COVID-19 and the bid/ask gap in Italian M&A deals: some equity and debt solutions

The ongoing economic crisis following the CV-19 pandemic has made it more challenging for acquisitive private equity firms to meet the selling entrepreneurs’ expectations in terms of target company’s evaluation and consequently of purchase price.

This article illustrates the main contractual tools that can be used to “fill the gap” between “bid and ask”. Therefore, it covers only the more typical earn-outs provided in favor of the seller and does not address also the so called “reverse” earn-out provided in favor of the purchaser. Certain key tax considerations are included when relevant.

Key points

• The legal tools generally used to fill the gap between bid and ask in the context of M&A transactions are the “earn-out” clauses. These arrangements, which can be structured either as “performance” or “exit” earn-out, have different functions, are generally based on different financial items and have to be distinguished from purchase price adjustments. From a tax perspective, the content of these clauses is crucial to identify the present and future tax treatment of the parties. In order to calculate the performance of an investment with certainty and minimize tax risks, it is therefore paramount to carefully draft the provisions at hand as their content may be relevant for a number of different taxes, including income taxes, financial transaction tax and registration tax. See § 1 (Earn-out clauses: Purpose and classification).

• Main legal implications to be considered in structuring and negotiating earn-out clauses are: (i) corporate governance and seller’s management rights; (ii) definition of liquidity events or exit; and (iii) conditions precedent vs. earn-out. See § 1 (Earn-out clauses: Main legal implications).

• Financial items triggering earn-out are defined in the agreement, but their determination can be challenged and referred to third parties. The difference among arbitration, arbitrator and appraisal needs to be considered under Italian law as entailing different consequences. See § 1 (Earn-out clauses: Earn-out targets’ determination in the event of disputes).

• Another method that may prove helpful to make a deal palatable to both parties is the deferral of the payment of part of the purchase price granted by the seller to the buyer and usually labelled as "vendor loan". See § 2 (Vendor loan: Purpose).

• In structuring a vendor loan, in relation to an Italian acquisition, the parties should consider the following matters: (i) financial assistance; (ii) debt push down; (iii) structural subordination and ranking; (iv) contractual subordination; (v) standard documentation and withholding tax; and (vi) derecognition of the target's assets and liabilities. See § 2 (Vendor loan: Main legal implications).

• Alternative structures that could be used to fill the gap between seller’s and purchaser’s positions are “bonus” shares or warrant(s), exchangeable and/or convertible bonds. Such mechanisms impact on the seller’s dilution and target’s evaluation and the alignment of parties’ position is deferred to a liquidity event. See § 3 (Certain alternative mechanisms).

1.  Earn-out clauses

Purpose and classification

It is generally acknowledged that the more immediate tool to fill the gap between seller’s and purchaser’s evaluations is represented by earn-out mechanisms.

An “earn-out” clause provides for the payment of part of the purchase price to the seller upon the occurrence of certain circumstances, typically consisting of the achievement of certain financial or commercial goals, either during the life of the investment (known as a “performance” earn-out) or at exit (known as an “exit” earn-out). 

The items that would typically trigger a performance earn-out are financial statements-based items, with EBITDA playing a major role. A combination of items is also considered, with particular reference to net financial position. Cost multiples can also be used, especially in combination with other items.

In other cases, the performance earn-out is associated with business (rather than financial) goals, especially where external growth (not necessarily immediately valuable in purely EBITDA terms) is a key factor in the business plan underlying the acquisition. A typical case is represented by completion of M&A / add-on transactions by the target within a given period of time or within a list of targets included in the transaction documents (such earn-out clauses are sometimes also referred to as a “M&A premium”). Of course, business targets triggering the application of earn-outs vary significantly depending on the reference market (e.g., in hotel or retail businesses it is not uncommon to measure the relevant performance on the basis of new openings). 

The exit earn-out is generally, if not always, triggered by parameters measuring the investor’s financial performance. Such indicators are typically either the IRR or money multiples (such as return on cash or cash-on-cash) or a combination of the two (e.g., IRR threshold triggered with a minimum money multiple). The use of the IRR in exit earn-out clauses is predominant, as IRR factors-in time and therefore reflects a more realistic evaluation of actual performance, while cash-only based parameters are time neutral.

In all cases, the earn-out amounts agreed between the parties can also be proportionate to the relevant targets, either by setting thresholds enabling the payment of different amounts or linearly with respect to the IRR levels (or other agreed criteria). 

The rationale and purpose of performance and exit earn-outs coincide only to a certain extent, as clear differences exist. It can be broadly said that that while performance earn-outs are primarily aimed at filling the gap between parties’ evaluations in the short to medium term, exit earn-outs are primarily aimed at aligning the parties’ interests in the long(er) term in light of the investors’ exit.

For this reason (and also in the context of the CV-19 crisis), the performance earn-out is likely to be more suited to filling the gap between ask and bid. The seller will be more reluctant to delay a potential reconciliation of evaluations up to exit (bearing in mind also the risks of economic cycles and different market conditions in the long term).

Finally, earn-out clauses differ from purchase price adjustments, although the items relevant for their determination may coincide.

In fact, while earn-out is set to potentially reward the purchaser with an additional portion of purchase price upon reaching certain agreed goals (in some case with the aim also to settle the different evaluations supported by the parties), purchase price adjustment is set to technically calculate the eventual purchase price on the basis of the determination of its components at a specific date. Such components are often represented by EBITDA and/or net financial position but can include, among the others, also EBITDA specific normalizations or working capital levels.

This assumes - as typically occurs - that the purchase price adjustment takes place as soon as necessary for the purchase price determination (and therefore shortly after closing) while the earn-outs would take place in the mid-to-long term after completion of the transaction. For these reasons, clearly the purchase price adjustment cannot be used to balance seller and purchaser’s position, in consideration of the unfortunately longer CV-19 effects on the financials of the companies. 

However, it should be noted that, although from a business standpoint earn-outs and purchase price adjustments have a very different role, from a strict Italian civil law perspective, they both represent a portion of a required feature of a purchase contract under articles 1325 and 1470 of the Italian Civil Code (“ICC”): the purchase price.

From a tax standpoint, the absence of a definition of "earn-out" may lead to potential risks if the relevant arrangements are not carefully drafted. In certain decisions, the Supreme Court has concluded for the application of a detrimental registration tax treatment when the sale and purchase agreement in a share deal contemplates payments linked to financial parameters or the performance of the underlying company. On the basis of the case law available, earn-out clauses, if properly drafted, should be deemed as a price component and the relevant amount should thus not result in additional registration costs in the context of a share deal. 

The Italian tax authorities explicitly commented on the treatment of earn-out clauses in relation to the Italian financial transaction tax, where they clarified that earn-out clauses "are contractual arrangements according to which the payment of a part of the price is conditional and/or dependent on a certain result or situation of the company purchased in a moment or period of time after the transfer". 

Consistently with the classification of the additional payment as a purchase price component, a top-up payment of financial transaction tax (if applicable) may be required on the date on which such payment is made. In case of downward price revision, the taxpayer is entitled to be refunded of the overpaid financial transaction tax. 

Moreover, for Italian corporate income tax purposes, the importance of proper and clear drafting of such clauses also comes from the seller's aim to enjoying participation exemption on any additional price component resulting in a capital gain.

Main legal implications 

The most typical and material aspects that parties will have to consider in relation to earn-out mechanisms, both from a legal and a negotiation perspective, are the following.

• Appropriate governance rights will be requested by the seller in order to have sufficient management tools to achieve the earn-out targets.
  
  In the event of minority investments, where the seller maintains the main management rights, the above protection may be easily achieved by the seller (with the investor’s vetoes being focused on more strategic and extraordinary items). In the event of majority investments with the seller remaining in the shareholding and also involved in the management (e.g., in the case where the entrepreneur remains as CEO of the target), a balance is to be sought between the position of the majority shareholder and the expectation of the minority shareholder / manager to be able to drive the business to the agreed goals. In these scenarios, the seller would want to maintain sufficient lever on main business or commercial matters, including M&A, CAPEX and debt.
  
  In deals where 100% of the target’s equity is transferred (and consequently with no role whatsoever for the previous shareholder), the seller typically would rely upon alignment of interests with the purchaser and the new management. However, in this scenario the seller might want to carefully consider his level of confidence in the new management to be appointed by the purchaser (and disclosed with sufficient advance to the seller) as well as - potentially - the investor’s business plan guidelines. The 100% seller should also include in the transaction documents statements acknowledging the valorization of the company as the main target of the investment to be pursued in good faith by the purchaser, taking into account also the seller’s vested interest in the earn-out, and also include robust information rights to monitor the company’s performance. Although more speculative, the seller might consider to negotiate maintaining a (symbolic) participation and corresponding rights to challenge and question the management actions in the event of under performance and veto amendments to the business plan(s), to the extent they include goals not compatible with the earn-out targets.

• Definition of liquidity events or exit
  
  Relevant mainly for exit earn-outs. If the sale of the entire participation obviously qualifies as an exit, also sale of the majority of the participation or entailing a “change of control” should trigger the earn-outs. The definition typically refers to a transaction or a series of transactions which achieve the same result. Clauses providing for a partial payment of the earn-out proportionally to the exit are less frequent (as there is in any case a catch-up with the sale of the entire participation).
  
  The liquidity events (as the wording suggests) are generally required to have a cash effect. Therefore, non-cash-based transactions (such as mergers or different kinds of combinations having substantially the same effect) more often would not trigger the earn-out clauses. However, also in consideration of the accounting treatment of this kind of transaction, negotiations on this specific aspect are not infrequent. It can be said that non-cash-based transactions being considered for exit earn-out is not accepted by private equity investors (forced to call draw-downs to finance the earn-out) while a different outcome is possible for industrial players or other financial investors. In any case, from a seller’s perspective, the liquidity event or exit definition should be drafted to also include the sale of the participation (in the terms described above) of the entity resulting from a non-cash-based transaction (e.g., of the combined entity further to a merger).

• IRR of multiple parties
  
  In the event of multiple purchasers (e.g., in the event of equity syndication or investment consortium), IRR can potentially be different for the various investors (e.g., either due to differences in the time of exit or initial investments and/or for non-proportional investments and exit). In this event, the relevant earn-out could be triggered only vis-a-vis certain investors and the clauses will specify that the IRR calculation shall be made on a case-by-case basis. It is generally advisable to use the standard financial definition of IRR instead of more descriptive notions which may leave room for different interpretations.
  
  
  Where “i” is period of reference; “0” is the date of closing; “N” is the date of the liquidity event; “IN” is the sum of the amounts realized by the investor (e.g., dividends, shares sale price and any other amount received in connection with the participation) and “OUT” the sum of the amounts invested (not including the payment of the earn-out).

• Earn-out as a condition precedent
  
  From an Italian civil law perspective, it should be noted that the general rules on conditions precedent under article 1359 ICC provide that “the condition precedent is considered as not included when the condition has not occurred due to a reason attributable to the party having an interest contrary to its occurrence”.
  
  With this respect, in the event of failure to reach the relevant earn-out targets, the seller might claim that such targets qualify as a condition precedent to the payment of the purchase price, and that since the failure to satisfy them is attributable to the purchaser the condition has to be disregarded, and therefore the earn-out paid. Whilst it is clear that a broad construction of the above-mentioned provision of the ICC would jeopardize the rationale of the earn-out clauses, the Supreme Court has provided certain guidance on the application of article 1359 ICC. In particular, the Supreme Court has stated that: (i) the purchaser has a general duty to act in good faith - also in order to safeguard the seller’s right - and, as a consequence, to carry out all the actions that are required to be performed by the purchaser, it being understood that the latter cannot be requested to sacrifice his rights and interests (including by materially changing the overall economic balance provided by the contract); (ii) the application of article 1359 ICC is triggered only in the event of actual actions carried out by the purchaser with willful misconduct or negligence, not being sufficient for such purpose a mere omission (to the extent it does not constitute per se a breach of contract or good faith). The specific application of article 1359 ICC to earn-out clauses does not appear to have been expressly analyzed under case law. In our opinion, on the basis of certain decisions both of the Supreme Court and of lower Courts, it could be inferred that earn-out provisions (especially for performance earn-out and to the extent they would effectively be considered as conditions precedent) could be qualified as set in the interests of both parties (instead of the seller’s only) with the consequent non enforceability (according to the Supreme Court) of article 1359 ICC. Therefore, depending on the party’s position (i.e., as seller or purchaser), it can be advisable to (try to) qualify expressly the clause as set in favor of the seller (only) or in both parties’ interests.

• Specific financial items
  
  Finally, and for sake of completeness only, it should be remembered that certain specific financial items relevant for the earn-out definition might need to be addressed specifically (depending on the transaction structure and the negotiation among the parties). Just by way of example, management costs (in the event the seller remain as CEO or otherwise in the top management), specific EBITDA normalizations or iterative consideration of earn-out can be mentioned.

Earn-out targets’ determination in the event of disputes 

Although the relevant financial items (EBITDA, IRR etc.) are well defined in the transaction agreements, it is not infrequent that the parties would disagree on their eventual determination. In that regard, usually contracts provide for an agreed-upon procedure to resolve any dispute between the parties. Given the technical and non-legal nature of the dispute and of the disputed items, such disagreements are usually not settled by arbitration (or court proceedings) but rather by the intervention of an independent expert, sometimes referred to as “arbitrator”. 

Unlike under common law systems, in a civil law system - such as the Italian one - certain applicable statutory provisions need to be considered in order to carefully draft the relevant clauses aimed at settling disagreements on price determination (including earn-outs). Accordingly, it is important to clarify the nature of such expert(s) and/or “arbitrator(s)”. 

In fact, article 1349 ICC provides that in the event the determination of a contractual performance (such as the price) is deferred to a third party, such party will decide according to equity (arbitrium boni viri)¹ provided that the parties have not expressly deferred said determination to the third party’s sole discretion (arbitrium merum). With specific reference to purchase agreements, article 1473 ICC provides that the parties can refer the price determination to a third party either indicated in the agreement or afterwards. If the parties have referred the decision to the sole discretion of the third party, such decision can be challenged only providing evidence of his willful misconduct while in the event the third party will decide based on equity his decision can be challenged (also) if it is manifestly unfair or erroneous² (in this case, the determination shall be made by the Court while in the event of a decision according to the sole discretion rendered with willful misconduct, the Court can only repeal it). Therefore, the task of the arbitrator under articles 1349 and 1473 ICC is different from the task of an arbitrator in an arbitration proceeding - including informal arbitrations (arbitrato irrituale) - as it is not to resolve a dispute between the parties but rather to determine an element of the contract (i.e., the purchase price). 

On the other hand, market practice has generally made reference to a contractual appraisal (not regulated under Italian law) as a technical ascertainment referred by the parties to an independent third party chosen for its technical expertise, to decide upon a dispute of a technical and not legal nature and excluding any discretionary evaluation. Despite certain opinions in literature and case law, the Supreme Court has recognized the autonomy of the “appraisal” both with respect to “arbitrators” (under articles 1349 and 1473 ICC) and to (informal) arbitration³.

In consideration of the above, in relation to disputes arising between the parties upon items underlying the earn-out determination, parties would typically (i) exclude the application of the jurisdiction or arbitration clause; (ii) refer the decision to a (technical) expert; (iii) expressly provide - for the avoidance of doubt - that the application of the expert’s sole discretion is excluded; (iv) expressly indicate that the determination of the expert is the sole remedy and cannot be challenged (with the sole exception of willful misconduct); (v) in the event that, for any reason whatsoever, they intend to refer the determination of the items underlying the earn- to an “arbitrator” pursuant to article 1349 ICC, expressly exclude the arbitrator’s sole discretion.

2.  Vendor loan

Purpose

Another method to address the bid/ask gap in the context of M&A transactions is the deferral of the payment of part of the purchase price, which can be granted by the seller to the buyer. This instrument is usually labelled "vendor loan".

The expression "vendor loan" is partially misleading since there is no loan actually being disbursed by the seller to the buyer. The former simply accepts that part of the consideration for the target shares be paid at a later date, often subject to the satisfaction of certain parameters linked to the financial performance of the target group post-closing (e.g., EBITDA).

In connection with potential M&A deals, especially when at least one of the parties is a private equity investor, the vendor loan may prove extremely helpful to make the deal palatable to both parties. The vendor may be paid a higher consideration, while the buyer knows that at least a portion of the purchase price will be conditional upon the investment meeting certain pre-agreed financial objectives.

From a buyer's perspective, the vendor loan may also be used to protect the buyer in the event of breach of any of the representations and warranties given by the seller under the acquisition documents. In case of any such breach, the buyer may request that - instead of enforcing the relevant indemnities under the SPA - the “principal amount” of the vendor loan be reduced in proportion to the damage suffered by the buyer.

Main legal implications

In terms of structuring a vendor loan in connection with an Italian acquisition, the following tips may be taken into consideration:

• Financial Assistance: due to financial assistance issues, no liability relating to the vendor loan can be undertaken by a member of the target group (i.e., target and its Italian subsidiaries).

• Debt Push-Down via Whitewash Merger: the vendor loan can be placed at BidCo level, i.e. the relevant debt can be undertaken by the corporate vehicle set up by the buyer to complete the acquisition. Since the vendor loan may be regarded as “acquisition debt”, it can be “whitewashed” by the merger completed between target and BidCo in compliance with article 2501-bis ICC. The above merger, which is a regular feature in Italian LBO’s, is usually completed within one year from completion of the acquisition; its main drivers are (i) to allow the “push down” of the debt arising from the acquisition facility provided by the lenders to the equity sponsors to pay a portion of the purchase price, and (ii) to make the indebtedness arising from above facility eligible to benefit from security over assets of the target group. It is important to point out, however, that the vendor loan, even when it ends up being placed at MergeCo level (“MergeCo” being the company resulting from the BidCo/target merger), is never secured, let alone by security over assets of the target group.

• Structural Subordination/Ranking: lenders may not like the above structure because it entails a competing debt within the “core obligor group” (i.e., BidCo and its subsidiaries or successors, including MergeCo), and can therefore ask that the vendor loan be placed within a vehicle sitting above BidCo (e.g., TopCo); this can be achieved by an assumption of debt performed by TopCo (as new debtor) in favour of BidCo (as original debtor of the purchase price under the SPA). The vendor loan usually ranks senior to equity and equity loans/notes, and junior to senior, second lien, mezzanine and HY debt. In highly structured deals, the placing of the vendor loan (and of the relevant TopCo/borrower) will need to reflect the above ranking.

• Contractual Subordination: when lenders cannot obtain structural subordination of the vendor loan, they will need to control the debt under the vendor loan to avoid that - in a default scenario - they would have to negotiate with the seller how the relevant indebtedness be managed; this control can be achieved through appropriate ranking/protection clauses under the intercreditor agreement and/or by an assignment by way of security of the receivables under the vendor loan to be made by the seller to the lenders. If contractual subordination is the main or only protection for the lenders, it is essential - in order to comply with the principles set out in the decree issued by the Tribunal of Milan on 15 November 2018 - that the subordination covenant by the seller be express and, if the persons being “senior creditors” change during the life of the deal, be expressly confirmed also in favor of any new senior creditor.

• Documentation/WHT Issues: the vendor loan is usually documented under a finance document executed between the buyer (or any of its affiliates) and the seller (or any of its affiliates). The parties may freely elect the governing law of the vendor loan agreement, although the prevailing market practice is to choose the same law that governs the main finance documents (i.e. Italian law for mid-market deals, and English law for large transactions). If the borrower under the vendor loan is an Italian entity, this will trigger two points worth caution: (i) if the interest accruing on the vendor loan needs to be compounded (this is the standard scenario for debt service and ranking reasons), any clause on the capitalization of interest will need to comply with article 1283 ICC and (ii) if the lender under the vendor loan is a foreign entity, interest payments may suffer a withholding tax in Italy. Partial or full exemption from such withholding tax may be available under domestic/EU legislation or double tax treaty provisions. Any available measure to mitigate the tax charge requires the implementation of certain compliance formalities and cooperation between the parties. In order to avoid misunderstandings or infringements, it may be useful to build into the transaction documents provisions regulating the interaction between the parties in relation to such compliance requirements.

• Derecognition: from a seller’s perspective, it is crucial that the terms and conditions of the vendor loan be reviewed by its tax and accounting counsel in order to verify that derecognition of the target’s assets and liabilities is fully achieved as a result of the sale.

3. Certain alternative mechanisms 

While earn-out mechanisms are definitely the more common means to balance seller’s and purchaser’s positions, other structures - although not having the same kind of outcome - can be used for the same purposes. We are making reference to the cases where the gap is filled not directly through additional financial resources transferred by the purchaser to the seller but rather through other modalities granting the seller with the same value in economic terms.

This typically occurs either directly by a minor dilution for the seller or through the issuance of new shares (e.g., “bonus” shares). In all of these cases, in purely financial terms, the same result of an earn-out would only be achieved with a liquidity event. For such purposes, however, we are assuming here that the waterfall mechanism will allow the purchaser to retain the additional extra value at exit (after the one recognized to the seller upon reaching of the agreed targets) and that, conversely, the seller will have the right to monetize the new shares at the agreed value. 

Where bonus shares or warrants are used, the seller becomes the beneficiary of new shares or is granted the right to subscribe a specified number of newly issued shares based on achievement of the targets that would otherwise have been considered to set the earn-out goals. 

In these circumstances the seller would be paid at closing the equivalent of the pre-earn-out purchase price and would be awarded with a number of new shares that, upon exit, would grant him substantially the same amount of an earn-out structure (the actual amounts will be adjusted to factor-in also the time elapsed from closing to exit in order to put the seller in an equivalent position).

An alternative scheme, having though a direct impact on the structure of the transaction, is represented by an investment partially made through an exchangeable bond (convertendo) whose (mandatory) conversion ratio would be set to grant the purchaser a number of shares inversely proportional to the company’s performance (which otherwise would have been considered to trigger the earn-out amounts). In the event of achievement of the targets, the seller at exit will be in a position to sell a greater number of shares. 

In this respect, financial investors would typically prefer convertible bonds (i.e., with the conversion being an option of the purchaser) in order to maintain down-side protection (at least for the debt portion of the investment). These structures imply that the seller maintains a share participation in target and that, at inception, part of the purchaser’s money is injected into the company rather than paid to the seller (which - especially in the current CV-19 scenario - could potentially further support the achievement of the agreed performance targets, in the interest of both parties and the company). 

Finally, especially in periods characterized by higher market volatility (such as the current one) convertible preferred equity instruments tend to be used (e.g., such as in the recent KKR / Coty deal where shares carried a coupon of 9% and were convertible into ordinary shares at a fixed price equating to a 20% premium on the price at the investment date).

The tax treatment of these instrument depends on a number of factors mainly based on the specific terms and conditions of the relevant instrument and, in certain cases, its accounting treatment. Some structuring may be required in order to avoid inefficiencies that could affect the success of the deal.

If you have any queries on any of the matters dealt with in the present note, please contact your usual Ashurst contact, or any of the authors.

Authors: Mario Lisanti, Michele Milanese, Fabio Niccoli

1. According to literature and case law, such decision should be based on objective criteria, balanced and rationale, based on factual circumstances and clearly motivated.

2. A decision is manifestly unfair if appears clearly unbalanced and unjustified under the overall interests regulated by the agreement and so material to result also evident. On the other hand, a decision manifestly erroneous does not need to be also unfair. 

3. While the appraiser has (only) a specified technical task, the arbitrator(s) of an arbitration proceeding has/ve a mandate to resolve a more general dispute.