July 19, 2017
Earnouts: Yes, They Can Be Securities
Convincing business people that an earnout can be a “security” for purposes of the Securities Act is often a challenge. Fortunately, this recent Cooley blog provides some help. Here’s an excerpt:
Sellers (particularly financial investors) in private M&A transactions are increasingly seeking the right to be able to monetize their rights to contingent consideration by requesting royalty-like earn-out streams and requesting a right to sell the potential future payments to a single third-party purchaser.
However, giving the target stockholders the right to an earn-out raises significant issues for the buyer of the development-stage asset with regard to the US securities laws because the contingent consideration will likely be treated as a “security” of the buyer, requiring the buyer to comply with the federal securities laws and subjecting the buyer to liability for non-compliance.Therefore, buyers should be cognizant of these securities law considerations and some of their practical implications.
If the right to be paid contingent consideration is transferable, that right will likely be considered a “security” of the buyer under long-held SEC guidance. In general, under a line of SEC no-action letters on earn-outs and contingent value rights, there is a multi-factor test used in analyzing whether the contingent consideration is more like a contract or a “security,” with transferability being the most significant factor. If the contingent consideration is considered a “security,” any offering of the security must comply with the federal securities laws.
The blog then goes on to discuss the compliance and disclosure issues raised by an earnout’s status as a “security.”
– John Jenkins