Legal Watch--Performance Guaranty and Holdback

For most electronic security companies, their value on exit is directly related to the amount and quality of their recurring monthly revenue (RMR). In October (www.securityinfowatch.com/10781324), I outlined the differences between different types of RMR and how buyers assign a greater value to some revenue than others. This month’s topic is on the performance guaranty and holdback, two aspects of industry acquisitions unique to our industry.

A performance guaranty ties the final price the buyer will be obligated to pay to the seller to some (or all) of the attrition of accounts, which is measured from the date of closing until some agreed-upon time in the future. 

The date is often called the “determination date” or a similar term. Most buyers require RMR from an acquired account that was “performing RMR” as of the closing date to generate performing RMR as of the determination date. Performing RMR means that the account satisfies each of the buyer’s required criteria. For example, a buyer is likely to require that the subscriber has paid all amounts due within some agreed upon time (often 60 or 90 days but perhaps longer under certain circumstances). Another common requirement of performing RMR is that the account be on an acceptable form of subscriber contract that is materially unmodified.

Although some refer to this as an “earn-out,” it isn’t and in my experience, a performance guaranty is unique to the industry. Not every acquisition includes a performance guaranty. (Those acquisitions are called “walk-away” transactions.   The difficulty there centers on the right multiple to be applied at closing since the holdback is no longer at issue.) Assuming there is a performance guaranty, length is an important issue. Many acquisitions employ a 12-month guaranty. I’ve seen shorter and longer. The guaranty length often involves a number of trade-offs such as the size of the holdback.

Performance guarantees poses other issues. For example, every seller has attrition prior to closing. Is the seller’s historical rate of attrition excluded from the performance guaranty? (This is often called an “attrition deductible.” No matter what, buyers should obtain protection for pre-closing cancellations not communicated to buyer as of closing.) Is the guaranty a straight attrition guaranty (in which seller is charged for all attrition) or is seller relieved from responsibility where buyer causes the attrition?

The holdback portion

The holdback is the portion of the purchase price buyer “holds back” to secure seller’s obligations under the attrition guaranty (and perhaps other obligations, too). The holdback is generally referred to as a percentage of the overall purchase price. Assuming a 38 multiple and a 10 percent holdback, the effective holdback expressed as a multiple is 3.8 times. Under this formula, buyer would pay seller 34.2 times performing RMR at closing (or 90 percent of 38 times) and “retain” the 10 percent balance.

Legally speaking, most holdbacks are nothing more than a buyer’s contractual obligation to pay some portion of the holdback after the determination date. Rarely is the holdback actually funded. Only very occasionally is the holdback placed in the hands of an escrow agent or secured through a letter of credit or some other means. Occasionally, parties use a promissory note to evidence the amount due but seller generally remains buyer’s unsecured creditor. (Sellers should adequately diligence the credit risk.) In negotiating a holdback, parties often focus on the extent to which the holdback limits liability. Other issues include when does seller get paid and whether buyer can offset against the holdback for other reasons.  

Performance guarantees and holdbacks constitute a significant portion of a transaction’s value. Retain competent, industry-experience counsel to address these and other issues for any transaction.