member of the committee: "Mr. Halvorson
believes the bulletin fails in the essential matter of defi
nition. ,11 In essence, the Bulletin stated only that mate
rial contingent liabilities should be disclosed. No further
official pronouncements on the subject of contingent liabili
ties or their definition have been made by the AICPA since
Bulletin No. 50 in 1958.
In a recent article, Beaton specifies the meaning of a
contingent liability by comparing with "actual" liabilities:
The main characteristic which distinguishes
a contingent liability from an ordinary one,
is that a contingent liability eventuates
after the happening of two events, the first
of which is certain and has occurred by the
balance sheet date, and the other is uncer
tain and occurs, if at all, sometime there
after. *2
Where only the amount of a liability is uncertain, he states
that "such a liability is not a contingent liability because
although the amount is uncertain, the liability itself is cer-
tain as of the balance sheet date. J The distinction is an
important one, and one which accountants sometimes fail to
appreciate. Moonitz is even more precise to the point:
...the method of measurement of a given item
is a consideration wholly apart from its na
ture. Thus, income taxes are usually levied
as a percentage of net taxable income. Be
cause the tax is arithmetically a function
of income or profits does not make it a divi
sion of profits. Two distinct problems are
involved, namely, (1) what is the nature of
the item under discussion, (2) how do we mea
sure its magnitude? The two problems should
be kept distinct.14


128
Payment Media
The results of analyzing the earnout transactions in
terms of the medium of payment used in each case are summarized
in Table 17. Payments made at the closing have been more apt
to include more than one medium than is the case with contin
gent payments. It is rare for the earnout payment to involve
a combination of media: only five transactions were so struc
tured. No conclusions with respect to the frequency of the
use of cash are drawn here inasmuch as the data source is
biased against the inclusion of cash transactions. Use of
preferred stock which is of the straight (non-convertible)
type is seen to be infrequent. Convertible preferred was more
frequently used, and accounted for approximately 10# of the
use made of equity securities. Neither type of preferred,
however, came into noticeable use until 1966. The greatest
incidence of preferred securities is evident during 196?, when
17 of the 49 acquisitions in that year made use of convertible
preferred at the closing, followed by a decline in use during
1968a decline especially striking in view of the rising num
ber of acquisitions in 1968 that employed common. For the
1960-1968 agreements, in nine out of ten cases where equity
securities are to be issued to the former owners, they will
receive common stock if their earnings goals are met. If con
vertible preferred is viewed as the equivalent of common, one
may conclude that earnouts have usually been negotiated by
the use of residual securities.


36
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."1^
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


107
Frequency of Use of the Basic Earnout Models
The earnout formulations which were used in the acquisi
tions selected for study have been classified, in Table 12,
according to the basic models that have been detailed above.
Some acquisitions make use of more than one type of earnout
formula and, for this reason, the totals are sometimes in ex
cess of the total number of acquisitions studied.
Table 12 indicates that the excess earnings-fixed divisor
type of earnout is the one most frequently found in contingent
payment acquisitions, with the excess earnings-market value
type as the next most common. About two-thirds of the agree
ments classified are dependent upon the amount of the achieved
earnings which is in excess of the earnings goal in order to
compute the contingent payment. Agreements which depend upon
the mere profitability of the seller or upon his ability to
attain a specific earnings target are less common. Each of
the four common earnout models has been utilized during most
of the years shown, with no definite trends emerging from the
data.
Earnings Goals
Regardless of the model used, all earnout payments are
predicated upon the attainment of a certain level of future
earnings by the newly acquired business. For about twelve
per cent of the combinations analyzed, that level was found


This dissertation was submitted to the Dean of the College of
Business Administration and to the Graduate Council, and was
accepted as partial fulfillment of the requirements for the
degree of Doctor of Philosophy.
June, 1971
Dean, Graduate School


21
Table 3
Annual Merger Activity, 1963-1969
Number of
Increase over
previous
Year
Mergers*
Numerical
Per cent
1963
1964
1,361
1,950
589
43.3
1965
2,125
175
9.0
1966
2,377
252
11.9
1967
2,975
598
25.2
1968
4,462
1,487
50.0
1969
6,132
1,670
37.4
^Merger announcements, net of cancellation.
Sources: V/. T. Grimm & Co., 1968 Merger Summary,
p. 1; and The Wall Street Journal,
January 15, 1970, p. 1.


172
the current level, in computing fully diluted earnings per
share, earnings should be adjusted to reflect the increase in
earnings specified by the particular agreements (if different
levels of earnings are specified, the level which would result
in the largest potential dilution should be used). Previously
reported earnings per share data should not be restated to
give retroactive effect to shares subsequently issued as a
result of attainment of specified increased earnings levels.
When an earnout acquisition has not been economically success
ful upon the expiration of the earnout period, the unissued
shares should not be considered as outstanding in that year.
Previously reported earnings per share data should then be
restated to give retroactive effect to the removal of the
33
earnout contingency.
Both APB No. 9 and APB No. 15 were concerned with im
provement in computing and disclosing earnings per share.
Neither, however, recommended any changes from current prac
tices with respect to the accounting for the various convert
ible securities and contingent issuances (including earnouts)
whose recent and frequent use prompted the issuing of these
Opinions. Except for the addition of the dual presentation
of per share earnings on the income statement, no changes
were prescribed for the content of published financial state
ments. In fact, until 1970, no authoritative statements from
any accounting body had been issued which dealt with the ac
counting for earnout business combinations. The lack of gen
erally accepted accounting principles with respect to earnouts


4
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^
(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
corporation.5
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 paymentwith 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,"^ 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


5
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 19^+8, it was nevertheless regarded as
novel.^ 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


65
(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
exchange.31
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


95
years in order to receive the maximum number of issuable
shares.
The per-share earnings equivalent which serves as the de
nominator in the formula for an excess earnings-fixed divisor
earnout is sometimes clearly related to a market price per
share of the buyer's common shares. In several earnout ac
quisitions by Lehigh Valley Industries during 1968, the fixed
divisors were in magnitudes of ¡$17.50 $16.00 and $14,625, each
of these figures approximating the fair market value of Le
high's common stock near the time of acquisition. In the ac
quisition of Thermo-Plastic Products Company by Purex, the ag
gregate number of shares issuable at the end of each fiscal
year was to be equal to one-half the amount by which the sel
ler's earnings exceed $30,000, divided "by $35 as the assumed
0 /
agreed value of Purex's Common Stock." 0 In most instances,
however, there is no such indication and the basis for the
fixed per-share earnings equivalent is neither stated nor ap
parent .
Attaching such a fixed value to the shares of the buyer's
stock will be advantageous to the seller if the stock should
rise in price, since he will receive more shares than would
be the case if the shares were issued using their current mar
ket values. If the buyer's stock suffers a decline in value
below the fixed value of the agreement, then the seller would
prefer that current market values had been used in lieu of the
fixed value. In one agreement, the parties agreed to a com
promise favoring the seller on this point: the fixed value


191
Amounts
paid as of
acquisition
Amounts
paid since
acquisition
Remaining
maximum
contingent
shares
Acquired in 1968:
Evangeline Shoe Corp.
Common stock
124,115 shs.


Loree Footwear Corp.
and related company
Common stock
150,000 shs.
44,440 shs.
88,891 shs.
In addition to this schedule, Lehigh Valley provided other ex
planatory footnote material concerning details such as escrow
provisions, duration of the contingent payment period, and
accounting policies for specific acquisitions. Any dilutive
impact of its earnout contingencies was not specifically de
lineated, however, as it was in Genesco's disclosure.
If the writer is correct in his supposition that share
holders desire to be informed of the use of the earnout method
of acquisition by management, the degree of potential dilution
such use engenders, and the resultant successes (and failures)
of this approach, then this study indicates that acquirers
have much room for improvement of their disclosure policies
and practices. In general, the shareholder is given only
fragmentary information with respect to earnouts by the use
of footnotes to the financial statements. Although it is not
necessarily so, footnote narrative in the reports studied
tended to be vague and tedious. Where the number of earnout
acquisitions was large, the footnote tended to be very general
and less informative.


149
basic nature of a business combination. Those who favor the
purchase method believe that it is rare for a combination to
take place where one company does not emerge as the acquirer,
although it may be difficult to identify the acquiring and
the acquired companies in cases where the two are of approxi
mately the same size. The acquirer issues its stock in order
to obtain assets from the shareholders of the selling company.
The price paid for these newly acquired assets is arrived at
in the same way that asset costs are usually determinedby
the bargaining which takes place between independent parties.
Accordingly, it is believed that the purchase method of ac
counting for a business combination is consistent with the
traditional principles of acquiring assets based upon histori
cal costs. The particular medium of payment employed is not
deemed relevant; stock may be utilized as well as cash or
debt instruments. Assets acquired are recorded at their cur
rent purchase costs, with goodwill recorded if the total cost
exceeds the fair value of the tangible assets. Retained
earnings of the acquired company are not carried forward;
only profits from the date of its acquisition are included in
the surviving corporation's retained earnings.
Advocates of the pooling method believe that no new
basis of accountability arises when a business combination is
effected by an exchange of common stock since no new resources
are added to the economic entities that were combined and
since the shareholder groups were neither expanded nor con
tracted. Since common shares are the medium of payment, no


211
are contingent liabilities or actual liabilities from a con
ceptual standpoint. The definitional imprecision already
noted with respect to the notion of a contingent liability may
be part of the problem. In accounting practice the term has
been and continues to be used loosely. There has been a ten
dency to include in the classification of contingent liabili
ties actual liabilities of indeterminate amount. The differ
entiation between a contingent liability and an actual
liability is said to be the uncertainty as to whether there
21
will be any legal obligation. If we keep in mind the
distinction between the obligation itself and the measurement
of the amount of the obligation, our analysis of the appro
priateness of accounting for earnouts may be facilitated.
The legal contract which is the earnout agreement is
specific with reference to the obligations of the contracting
parties. The buyer clearly has an obligationspelled out by
formulato make payment to the sellers provided that they
operate profitably. It is the uncertainty that exists re
garding the amount of future profit of the acquired company
that is at the root of the problem. This uncertainty is re
flected then in terms of the measurement of the amount of the
buyer's obligation. It seems that earnout acquirers may have
confused the separable problems of (1) determining the exis
tence of a liability and (2) the difficulty of measuring its
amount because of the uncertainty which generally surrounds
estimates of future profit.
It is appropriate to point out at this time that not
only is the concept of a contingent liability imperfectly


194
13. American Accounting Association, A Statement of Basic
Accounting Theory, 1966, p. 33
14. See, for example, Abraham J. Briloff, "Dirty Pooling,"
The Accounting Review (July, 197), pp. 489-496.
15. American Institute of Accountants, "Business Combina
tions," Accounting Research Bulletin No. 40. New
York: American Institute of Accountants, 1950.
16. American Institute of Certified. Public Accountants,
"Business Combinations," Accounting Research Bulle
tin No. 48. New York: American Institute of*
Certified Public Accountants, 1957.
17. George R. Catlett and Norman 0. Olson, "Accounting for
Goodwill," Accounting Research Study No, 10. New
York: American Institute of Certified Public
Accountants, 1968, p. 50.
18. See, for example, Ronald M. Copeland and Joseph F.
Wojdak, "Valuation of Unrecorded Goodwill in
Merger-Minded Firms," Financial Analysts Journal,
(September-October, 1969)
19. Litton Industries, Inc., Supplement to Listing Applica
tion No. A-23644 to the New York Stock Exchange,
February 28, 1967, p. 1.
20. Samuel P. Gunther, "Contingent Pay-Outs in Mergers and
Acquisitions," The Journal of Accountancy (June.
1968), p. 34.
21. Studebaker-Packard Corporation, Listing Application
No. A-I92O8 to the New York Stock Exchange,
October 8, i960, p. 1.
22. Purex Corporation, Ltd., Listing Application No. A-22422
to the New York Stock Exchange, April 26, 1965, p. 2.
23. Gunther, op. cit., p. 35.
24. Beatrice Foods Co., Listing Application No. A-26309 to
the New York Stock Exchange, August 17, 1968, p. 4.
25. Ibid.
26.American Institute of Certified Public Accountants,
Business Combinations: Accounting Principles Board
Opinion No. 16^ New York: American Institute of
Certified Public Accountants, 1970, paragraph 43.


Disclosure Principles in Annual
Reports to Shareholders
178
It was noted, in Chapter I, that in its acquisition of
the Toni Company, Gillette disclosed terms of the merger
agreement and also reported to its shareholders annually
the amounts of contingent payments which accrued and the re
maining contingent liability. The purpose of this section of
the study is to investigate the extent and form of disclo
sure of earnout combinations, generally, to shareholders of
the acquiring corporation through its annual reports.
Annual reports of those corporations that acquired four
or more businesses during the 196O-68 period were selected
for detailed study. In total, there were twenty-one such
acquirers, involving 227 acquisitions. Reports were selected
for study for such years (including fiscal 1969) where a
potential earnout obligation existed as of the balance sheet
date. This selection process identified 115 annual reports
in which one might expect disclosures of earnout acquisitions
to be made. Five of the total number were not available to
the writer; therefore the following findings are based upon
the examination of 110 such reports.
Three-fourths (82) of the reports clearly disclosed that
the earnout concept was being used by the corporation in its
acquisition program. Only one of the twenty-one acquirers
issued reports where no specific identification of the use
of the earnout approach was made. Still, readers of this


113
was equal to a return on Goodrich's investment in Rayco
40
ranging from 12% to 15% for the four such calendar years.
Earnouts with increasing annual profit goals during the
earnings periods have sometimes been referred to in the lit
erature as incremental earnouts. In this study, earnings
goals that are based upon improving profits during the earn
out period were found to be not peculiar to any one of the
earnout models previously described. This type of goal will
be more restrictive for the seller since his business must
continue to achieve higher profits throughout the duration of
the earnout. Sellers may be expected to prefer the type of
earnings goal which does not change during the earnings
period.
From about the beginning of 1968, a third kind of earn
ings goal was notedone where the goal is in terms of the
market value of the shares issued at the closing. Four ac
quirers were identified as having set earnings goals in this
way. Whittaker's agreement to acquire Diamond S. International
Leasing Corp. provided for a total maximum of 190,476 shares,
with a maximum of one-half of that number issuable at the clos
ing, the exact number to be determined by dividing $6,000,000
by the average closing market price of Whittaker common during
the first ten of the twenty days preceding the closing date.
Earnout shares will be based upon Diamond's capitalizedat
a rate of fiveaverage annual earnings for three years that
are in excess of the $6,000,000 market value of the closing
shares. In other words, Whittaker is willing to pay five times


175
be amortized over the remaining life of the asset. In a
separate Opinion, the Board concluded that the period of
42
amortization should not exceed forty years.
The Opinion is silent with respect to the extent of dis
closure which should be made. Presumably, footnote disclosure
is intended. To this writer, it is clear that the Board viewed
earnout payments as contingent liabilities, rather than esti
mated liabilities, in most cases. This study has shown (Table
14) that in most of the acquisitions studied, the formulated
earnings goal for the acquired entity was not above its earn
ings at the time of acquisition. The data indicated that for
about 72i5 of these agreements at least some portion of the
earnout will become payable if the seller merely continues
to generate earnings at his current level. Since the proba
bility of earnout payment seems to be better than one half,
it is suggested that a view of earnout agreements as usually
constituting contingent liabilities may be inappropriate.
Further study involving the actual payment results for selected
earnout agreements will be examined in the next chapter.
Securities and Exchange Commission Policy
Relating to Accounting for Earnouts
Neither Regulation S-X nor the Accounting Series Releases
of the Securities and Exchange Commission reveals its policies
relating to the accounting for contingent payments in business
combinations. In fact, no general guidelines on the account
ing for such payments have been issued. Instead, transactions


118
Table 14
Earnings Goals and Current Profitability
of the Acquired Company
Number
Percent
Earnings
i goal is not above recent earnings
109
71.7
Coal is
5-10$ above recent earnings
11
7.2
Goal is
11-50$ above recent earnings
20
13.2
Goal is
more than 50$ above recent earnings
12
-hi
Total
152
100.0
Source: Listing applications to the New York Stock Exchange.


2
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
100/6 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 Gillette
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.^
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


121
expense frequently can have a material impact on the computa
tion of earnings. One approach to settling this question was
reflected in an agreement which provided that reductions in
earnings be made for write-offs with respect to "depreciable
property as defined in the federal income tax laws, to be
depreciated on a straight line basis in accordance with Inter
nal Revenue Service guidelines, and expenditures for the right
of use of property for a limited and determinable time being
amortized in equal installments over such period of time." J
Agreements commonly provide for interest terms on any
capital borrowed by the seller from the buyer. Additionally,
the following earnings definition considers expenditures for
patents and research costs, as well as federal taxes:
(i)the Net Earnings shall be determined
without taking into account (a) any non
recurring gains, losses and profits (as
determined under generally accepted ac
counting principles), (b) corporate
management or other intra-corporate fees
or charges asserted by REPUBLIC or its
other entities or divisions except for
reasonable fees and charges for serv
ices rendered or goods or products de
livered, (c) costs and expenses for re
search and development problems approved
by REPUBLIC (except for reasonable
amortization thereof), and (d) costs and
expenses of patents, trademarks and like
items (except for reasonable amortization
thereof);
(ii)the Net Earnings shall be determined
without taking into account any federal
income taxes and/or any state franchise
or income taxes;
(iii)the Net Earnings shall be reduced by a
charge of six percent (6%) per annum for
all capital invested by REPUBLIC in the
IKM Division. For the purpose of this


58
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
tionmay 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


51
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...."^ 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.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


189
1969
1968
Conversions of senior securities
ft .05
ft
.13
Conversions of employees' subordinated
convertible preferred stock
.21
.16
Conversion of debt of nonconsolidated
foreign finance subsidiary
.04
.02
Issuance of shares contingent upon
earnings of certain acquired
companies
.06
.05
Exercise of outstanding employee stock
options
.02
$ os
ft
O?
An explanatory sentence accompanying the above tabulation
indicates that "in the case of contingent issuances, earnings
have been increased to the levels which would be required to
57
make the issuances.
With one exception, no instances were found where the
acquirer attempted systematically to inform its shareholders
of the economic success of earnout acquisitions. Nine of the
twenty-one acquirers included at least some evidence in their
reports from which a reader could conclude that one or more
acquisitions had been successful. For example, a statement
of the changes during the past year in the capital surplus
account might indicate that a reduction therein was caused by
the issuance of an undisclosed number of shares earned. How
ever, in virtually every case, fragmentary evidence such as
this was either not clearly explained or was inconsistently
presented from year to year.


137
on the American Stock Exchange, had approximately one and
one-third million common shares outstanding and about 2,100
stockholders. Fifty-one per cent of the common shares were
owned by members of the Dunitz family. Under the acquisition
agreement, shareholders were provided with the option to
elect one of three mutually exclusive elections to receive
USI's Special Preference Stock (Series A) or its Special
Preference Stock (Series H). Both series are $2.50 par value
preferreds. Each Series A share is convertible into four
shares of common, while the Series H stock is not convertible.
Election No. 1 is to receive at the closing one share of
the convertible Series A for each six shares of Gloray common.
The agreed market value of the Series A stock may not exceed
$18 or be less than $15 per share of Gloray common. All the
shareholders, except two Dunitz owners who hold approximately
35" of the seller's shares, may elect Election No. 1.
Under Election No. 2, Gloray shareholders at the closing
receive one share of Series A for each nine shares of common,
with the agreed value of the Series A set at no more than $12
nor less than $10 per share of common. The agreement further
provides that under this election, the shareholders may re
ceive earnout shares of Series A stock over the next five
years worth a maximum of $10 per each share of Gloray common.
The earnout is of the excess earnings-market value type. This
election is open to all shareholders, including the members
of the controlling family.


Table 12
Basic Sarnout Models Utilized In
196O-I98 Business Combinations
Model
i960 '61
'62 63
64 '65
'66 '67
68
Total
Percent
Simple profit sharing
(Earnout payments are made
provided only that the sel
ler is profitable)
2
2
4
7 7
5
27
12.5
Target attainment
(Earnout payments depend
upon the seller's attaining
a specified level of
earnings)
7
2 2
3 4
6
15
39
18.0
Excess eamings-fixed divi
sor (Earnout payments
depend upon the amount of
the seller's earnings in
excess of a specified earn
ings goal)
2
2 2
5 8
11 20
32
82
38.0
Excess eamings-market value
(Earnout payments depend
upon the amount of the sel
ler's excess earnings and
the market value of the
buyer's equity security)
1 3
1
2 2
6 14
39
68
31.5
Subtotal
3 12
7 4
10 18
30 41
91
216
100.0


247
Lauver, R. C. "The Case for Poolings." The Accounting
Review (January, 1966), pp. 65-74.
Listing Applications to the New York Stock Exchange, 196O-
1968.
Maclean, Daniel C., III. "SEC Registration and Filing
Requirements for Mergers and Acquisitions," Mergers
and Acquisitions, the Journal of Corporate Venture
(March-April, 19o9), pp. 33-56
McCarthy, George D. Acquisitions and Mergers. New York:
The Ronald Press Co., 1963.
McNeill, Hugh M. "Certain Tax Aspects of Corporate Acqui
sitions," Corporate Growth Through Merger and Acquisi
tion, Management Report 75. American Management
Association, 19&3*
"Marko's Minimum-Risk Merger Method," Mergers and Acquisi
tions. the Journal of Corporate Venture (winter. l£o7),
PP. 55-57.
May, George 0. "Business Combinations: An Alternate View,"
The Journal of Accountancy (April, 1957), pp. 33-36.
"Mergers on Parade," Mergers and Acquisitions, the Journal
of Corporate Venture (January-Pebruary. 1969).
pp. 49-51.
Moonitz, Maurice. "The Changing Concept of Liabilities,"
The Journal of Accountancy (May, i960), pp. 41-46.
Moonitz, Maurice and Charles C. Staehling. AccountingAn
Analysis of its Problems. Volume 1. Brooklyn: The
Foundation Press, Inc., 1952.
Odell, I. Gordon. "Evaluation Factors and Techniques,"
Corporate Growth Through Merger and Acquisition.
Management Report 75. American Management Association,
"Profits Without Honor," Time (March 9, 1970), p. 62.
Reeves, James P. Tax Aspects of Corporate Mergers. Exchanges.
Redemptions. Liquidations and Reorganizations.
New York: Vantage Press, 1967.
Regulation 1.483-1 (Treasury Decision 6873, filed January 24,
1966).
Revenue Procedure 66-34, C.B. 1966-2, 1232.
Revenue Procedure 67-13, C.B. 1967-I, 590.


83
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 to a low of approximately 26# in later
years.13
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
ting the market value of the earnout shares to a total of
$2,000,000.
In the 1966 acquisition of Electro-Air Gleaner 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."1^
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


80
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
ments .
Simple Profit Sharing Earnouts
An early example of the use of a simple profit sharing
type of earnout is afforded by the October 5, I960, 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


193
NOTES
1. George 0. May, "Business Combinations: An Alternate
View," The Journal of Accountancy (April, 1957),
P. 36.
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. 14.
3. American Institute of Certified Public Accountants,
"Restatement and Revision of Accounting Research
Bulletins," Accounting Research Bulletin No. 43.
New York: American Institute of Certified Public
Accountants, 1953, Chapter 5, paragraph 9.
4. See, for example, William W. Wemtz, "Corporate Consoli
dations, Reorganizations and Mergers," The New
York Certified Public Accountant (July, 1964),
pp. 379-387; William M. Black, "Certain Phases
of Merger Accounting," The Journal of Accountancy
(March, 1947), pp. 2l4-20; Edward B. Wilcox, Busi-
ness Combinations: An Analysis of Mergers, Pur
chases, and Related Accounting Procedure," The
Journal of Accountancy (February, 1950), pp. 102-107.
5. Wyatt, pp. cit.. p. 15.
6. Andrew Barr, "Accounting Aspects of Business Combina
tions," The Accounting Review (April, 1959), p. 176.
7. Articles on the subject are currently appearing in the
nonfinancial as well as the financial press. See,
for example, "Profits Without Honor," Time (March
9, 1970), p. 62.
8. V/yatt, op. cit.; and George R. Catlett and Norman 0.
Olson, "Accounting for Goodwill," Accounting Re
search Study No. 10. New York: American Institute
of Certified Public Accountants, 1968.
9. R. C. Lauver, "The Case for Poolings," The Accounting
Reviev; (January, 1966), p. 71.
10. Ibid.
11. Homer Kripke, "A Good Look at Goodwill in Corporate
Acquisitions," The Banking Law Journal (December.
1961), p. 1035.
12. Wyatt, op. cit., p. 105.


CHAPTER VII
SUMMARY OF FINDINGS
Although the concept of the earnout is not new, its wide
spread use as a means of effecting and financing business
combinations is recent. An earnout is a form of business
merger in .which the agreement provides that the acquirer make
payments in the form of cash or securities at some time after
the closing date of the acquisition based upon the future
earnings of the acquired entity. Such agreements are also
referred to as "incentive transactions" and "contingent pay
ment (or payout) agreements."
In the United States there have been three distinct
merger movements, the third of which dates from World War II
and is still in progress. Although earnout acquisitions are
found during this time period, their frequency is not known
because appropriate statistics have not been compiled. In
deed, data on the incidence of mergers generally have been
incomplete. Until 1966, the number of earnout agreements
consummated annually by corporations listed on the New York
Stock Exchange was twenty or less, according to examination
of listing applications by the writer. Significant increases
in the use of the earnout device took place during i960, 1967,
and 1968 so that almost two hundred were found for 1968 alone.
221


222
While total mergers more than doubled during 1964-1968, the
number of earnouts increased fourteen-fold. These findings
are based upon earnouts effected through the use of securities.
The incidence of earnout combinations effected by the use of
cash as the medium of payment is not known because buyers
frequently decline to disclose such acquisitions or their
terms to the public. It was estimated by the financial con
sulting firm of Grimm & Co. that earnout transactions had
increased to approximately 12$ of total merger activity by
the end of 1969.
Not only has the incidence of the earnout combination
greatly increased during the late 1960's, but its use by cer
tain corporations has been significant. It was found that
just ten acquirers accounted for approximately 44$ of the
earnout activity of NYSE firms during 1960-1968. The cor
porations using earnouts most frequently viere those commonly
known as conglomerates in the financial press. It was found
that several of these corporations employ the contingent pay
ment approach in virtually every acquisition agreed upon.
Ninety per cent of the acquisitions made by these ten corpora
tions took place during 1967 and 1968, a time when the merger
movement was gaining momentum.
Because acquirers do not often disclose their reasons
for selecting one method of combination over others that are
available, it is not possible to state with assurance the
causes of the high rate of increase in the use of the contin
gent payment approach to business acquisitions.
It is likely


120
Gene seo for moneys advanced, by it, and
(iii) any reserves established for lia
bilities arising out of operations during
or prior to the year in question.^3
Other items which should be considered include future
changes by the buyer for administrative and manufacturing
services and for other intracorporate transactions. For
example, Loral Electronics in its acquisition of A & M Instru
ment, Inc. specified that expenses would include "all operating
and nonoperating expenses properly chargeable against A & M,
Inc. under generally accepted accounting principles as deter
mined by the independent certified public accountants of
A & M, Inc.," and specifically included "administrative charges
by Loral against A & M, Inc., for management services furnished
by Loral provided that such charges are computed in a manner
consistent with the charges made against other subsidiaries of
Loral," but not to exceed $20,000 per year. "All audit,
legal, or other specialized services rendered to or on behalf
of A & M, Inc. by Loral's accountants, attorneys or consul-
lZl
tants shall be chargeable against A & M, Inc."
Capital gains and losses, capital expenditures, and depre
ciation of acquired capital assets all need to be considered
in the determination of the definition of the seller's earn
ings. Capital gains and losses are normally viewed as nonrecur
ring or extraordinary and are therefore not taken into account,
unless so specified. With regard to asset additions made dur
ing the earnout period, there is the question of the basis upon
which their depreciation should be taken, since depreciation


Table 5
Year
1960
1961
1962
1963
1964
1965
1966
1967
1968
Incidence of Earnout Use During 196O-I968,
by Corporations Listed on the New York Stock Exchange
Number of Earnout
Combinations
Increase (Decrease) over previous year
Numerical Per cent
5
13
9
7
14
20
39
102
196
8
(4)
(2)
7
100.0
6
42.9
19
95.0
63
161.5
94
92.2
Total 405
Source: Listing applications to the New York Stock Exchange.


228
Almost no published, research was found concerning the
earnout concept and only one author has even attempted to
classify earnout agreements. Because that classification
attempt resulted in categories that were not mutually exclu
sive, this study includes analyses of a large number of
agreements in order to delineate the types of earnouts that
buyers and sellers have negotiated. Of the 405 agreements
negotiated during 196O-I968 by acquirers listed on the New
York Stock Exchange, 265 were analyzed. It was found that
the necessity of the acquired company's earning a future
profit is the common thread running through earnouts and that
the agreements could be differentiated into four mutually
exclusive classes.
In the "profit sharing" type the contingent payment is
set equal to a specified fraction of all earned future profit.
Payment is made in cash or in securities with the value of
the security usually stated in terms of its current market
value, but in some cases a quoted value other than current
market was used. The "target-attainment" earnout is charac
terized by the payment of a fixed amount of cash, number of
shares, or dollar value in shares provided that the selling
entity achieves a specified earnings target. Some agreements
provided that the target and/or the magnitude of the fixed
payment were different for each year of the earnout period.
The essence of the "excess earnings-fixed divisor" model is
that contingent payments depend upon the amounts of the ex
cesses of actual earnings over specified earnings targets.


212
definedso also is that of an actual liability. This diffi
culty is illustrated in a recent statement of the Accounting
Principles Board in which liabilities are defined as economic
obligations of an enterprise that are recognized and measured
in conformity with generally accepted accounting principles.
However, liabilities also include certain deferred credits
that are not obligations, such as those arising from income
tax allocation, but that are recognized and measured in con-
22
formity with generally accepted accounting principles. The
basic problem is a matter of what should be included and what
23
should be excluded from the liability classification.
Further, the outer limits of the concept have expanded over
oh,
the years. There seems little likelihood that the basic
obligation created via the earnout merger might be viewed
conceptually as falling outside the parameters of a liability
definition, considering the widened breadth of the concept
in accounting.
Even though the earnout obligation falls within the
classification of liabilities to be recorded, there still re
mains the problem of quantifying the obligation. An inability
to quantify such an obligation does not imply that it is not
a liability. As already noted, the existence of the obliga
tion and its measurement are two distinct aspects. A general
footnote is no substitute for an accrual, and a liability
which can be translated into a monetary amount and which is
reasonably certain, even though it may not be finally due or
determined, should be provided for by means of a balance sheet
accrual rather than omitted and indicated by footnote.^


156
Accounting for Pooled Earnout Combinations
Initial Payments
From a record-keeping standpoint, the advantage of the
pooling method is its simplicity of application. No appraisals
of assets or difficult allocations of total acquisition cost
among individual assets are needed to account for the merging
of the two entities. The asset, liability, and retained earn
ings accounts are combined at their old book values. The
capital stock account of the acquirer is increased by the par
or stated value of the shares issued at the closing. Differ
ences between the total net assets plus retained earnings on
the books of the seller and the stated capital of the closing
shares issued are adjusted through a capital surplus account
usually increased because par and stated values are nominal in
amount.
Earnout Payments
The accounting for any contingent shares actually issued
also poses no problem. Earnout shares when issued increase
the aggregate balance in the capital stock account while de
creasing the capital surplus account by the same amount. In
the absence of sufficient capital surplus, the charge will be
made to retained earnings. Neither current share values nor
current asset values will have any effect upon the accounting
at the closing or at the time of the issuance of any earnout
shares.


CHAPTER III
LEGAL FACTORS
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.^-
The Securities Exchange Act of 193^ is mainly concerned with
48


93
fixed, per-share equivalent of $6 2/3. A maximum was set for
the 1967 issuance at 30,000 shares, plus not more than 7,500
shares as were not earned, in 1966. In making the computations,
if earnings in a period, exceed, the maximum earnings required,
to earn all the shares payable, then such excess earnings are
disregarded.. A maximum of 7,200 shares could be issued at
the closing in addition to the 48,936 shares already mentioned.
These additional shares are also earnout shares and were is
suable on the basis of one share for each $3 1/3 by which the
average of the annual recurring earnings of the Delight com
panies for the three fiscal years ended March 31, 19&5 exceed
$141,000. The additional shares were conditioned upon the
availability, at the closing, of an audited statement of re-
24
curring earnings for the 1965 fiscal year. Thus, in this
case, part of the closing shares were based upon an excess-
earnings earnout formulation. However, this is not usual,
based upon the acquisitions studied by the writer.
It is common with this type of earnout to have the excess
profit measured according to an increase over the preceding
fiscal period, as was the case in the Consolidated-Delight
merger. However, as it is also true with other earnout models,
the profit targets may be set at a constant level for each
year, rather than at increasing levels.
In addition to the effect of the magnitude of the excess
earnings, any annual increases in the per-share earnings equi
valent will help to determine the quantity of the earnout
shares to be issued. Looked at as a fraction where the amount


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
EARNOUT BUSINESS COMBINATIONS
By
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.
ix


54
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 validity 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.1-^
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.1^
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


239
mergers to be sure that circumstances warrant the capitaliza
tion of the additional payment as an additional investment
cost. The possibility of understatement of asset and liability
valuesimplicit in a view that regards earnout payments as
contingent liabilities instead of actual liabilitieswas
apparently not considered to be an issue either by the SEC
or the APB. Opinion No. 16 concluded that the acquirer should
capitalize the additional consideration at its fair value as
additional cost at the time such consideration becomes dis
tributable. We conclude therefore that the official AICPA
view is that earnout obligations constitute contingent liabili
ties warranting footnote disclosure.
Prom this research study it was found that such a view
of earnout obligations is inappropriate. The hypothesis
tested was that the economic success of the acquired entities
during the earnout period would indicate that earnout obliga
tions are more properly viewed as actual liabilities which
should be estimated and recorded in the accounts. The meaning
of contingent liabilities was explored by searching the ac
counting literature. It was found that writers on the subject
frequently are not precise as to the meaning of the term but
that several characteristics of contingent liabilities seem
to be basic. There must be an obligation arising from a past
event but dependent upon a future event which may or may not
occur. If, however, the future event is a probable one, the
obligation should be estimated and recorded in the accounts
as a liability and not treated as a contingent liability.


159
earnout combination, as these concepts are currently applied.
However, under the purchase concept, aggregate asset valuation
will tend to agree with total current value inasmuch as the
fair market value per share of those issued is the usual basis
for establishing the aggregate accounting value of the business
acquired. Pooling produces the more conservative balance
sheet.
In only one purchase earnout combination studied was there
no resulting excess of initial cost over net assets acquired;
instead, a liability was recorded. The accounting for Litton1s
1966 agreement to acquire Sturgis Newport Business Forms was
changed in 1967, after terms of the earnout were revised:
Under the terms of the original agreement, this
was considered to be a pooling of interests.
Due to changes in the agreement, it is presently
recorded as a purchase. In consolidation the
difference between the net book value of the
assets and liabilities of Sturgis and the
amounts initially paid will be recorded as a
liability to be resolved upon termination of the
formula period. At that time, the total pur
chase price will be allocated to the assets re
ceived based on fair value. Any unallocated
excess will be classified in Litton's consoli
dated financial statements as excess of cost
over related net assets of businesses purchased;
any unallocated credit balance remaining at the
end of this period will be amortized over a
reasonable period of time.*9
It appears that the buyer anticipates making earnout
payments in the future, as implied by the fact that no asset
accounts were reduced to initial cost upon change in the terms
of the agreement. If no earnout payments are made, then asset
values of the buyer will have been overstated during the earn
out period. If any unallocated credit balance is amortized to


227
as that utilized by the seller for tax purposes; no recogni
tion of current asset values is given and no taxes arise. The
seller's tax basis for his equity in the acquired company is
retained as his basis for the shares he receives from the
buyer, thus deferring income taxes. It is particularly impor
tant for earnout mergers to be tax-free where the stockholder-
executives of a young and growing company have appreciation
in the value of their investments in the business but neither
the cash nor the desire to pay taxes upon the sale of their
company. It is also important that the right to receive
earnout payments does not invalidate the tax-free status of
the acquisition. As the result of a series of cases in which
the tax nature of contingent rights to receive additional
stock in the future was considered, the Internal Revenue Serv
ice has evolved guidelines (Revenue Procedure 67-13) for the
issuance of advance rulings on proposed reorganizations involv
ing contingent shares. It is prudent for parties to a pro
posed earnout to insure its tax-free status by designing the
agreement with the guidelines in mind and by requesting a
ruling on its status from the Commissioner of Internal Reve
nue. Both taxable and tax-free agreements should also provide
for interest of at least 4# annually on contingent payments;
otherwise interest will be imputed by the I.R.S. at the rate
of per year with the result that the sellers are taxed on
such imputed interest as ordinary income in lieu of receiving
capital gains treatment.


170
is material, supplementary pro forma compu
tations of earnings per share should be
furnished, showing what the earnings would
be if the conversions or contingent issu
ances took place.28
Pro forma earnings per share reflecting such potential
material dilution resulting from earnout agreements were rec
ommended by the Board for disclosure in the income statement.
Further, if increased earnings levels were required under the
terms of the earnout, then such increased earnings levels
"should be given appropriate recognition in the computation
of potential dilution."29 Before the issuance of APB Opinion
No. 9, it was rare for corporations to present pro forma
earnings per share data of this type except in prospectuses
and proxy statements.^
The issuance of APB Opinion No. 15, Earnings per Share,
in May, 1969, brought additional disclosure and computational
requirements relating to per share earnings. Whereas APB
No. 9 recommended that supplementary pro forma earnings per
share data reflecting potential material dilution resulting
from earnouts be shown in the income statement, APB No. 15
required such disclosure on the face of this statement. This
Opinion makes mandatory the presentation of two types of earn
ings per share amounts in the income statement: "primary"
earnings per share, and "fully diluted" earnings per share.
The first type represents earnings attributable to each share
of common stock outstanding, including "common stock equi
valents" (i.e., securities which are in substance equivalent
to common stock because of their terms or because of the



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104
If any annual computation...results in an
excess of ten times the average net income
over the agreed base, the number of addi
tional shares to be delivered shall be
determined by dividing such excess by the
higher of (1) the average of the means
between the high and low prices for Uni-
Royal shares on the New York Stock Ex
change during each of the first twenty
days in which UniRoyal shares were traded
on such Exchange following the close of
the previous fiscal year of Heller or (2)
the book value of UniRoyal's shares at the
end of the most recent preceding calendar
quarter.34
Typically, the excess earnings-market value type of
earnout has no specified upper or lower valuation limitation
per contingent share issued. Ceilings on the aggregate num
ber of earnout shares that may be issued and/or the aggregate
market value of those shares are the rule, however. With
regard to a given earnout payment, the former owners of the
acquired business will usually find themselves in the position
of receiving shares which are a "cash equivalent" of the
capitalized excess earnings as defined in the earnings formula.
The measurement of this equivalent is most often based upon a
time period which is reasonably close (i.e., within a few
months) to the end of the period during which the excess earn
ings have been achieved. There are four factors in excess
earnings-market value formulas: two fixed (the earnings goal
and the capitalization rate), and two variable (earnings of
the seller and the market value of the buyer's shares). Not
only is the success of the acquired business basic to the
interests of its former owners; the performance of the buyer's


39
management 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 lessperhaps considerably lessthan
the amount of stock which would have been transferred under
21
a straight stock-for-stock acquisition.
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


124
Duration of the Earnings Period
The period of time during which the earnings goals can
be met is not usually more than five years. Durations of as
short a period as one year are sometimes found, and the long
est earnouts in the sample have lives of ten* thirteen, and
fifteen years. Durations of two, three, four, and five years
are the rule however. The results of analyzing each of the
earnout acquisitions studied in terms of their earnout period
durations are indicated in Table 15. In compiling the table,
nine earnouts had durations which included fractions of years
and these were rounded to the nearest whole number. Thus, an
agreement having an earnings period of four and three-fourths
years was counted as having a life of five years.
The data in Table 15 indicates that, from i960 through
1965, the modal earnout period was five years. In each of
those years, fifty per cent or more of the agreements had dura
tions of five years or more. During 1966 there was a change
toward earnout periods of shorter duration, and this pattern
continued in 1967 and in 1968. Ten of the 1966 agreements
were negotiated by the major acquirers, and only three had
durations of five years or more. The discernible switch to
shorter-lived agreements therefore seems to be a general one,
and not merely a reflection of the acquisition policies fol
lowed by the major acquirers.


9
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 sura 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 193^*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


163
account for the fair market value of the earnout shares at
the time of their issuance. In recent years it has been the
practice of the acquirer not to amortize intangibles so
created.
Of the total purchase acquisitions studied, five were
found to have been accounted for by the recording by the buyer
of the contingent payments as if already earned as of the date
of acquisition. Apparently the expectation in each of these
cases was that the contingent payments would be made in the
future periods, according to the terms of the formula. This
treatment is in contrast to the usual practice of increasing
the buyer's asset cost only after such time as the contingent
payment is actually earned.
Studebaker-Packard's i960 acquisition of D. W. Onan &
Sons, Inc., for example, was accounted for as a purchase of
net assets at their appraised value. The buyer determined to
include in the value of the acquired net assets "the Corpora
tion's entire obligation to make contingent cash payments
rather than to recognize such cash payments only as earned."^1
Studebaker's earnout obligations in cash amounted to $3 mil
lion, or approximately one-fourth of the total value of the
transaction.
In a 1965 acquisition anticipating contingent payments
in the form of common stock, the accounting by Purex for its
acquisition of the "Wallace Companies" was detailed as
follows:
Purex has recorded the investment at $733,554
on the assumption that, in addition to the
$583,554 paid in cash, all 5,000 Contingent


226
Devices such as the "investment letter" and warnings stamped
on the securities are used in order to enforce such require
ments. To provide the sellers with recourse should they want
to sell their securities after the acquisition, provision
should be made in the earnout agreement for guarantees that
the buyer will file registration statements under specified
conditions but with a limitation on the number of such regi
strations promised. Such a provision could also be a protec
tion for the acquiring corporation against the subsequent
sale of securities by a seller which might violate the original
exemption.
The parties to an earnout agreement also need to be aware
of the impact of Federal income taxes before the acquisition
takes place so that their tax burdens may be minimized. In
a "taxable" acquisition, the buyer must compute a new tax
basis for the assets he receives and must allocate his pur
chase price among those assets. He will want to attribute as
much as possible to depreciable property and as little as
possible to goodwill since the former is tax deductible and
the latter is not. The seller, however, prefers to have most
of the price allocated to goodwill in order to obtain capital
gain treatment rather than to other assets and be taxed on
the resulting gain on such assets at the higher ordinary in
come rates.
In the favored and dominant "tax-free" reorganization,
no tax liabilities arise at the time of merger; instead they
are deferred. The buyer acquires the same basis for assets


230
future earnings of the absorbed company as well as speculate
on future market prices of the buyer's securities which might

be used as the contingent payment medium. These projections
along with each party's earnings goals, capitalization rates,
and preferences for a particular approach will result in the
formulation through the bargaining process of one of the earn
out models.
Aside from the one agreement in eight where simply oper
ating profitably was the goal, most (67) agreements specified
a fixed, minimum level of earnings that the business must at
tain during the earnout period if payments are to be made.
In 29 of the agreements the earnings goals were of the incre
mental type; the business must attain increasing levels of
earnings during the earnout period. In 4% of the acquisitions
studied the earnings goal was defined in terms of a market
value of the closing shares. Where this was a future market
value, definition of the earnings goal implies an estimation
factor.
It is critical that earnout agreements clearly define the
meaning of earnings inasmuch as contingent payments depend
upon such definitions. Earnings may be defined according to
generally accepted accounting principles so long as all im
portant deviations therefrom are detailed. These deviations
pertain to such items as federal taxes, capital expenditures,
interest on intra-corporate capital invested, research and
development, overhead and management fees, and capital gains
and losses. The duration of the earnings period was most


75
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 $375,000,
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 combined net worth as at January
31, 1965.5
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


122
subparagraph (iii), "capital invested"
shall include any funds or property
advanced to the IKM Division, whether
in the form of loans or equity, but
shall not include accumulated Net
Earnings (reduced by federal and state
tax liabilities, but not reduced by
the six percent (6$) charge for capi
tal invested) of the IKM Division.
Further, "capital invested" shall be
reduced, by all withdrawals of capital
from the IKM Division by REPUBLIC.
The charge provided for by this sub-
paragraph (iii) shall be in lieu of
and not in addition to any interest
charges which REPUBLIC may otherwise
make against the IKM Division with
respect to capital invested. The
amount of any accumulated federal or
state tax liability (determined cumu
latively on a quarterly basis through
out the taxable periods without regard
to the actual due dates for the pay
ment of any such taxes) referable to
income of the IKM Division (as deter
mined for tax purposes) to the extent
not withdrawn by REPUBLIC, shall,be
considered as capital invested.^-0
Buyer and seller need to agree on whether earnings are
to be defined as before-tax earnings or after-tax earnings.
With the general tendency toward higher federal taxation
rates, the seller will probably prefer a before-tax definition.
After-tax earnings would likely reduce his receipt of future
earnout payments. Buyers should tend to prefer after-tax
earning's definitions since the seller will then, in effect,
bear some of the increased taxation cost. Of the total of
265 transactions analyzed, 210 indicated the place of income
taxes in the definition of earnings. Seventy-seven, or 37$,
specified before-tax earnings; 92 transactions (44$) specified
after-tax earnings; and 4l transactions (19$) specified "net


46
NOTES
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. clt.. p. 4.
5. Robert G. Dettmer, "Reasons for Mergers and Acquisi
tions," Corporate Growth Through Merger and
Acquisition. Management Report 75. American
Management Association, 19o3, P29.
6. Wyatt, op. clt.. 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, op. cit., p. 51
11. See, for example, Harlan Byrne, "Merger Come-Ons,"
The Wall Street Journal (June 6, 1969), p. 1;
and Main Laurentz & Co., "The Contingent Payout,"
in its Mergers & Acquisitions Newsletter
(Augus t, 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.


Earnout Business Combinations
By
JOHN ALBERT YEAKEL
A DISSERTATION PRESENTED TO THE GRADUATE COUNCIL OF
THE UNIVERSITY OF FLORIDA IN PARTIAL
FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF
DOCTOR OF PHILOSOPHY
UNIVERSITY OF FLORIDA
1971


97
AMTRON Division for the three (3) year
period, commencing February 1, 198 and
ending January 31, 1971 exceed Two Hun-
dred Eighty Thousand Dollars ($280,000.00).
This earnout formula is therefore weighted in favor of
the buyer. Should the common shares of the buyer rise above
$110, then the fractional part of a share which is used in the
formula will decrease and the number of shares issuable under
the earnout also decreases. Should the buyer's shares fall
in price, however, there is no provision benefiting the sel
ler, such as that given in the previous illustration. Al
though the formula is fundamentally of the excess earnings,
fixed divisor type, one might view it as a hybrid since it may
embrace fair market values should share prices rise sufficiently.
In some agreement terms, the use of a capitalization rate
is apparent as part of the numerator. For example, an acquisi
tion provided for a contingent payment of "such number of addi
tional shares of the Company's Common Stock (valued at $43.02
per share) as shall equal ten times the excess of the Southwest
companies' average annual net income after taxes...over
$80,000 during the period May 1, 1963 through April 30, 1966
29
plus 50 per cent of certain capital gains during such period."
In this combination, the fixed divisor in terms of a per-share
value ($43.02) and the capitalization rate (10) are clearly
identified. In other combinations, however, these factors are
not specifically delineated. Genesco's terms for acquiring
three separate businesses in early 1967 are illustrative. Each
of the three was dependent upon the excess of aggregate after
tax income earned during a period of several years over defined


236
over a period not exceeding forty years, according to Opinion
No. 17. These two Opinions can have a profound effect upon
the future utilization of the earnout approach. To have an
acquisition still qualify for pooling treatment, the earnout
period may not extend beyond one year. It was found in this
study that the duration of the earnout period often has been
two, three, or five years. Unless future earnout agreements
are negotiated for much shorter time periods, the adverse
income effects of the purchase approach must be recognized.
It may be that the attraction to the pooling method is so
strong that acquisition-minded corporations conclude that the
advantages of the earnout approach are not sufficient to
overcome the disadvantages of the purchase method* Under the
purchase concept, the acquirer needs to come to grips with
the recording and the disclosure of the agreed valuation of
the acquired enterprise. While in recent years the income
depressing effect of any goodwill amortization was obviated
by assuming that goodwill retained its value, this assumption
is no longer an acceptable basis for accounting practice.
Elimination of the pooling method for most earnouts should
help to reveal something of the significance of certain other
advantages ascribed to the earnout approach such as its use
fulness in the financing of acquisitions and in the settle
ment of disagreements over the valuation of the enterprise to
be acquired. Any substantial disappearance of the earnout
would seem to indicate that the main reason for its use was
not in its financing and other advantageous aspects, but
rather that its use when combined with pooling was a primary


77
Year ending in 1965, $222,000 in the Fis
cal Year ending in 19&6, $259,000 in the
Fiscal Year ending in 1967, $296,000 in
the Fiscal Year ending in 1968, and
$333,900 in the Fiscal Year ending in
1969.6
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
second.?
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


176
of the earnout type are reviewed by the SEC staff to "insure
that the circumstances in each individual case warrant charg
ing all or a portion of the additional payments as an addi-
43
tional cost of the investment."
In one particular case, Paradyne Electronics Corporation,
the Commission prohibited the registrant from charging addi
tional payments to the carrying value of plant assets, with no
recognition of goodwill. In its acquisition in i960 of the
assets and business of a partnership, Paradyne paid ,$150,000
as an initial payment and agreed to pay additional fixed pay
ments of $1,400,000, and also contingent payments up to a
maximum of $2,500,000 over 20 years, based upon 50^ of annual
net profits after taxes. The SEC ruled that in this case the
transaction was actually a profit-sharing or division-of-
eamings arrangement, and that the contingent payments had to
be deducted from earnings on the income statement, and not
added to the investment cost.^ The Paradyne case is an ex
ception, however, to the general SEC practice of treating such
45
payments as additional cost. The case was atypical in that
the buying corporation and the selling partnership were under
common control: no contingent payments could be said in any
realistic sense to become the property of Paradyne.
The SEC has not required registrants to set up an esti
mated liability at the time of consummation of a business
combination for contingent payments that may be made, whether
they are based on maintaining an earnings level or on in-
46
creased earnings. But neither has the Commission prohibited
the recording of such a liability, as earlier evidenced by


59
consequences,1''7 in the majority of cases the owners of the
business to be sold will be interested in a nontaxable merger
18
in order to defer income taxes. 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.1^
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
20
acquisition. From a tax standpoint, the sellers are treated
as if the sale had not occurred since the shares they receive


219
NOTES
1. H. A. Finney, Principles of Accounting, Volume 1.
New York: Prentice-Hall, Inc., 1927, p. 230.
2. Glenn L. Johnson and James A. Gentry, Jr., Finney and
Miller's Principles of Accounting, Introductory.
7th ed. Englewood Cliffs, New Jersey: Prentice-
Hall, Inc., 1970, p. 266.
3. See, for example, DeWitt Carl Eggleston, "Contingent
Liabilities and Fire Losses," in Modern Accounting
Theory and Practice. Volume 1. New York: John
Wiley & Sons, Inc., 1930, p. 350; also J. B. C.
Woods, "Auditing Procedures; LiabilitiesDirect
and Contingent," New York Certified Public
Accountant (August, 1950), p. 471.
4. Joseph Getz, "The Difference Between Contingent Liabili
ties and Material Commitments," New York Certified
Public Accountant (March, 1939), P. 257.
5. D. C. Beaton, "Contingent LiabilitiesSo-called," The
Accountant (August 21, 1965), p. 237.
6. Thomas Henry Sanders, Henry Rand Hatfield, and Underhill
Moore, A Statement of Accounting Principles. New
York: American Institute of Accountants, 1938, p. 82.
7. Victor Z. Brink, ed., "Contingent Liabilities,"
(Auditing Practice Forum), Journal of Accountancy
(December, 1946), p. 523*
8. American Institute of Certified Public Accountants,
"Contingencies," Accounting Research Bulletin No. 50.
New York: American Institute of Certified Public
Accountants, 1958, paragraph 1.
9. Ibid.. paragraph 3.
10. Ibid., paragraph 2.
11. Ibid.. p. 39.
12. Beaton, op. cit.
13. Ibid.. p. 238.
14. Maurice Moonitz and Charles C. Staehling, Accounting
An Analysis of its Problems. Volume 1. Brooklyn:
The Foundation Press, Inc., 1952, p. 434.
15. Ibid.. p. 444.


91
of the two earnout components are linked, with the outcome of
the target-attainment segment indicating a possible change in
the terms of the major earnout provision.
In summary, the incentive transactions which are labeled
as target-attainment earnouts in this study are characterized
by the payment of a stated and fixed amount of cash, number
of shares, or dollar value in shares, contingent upon the ac
quired entity's achieving a specific earnings target. For
earnouts with a duration in excess of one year, the target
may be at the same level in all years, or it may be for a
higher amount in later years. The magnitudes of the actual
payments may also be fixed at different amounts for different
years. Usually, the earnings target is set at a higher level
than current earnings. Variations in the use of this kind of
earnout have been noted in the acquisition agreements effected
by U. S. Industries, Inc., the major acquirer in recent years
making use of earnout agreements. Commonly USI uses this
type of earnout in conjunction with some other type to effect
a given business combination. The two or more earnout com
ponents may be separate or in some cases may be linked. For
target-attainment earnouts, one need only verify (a) that the
defined earnings target was reached to know (b) the amount of
the actual earnout payment, since it is a fixed quantity. This
type of earnout may be thought of as a straightforward a *b
formulation.


43
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


3
$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 ;||>20 mil
lion for Toni. Thus, the purchase price vis-a-vis the gross
sales of Toni was in a 1-to-l ratio.
I>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
Gillette'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 o* 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 $7,5^7,600 due to the former
shareholders of the Toni Company (reduced in
1950 from $8,000,000 by the acquisition of the


184
Por those reports in which the existence of earnout obli
gations was disclosed, two out of every three, on the average,
informed the reader of the maximum amount which might become
payable through the duration of the earnout period. One in
four specified an estimated amount which would become payable,
based upon the continuation of earnings at a rate equal to the
current level. In addition, approximately one in four (but a
different set of acquirers than those just referred to) indi
cated that shares were being reserved to provide for earnout
obligations. These reservations appear to be based upon maxi
mum obligations or estimated amounts payable, and were commonly
found as part of a footnote.
Table 19 pinpoints the locations within the annual reports
where disclosure regarding earnouts was found. Because most
of the earnout obligations involved in this study are payable
through the use of common stock, it is perhaps not surprising
to find that acquirers most often chose to reveal their exis
tence through the capital stock footnote. On the other hand,
earnout obligations are commonly spoken of and apparently
thought of as contingent payments. Logically then, we should
expect to find earnout obligations as a component of the
footnote for commitments and contingent liabilities. However,
this was found not to be the case generally. Only 30,* of
the footnotes for contingent liabilities and commitments
contained any reference to contingent earnout payments.
All of these instances, however, occurred in reports for the
acquirer's most recent fiscal years.
This may indicate that


231
frequently two, three, or five years. There has been a dis
cernible switch to shorter-lived (less than 5 years) agree
ments in recent years.
Regardless of the duration of the earnings period,
actual payments under an earnout were scheduled to be made
annually during the period instead of only at the end of the
period by a majority of 2 to 1. Neither straight nor convert
ible preferred was commonly specified as the medium of pay
ment for either closing or contingent payments, although
convertible preferred was the more common of the two. Where
equity securities are to be issued to the former owners if
their earnings goals are met, common stock was specified in
90f, of the agreements. Buyers almost invariably set maximum
limits on the amounts of any future payments so as to restrict
asset severance or to prevent earnings dilution.
In 9% of the combinations studied there was provision
made for the escrowing of a portion of the purchase price
until certain earnings goals are achieved. The purposes of
escrowed shares with release provisions in earnout terms are
apparently to avoid the imputation of interest, to help ren
der the reorganization tax-free, and to help reduce the risk
of overpayment through the return of shares in case the earn
ings goals are not achieved.
Although earnouts have been used primarily to acquire
closely held businesses, there is evidence that publicly
owned companies may also be merged by this method even though
it may be troublesome to negotiate and implement. Six of the
acquisitions studied contained one or more options whereby a


146
for goodwill is not allowable as a deduction for Federal
income tax purposes. The market value of the surviving com
pany^ stock may be materially affected by such a decrease in
reported earnings. For an acquisition-minded company in par
ticular, such future impacts upon earnings might even be
adverse enough to cause abandonment of proposed business
combinations. Therefore, the accounting treatment accorded
mergers by the purchase method may be quite significant in
terms of its effect upon subsequent economic events.
Pooling of Interests Accounting
During the late 1940's and early 1950's, business combi
nations came to be viewed as constituting either acquisitions
(purchases) or mergers (poolings).^ During the 1950's two
alternative accounting treatments were followed, and by i960
"most business combinations apparently could be accounted for
either under the purchase concept or under the pooling con
cept, and either treatment would be held to be in accordance
with generally accepted accounting principles."^
The pooling of interests method accounts for a business
combination as a Joining together of the ownership interests
of the two companies, and treats them as though they had
always been combined. Pooling is said to take place when
equity securities are exchanged, and an acquisition (or pur
chase) is not recognized because the combination is consum
mated without the acquirer's having to disburse cash or other
assets. The surviving company records its newly acquired


CHAPTER IV
ANALYSIS OF THE TERMS OF
EARNOUT BUSINESS COMBINATIONS
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 i960 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 yearsa time during
which earnouts were not commonly employed. Most of the agree
ments studied, however, were consummated during the last two
72


89
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 $4,867,000 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


171
circumstances under which they are issued). Fully diluted
earnings per share is the amount of current earnings per
share reflecting the maximum dilution that would have re
sulted from conversions, exercises and other contingent issu
ances that individually would have decreased earnings per
share and in the aggregate would have had a dilutive effect.
All such potential issuances are assumed to have taken place
at the beginning of the period (or at the time the contin
gency arose, if later).^ Further, the 1969 Opinion defined
material dilution as any reduction of earnings per share of
J>% or more in the aggregate. This recent requirement to
prominently disclose diluted earnings per share should neu
tralize one of the earlier stated advantages to the buyer
under the earnout method of combinationthat of restricting
the immediate dilution of earnings per share.
Determination of whether contingent earnout shares are
to be part of the computation of fully diluted earnings per
share only, or if they should be considered as outstanding
for the purpose of computing both primary and fully diluted
earnings per share, is dependent upon the terms of the agree
ment and the acquired entity's current level of earnings. If
attainment or maintenance of a level of earnings is the condi
tion, and if that level is currently being attained, then the
earnout shares are to be considered as outstanding for both
per share computations. If the level is not being attained,
then the earnout shares are to enter into the computation of
fully diluted earnings per share only. Where the agreement
calls for an increased level of earnings "reasonably above"


Dedicated
to
Deborah


235
is that the assets of the acquirer are not undervalued during
the earnout period, assuming of course that management's
earnout probability estimates prove to be reasonably accurate.
In most earnout acquisitions, however, assets are undervalued
during the earnout period.
No recommendations or requirements for the disclosure of
or the accounting for earnout acquisitions were specified by
the accounting profession before the issuance of APB Opinion
No. 9 in December, 1966. This Opinion recommended that sup
plementary pro forma earnings per share data reflecting poten
tial material dilution resulting from earnouts be shown on the
income statement. Opinion No. 15, issued in 1969, required
disclosure of such dilution through the presentation of primary
and fully diluted earnings per share. If the earnings goal of
the seller is currently being attained, then earnout shares
are to be considered as outstanding for both presentations.
If the goal is not being attained, the earnout shares enter
into the computation of fully diluted earnings per share only.
Where the goal is reasonably above the current level, in
computing fully diluted earnings per share, earnings should
be adjusted to reflect the increase in earnings specified by
the agreement. These disclosure requirements of APB No. 15
are currently in effect.
Earnout acquisitions must now usually be accounted for
as purchases if the combination was initiated after October 3,
1970, according to APB Opinion No. 16, which restricted the
guidelines pertaining to poolings. Goodwill that results
from application of the purchase concept must be amortized


44
interest rates, so that neither party to the agreement gets
unfairly "locked in" during a period of fluctuating interest
rates.
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


88
or may not be different, however. To illustrate, Ashland Oil's
acquisition of Southern Fiber Glass Products, Inc. provided
that:
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 19o9, Ashland will
issue...Common Stock having a value equal
to $150,000, following the close of any
one of such years.20
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, 1§66:
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.1


90
approximately 50% of annual before-tax profits in excess of
.'13 million for a period of five years, USI's agreement to
acquire Capital Wire and Cable Corp. contained a second earn
out component. The fixed deferred provision obligated USI
to issue another $10 million if Capital's before-tax income
was equal to, or in excess of, $6 million during any of the
five calendar years of the earnout period.^ At the time of
its acquisition, Capital's net income before taxes was ap
proximately $3,740,000 for its fiscal year ended in 1968.
The fixed deferred earnout provision here constitutes an
extra bonus for special earnings achievement.
In another acquisition, USI appears to use a target-
attainment earnout to help insure that the major earnout com
ponent of its agreement is properly defined. To acquire Huron
Tool & Mfg. Co., Inc. and Worth Industrial Processing Corp.,
USI paid $1.2 million in common shares at the closing. It
agreed to issue another $800,000 worth of stock provided the
sellers' business produced before-tax earnings of $250,000 or
more for 1968. If the target was achieved, then the major earn
out component of the agreement provides that, over a five-year
period, additional shares will be issued equal to varying per
centages times the excess of actual before-tax earnings over
$400,000. A maximum of $1 million in shares may be so issued.
If, however, the target of $250,000 is not reached, then terms
of the five-year earnout are changed so as to reduce the earn
ings goal of $400,000 to $250,000 beginning with 1969 and to in
crease the maximum of $1 million to $1.8 million. Thus the terms


66
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 annually when property
is acquired on a deferred payment basis.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


38
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
management 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
rthe earnout^ portion of the consideration
for 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 $8,000,000 Qthe maxi
mum contingent payout^.1
For the acquiring firms, the major attraction of earn
outs is the way the plans serve to retain and motivate execu-
19
tives of the acquired firms. 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. in addition, earnout arrangements
provide time for training and building up the next level of


145
the properties may indicate a fair market value of the assets
at $2 million. Assuming that Company B then acquires all the
stock of Company A (or acquires all the assets and assumes
all the liabilities) for cash or other assets totaling $3 mil
lion, the result would be goodwill of $1.3 million recorded
by Company B to effect the purchase. This purchase treatment
"is squarely in accord with the basis used in accounting for
other acquisitions of assets or property under the generally
accepted practice of accounting for assets initially on the
2
basis of their cost to the acquiring company."
It is the disposition of the goodwill recorded at the
consummation of the acquisition that is the source of much
of the controversy in accounting and financial circles. Cur
rent accounting practices give the acquiring company consid
erable latitude in handling goodwill. Some regard its life
as indeterminate and carry it indefinitely on their books.
Others assign an arbitrary life to the goodwill and expense
it over that period of time. Still others have advocated
writing it off as an extraordinary charge, either when ac
quired or at some later date, perhaps to current earnings or
to one of the "surplus" accounts of the buyer, although a
pronouncement of the profession provided that the cost of
purchased goodwill should not be written off or reduced to a
nominal amount at, or immediately after, acquisition.^
Amortization of goodwill by charges to income annually
can result in significant reductions in net income, and the
reduction is all the more substantial inasmuch as a write-off


57
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 taxesnot eliminate
them.
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
gives up and the market value of the consideration received
is gain or loss to the seller. Generally, the seller will


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American Accounting Association. A Statement of Basic
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