TABLE OF CONTENTS

1. Extract from Model Asset Purchase Agreement with commentary, Committee on Negotiated Acquisitions, Section of Business Law, American Bar Association, 2001.

2. Extract from Model Stock Purchase Agreement with commentary, Committee on Negotiated Acquisitions, Section of Business Law, American Bar Association, 1995.

3. “Purchase Price Adjustments, Earnouts and Other Purchase Price Provisions”, written by Leigh Walton and Kevin D. Kreb, February 2005.

4. Purchase Price Adjustments Bibliography.

5. Sample clauses regarding purchase price adjustments.

EXTRACT FROM MODEL ASSET PURCHASE AGREEMENT WITH COMMENTARY, COMMITTEE ON NEGOTIATED ACQUISITIONS,

SECTION OF BUSINESS LAW, AMERICAN BAR ASSOCIATION, 2001.

2.3 CONSIDERATION

The consideration for the Assets (the “Purchase Price”) will be (a) ______ dollars ($______) plus or minus the Adjustment Amount and (b) the assumption of the Assumed Liabilities. In accordance with Section 2.7(b), at the Closing, the Purchase Price, prior to adjustment on account of the Adjustment Amount, shall be delivered by Buyer to Seller as follows: (a) ______ dollars ($______) by wire transfer; (b) ______ dollars ($______) payable in the form of the Promissory Note; (c) ______ dollars ($______) paid to the escrow agent pursuant to the Escrow Agreement; and (d) the balance of the Purchase Price by the execution and delivery of the Assignment and Assumption Agreement. The Adjustment Amount shall be paid in accordance with Section 2.8.

COMMENT

In Section 2.3 of the Model Agreement, the consideration to be paid by Buyer for the assets purchased includes both a monetary component and the assumption of specific liabilities of Seller. In addition to the consideration set forth in Section 2.3, Seller and Shareholders may receive payments under noncompetition and employment agreements. If an earnout, consulting, royalty or other financial arrangement is negotiated by the parties in connection with the transaction, additional value will be paid.

The amount a buyer is willing to pay for the purchased assets depends upon several factors, including the seller’s industry, state of development and financial condition. A buyer’s valuation of the seller may be based upon some measure of historical or future earnings, cash flow or book value (or some combination of revenues, earnings, cash flow and book value) as well as the risks inherent in the seller’s business. A discussion of modern valuation theories and techniques in acquisition transactions is found in Thompson, A Lawyer’s Guide to Modern Valuation Techniques in Mergers and Acquisitions, 21 J. Corp. L. 457 (Spring 1996). See also Dickie, Financial Statement Analysis and Business Valuation for the Practical Lawyer (1998). The monetary component of the purchase price is also dependent in part upon the extent to which liabilities are assumed by the buyer. The range of liabilities a buyer is willing to assume varies with the particulars of each transaction and, as the Comment to Section 2.4 observes, the assumption and retention of liabilities is often a heavily negotiated issue.

The method of payment selected by the parties depends upon a variety of factors, including the buyer’s ability to pay, the parties’ views on the value of the assets, the parties’ tolerance for risk and the tax and accounting consequences to the parties (especially if the buyer is a public company). See the Comment to Section 10.2 and Appendix B for a discussion of the tax aspects of asset acquisitions and the Comment to Section 2.5 for a discussion of the allocation of the purchase price. The method of payment may include some combination of cash, debt and stock and may also have a contingent component based upon future performance. For example, if a buyer does not have sufficient cash or wants to reduce its initial cash outlay, it could require that a portion of the purchase price be paid by a note. This method of payment,

together with an escrow arrangement for indemnification claims, is reflected in Section 2.3. If the method of payment includes a debt component, issues such as security, subordination and post-closing covenants will have to be resolved. Similarly, if the method of payment includes a stock component, issues such as valuation, negative covenants and registration rights must be addressed.

If a buyer and a seller cannot agree on the value of the assets, they may make a portion of the purchase price contingent upon the performance of the operations following the acquisition. The contingent portion of the purchase price (often called an “earnout”) is commonly based upon the assets’ earnings over a specified period of time following the acquisition. Although an earnout may bridge a gap between the buyer’s and the seller’s views of the value of the assets, constructing an earnout raises many issues, including how earnings will be determined, the formula for calculating the payment amount and how that amount will be paid (cash or stock), how the acquired business will be operated, who will have the authority to make major decisions and the effect of a sale of the buyer during the earnout period. Resolving these issues may be more difficult than agreeing on a purchase price. See the form of Earnout Agreement attached as Ancillary Document 4.

The Model Agreement assumes that the parties have agreed on a fixed price, subject only to an adjustment based upon the difference between Seller’s Working Capital on the date of the Balance Sheet and the date of the Closing (see Sections 2.8 and 2.9).

2.8 ADJUSTMENT AMOUNT AND PAYMENT

The “Adjustment Amount” (which may be a positive or negative number) will be equal to the amount determined by subtracting the Closing Working Capital from the Initial Working Capital. If the Adjustment Amount is positive, the Adjustment Amount shall be paid by wire transfer by Seller to an account specified by Buyer. If the Adjustment Amount is negative, the difference between the Closing Working Capital and the Initial Working Capital shall be paid by wire transfer by Buyer to an account specified by Seller. All payments shall be made together with interest at the rate set forth in the Promissory Note, which interest shall begin accruing on the Closing Date and end on the date that the payment is made. Within three (3) business days after the calculation of the Closing Working Capital becomes binding and conclusive on the parties pursuant to Section 2.9, Seller or Buyer, as the case may be, shall make the wire transfer payment provided for in this Section 2.8.

COMMENT

The Model Agreement contains a purchase-price adjustment mechanism to modify the Purchase Price in the event of changes in the financial condition of Seller during the period between the date of the Initial Balance Sheet and Closing. Such a mechanism permits the parties to lessen the potentially adverse impact of a flat price based upon stale pre-closing information. Through use of a purchase-price adjustment mechanism, the parties are able to modify the purchase price to reflect more accurately the seller’s financial condition as of the closing date. Not all transactions contain purchase-price adjustment mechanisms, however. Such mechanisms are complex in nature and are frequently the subject of contentious negotiations. As a result, the

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parties rely on other mechanisms in many cases, such as resorting to claims for breach of representations and warranties, indemnification rights and walk-away or termination provisions to achieve their objectives.

In the absence of a purchase-price adjustment mechanism such as the one employed in the Model Agreement, provision is frequently made for the proration of certain items (such as rent under Leases included within the Assumed Liabilities and ad valorem taxes with respect to the Real Property and Tangible Personal Property) to ensure that the seller is responsible for such liabilities only to the extent they cover periods up to and including the date of closing, and the buyer is responsible for such liabilities only to the extent that they cover periods subsequent to the closing. A proration mechanism is rarely appropriate if the parties have agreed to a purchase-price adjustment mechanism. The following is a sample of a proration provision:

ADJUSTMENTS TO PURCHASE PRICE

The Purchase Price shall be subject to the following credits and adjustments, which shall be reflected in the closing statements to be executed and delivered by Buyer and Seller as hereinabove provided:

(a) Prorations. Any rents, prepaid items and other applicable items with respect to the Assumed Liabilities shall be prorated as of the Closing Date. Seller shall assign to Buyer all unused deposits with respect to the Assumed Liabilities and shall receive a credit in the amount thereof with respect to the Purchase Price.

(b) Ad Valorem Taxes. Ad valorem real and tangible personal property taxes with respect to the Assets for the calendar year in which the Closing occurs shall be prorated between Seller and Buyer as of the Closing Date on the basis of no applicable discount. If the amount of such taxes with respect to any of the Assets for the calendar year in which the Closing occurs has not been determined as of the Closing Date, then the taxes with respect to such Assets for the preceding calendar year, on the basis of no applicable discount, shall be used to calculate such prorations, with known changes in valuation or millage applied. The prorated taxes shall be an adjustment to the amount of cash due from Buyer at the Closing. If the actual amount of any such taxes varies by more than dollars ($ ) from estimates used at the Closing to prorate such taxes, then the parties shall reprorate such taxes within ten (10) days following request by either party based on the actual amount of the tax bill.

The type of purchase-price adjustment mechanism selected depends upon the structure of the transaction and the nature of the target company’s business. There are many yardsticks available to use as the basis of a post-closing adjustment to the nominal purchase price. They can include, among others, book value, net assets, working capital, sales, net worth or shareholders’ equity. In some cases, it will be appropriate to adjust the purchase price by employing more than one adjustment mechanism. For example, in a retail sales business, it may be appropriate to measure variations in both sales and inventory. Finally, the nominal purchase price may be subject to an upward or downward adjustment or both. The purchase price also may be adjusted dollar for dollar or by an amount equal to some multiple of changes in the yardstick amount.

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The Fact Pattern indicates that Seller is a manufacturing concern with a full range of business activities and, for purposes of illustration, the Model Agreement provides for an adjustment to the Purchase Price based upon changes in Seller’s Working Capital. Working Capital of Seller is determined as of the date of the Balance Sheet and the Closing Date, and the nominal Purchase Price is adjusted either upward or downward based upon the amount of the increase or decrease in the level of Seller’s Working Capital. In order to lessen the opportunity for manipulation of the Working Capital amount during the measurement period, restrictions on Seller’s ability to manipulate its business operations and financial condition are set forth in Seller’s pre-closing covenants contained in Article 5.

The parties may also choose to place limits on the amount of the purchase-price adjustment. Depending upon the relative bargaining position of the parties, the acquisition agreement may provide an upper limit (a “cap” or “ceiling”) to any adjustment amount the buyer will be obligated to pay the seller. Alternatively, the parties may agree upon an upper limit to any adjustment amount the seller will be obligated to pay or give back to the buyer after the closing, the effect of which is to reduce the final purchase price paid by the buyer to a specified “floor.” The acquisition agreement may further provide for both a cap or ceiling and a floor (when used in such combination, a “collar”) on the adjustment amount. The purchase-price adjustment provision can also contain a de minimis “window” (i.e., a range within which neither party pays a purchase price adjustment amount).

2.9 ADJUSTMENT PROCEDURE

(a) “Working Capital” as of a given date shall mean the amount calculated by subtracting the current liabilities of Seller included in the Assumed Liabilities as of that date from the current assets of Seller included in the Assets as of that date. The Working Capital of Seller as of the date of the Balance Sheet (the “Initial Working Capital”) was ______ dollars ($______).

(b) Buyer shall prepare financial statements (“Closing Financial Statements”) of Seller as of the Effective Time and for the period from the date of the Balance Sheet through the Effective Time on the same basis and applying the same accounting principles, policies and practices that were used in preparing the Balance Sheet, including the principles, policies and practices set forth on Exhibit 2.9. Buyer shall then determine the Working Capital as of the Effective Time minus accruals in accordance with GAAP in respect of liabilities to be incurred by Buyer after the Effective Time (the “Closing Working Capital”) based upon the Closing Financial Statements and using the same methodology as was used to calculate the Initial Working Capital. Buyer shall deliver the Closing Financial Statements and its determination of the Closing Working Capital to Seller within sixty (60) days following the Closing Date.

(c) If within thirty (30) days following delivery of the Closing Financial Statements and the Closing Working Capital calculation Seller has not given Buyer written notice of its objection as to the Closing Working Capital calculation (which notice shall state the basis of Seller’s objection), then the Closing Working Capital

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calculated by Buyer shall be binding and conclusive on the parties and be used in computing the Adjustment Amount.

(d) If Seller duly gives Buyer such notice of objection, and if Seller and Buyer fail to resolve the issues outstanding with respect to the Closing Financial Statements and the calculation of the Closing Working Capital within thirty (30) days of Buyer’s receipt of Seller’s objection notice, Seller and Buyer shall submit the issues remaining in dispute to ______, independent public accountants (the “Independent Accountants”) for resolution applying the principles, policies and practices referred to in Section 2.9(b). If issues are submitted to the Independent Accountants for resolution, (i) Seller and Buyer shall furnish or cause to be furnished to the Independent Accountants such work papers and other documents and information relating to the disputed issues as the Independent Accountants may request and are available to that party or its agents and shall be afforded the opportunity to present to the Independent Accountants any material relating to the disputed issues and to discuss the issues with the Independent Accountants; (ii) the determination by the Independent Accountants, as set forth in a notice to be delivered to both Seller and Buyer within sixty (60) days of the submission to the Independent Accountants of the issues remaining in dispute, shall be final, binding and conclusive on the parties and shall be used in the calculation of the Closing Working Capital; and (iii) Seller and Buyer will each bear fifty percent (50%) of the fees and costs of the Independent Accountants for such determination.

COMMENT

The specific terms of the business deal must be considered when developing a purchase-price adjustment mechanism. For example, if the transaction contemplates an accounts receivable repurchase obligation requiring the seller to repurchase all or a portion of its accounts receivable uncollected prior to a certain date, the purchase-price adjustment procedure must take such repurchases into account when determining the adjustment amount. The Model Agreement provides that Buyer will prepare the Closing Financial Statements and calculate the Working Capital as of the Effective Time. In order to account for the effects of the underlying transaction, Working Capital is limited to the difference between the current liabilities of Seller included in the Assumed Liabilities and the current assets of Seller included in the Assets.

In order to minimize the potential for disputes with respect to the determination of the adjustment amount, the acquisition agreement specifies the manner in which the adjustment amount is calculated and the procedures to be utilized in determining the adjustment yardstick as of a given date. The Model Agreement addresses this objective by stating that the Closing Financial Statements shall be prepared on the same basis and applying the same accounting principles, policies and practices that were used in preparing the Balance Sheet, including the principles, policies and practices listed on Exhibit 2.9. Therefore, the buyer’s due diligence ordinarily will focus not only on the items reflected on the Balance Sheet but also on the accounting principles, policies and practices used to produce it because it may be difficult for the buyer to dispute these matters after closing. For cost, timing and other reasons, the parties may elect to prepare less comprehensive financial statements for the limited purpose of determining the adjustment amount. Determination of the adjustment amount will depend upon the type of

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financial statements that have been prepared, and special accounting procedures may need to be employed in calculating the adjustment components. Where the parties engage the accountant to issue a report of findings based upon the application of agreed-upon procedures to specified elements, accounts or items of a financial statement, such agreed-upon procedures should follow applicable statements on accounting standards and be clearly set forth in the acquisition agreement. See Statement on Auditing Standards No. 75, “Engagements to Apply Agreed-Upon Procedures to Specified Elements, Accounts, or Items of a Financial Statement,” and Statement on Standards for Attestation Engagements No. 4, “Agreed-Upon Procedures Engagements.” Unless consistent accounting principles, policies and practices are applied, the purchase-price adjustment will not be insulated from the effects of changes in accounting principles, policies and practices. Because purchase-price adjustment mechanisms rely heavily on the application of accounting principles and methods to particular fact situations, the input of the parties’ accountants is important to the crafting of a mechanism that is responsive to the facts, workable and reflects the expectations and intentions of the parties in establishing the ultimate purchase price.

Provisions establishing dispute resolution procedures follow the provisions for the initial determination and objection. If the parties are unable to amicably resolve any disputes with respect to the Closing Financial Statements and the Closing Working Capital, Section 2.9(d) provides for dispute resolution by independent accountants previously agreed to by the parties. If the acquisition agreement does not specify who will serve as the independent accountants, the parties should establish the procedure for selection. Even if the independent accountants are named, it may be wise to provide replacement procedures in case a post-closing conflict arises with respect to the selection of the independent accountants (e.g., through merger of the independent accountants with accountants for the buyer or the seller).

The procedure to be followed and the scope of authority given for resolution of disputes concerning the post-closing adjustments vary in acquisition agreements. Section 2.9 provides that Buyer will determine the Closing Working Capital based upon the Closing Financial Statements using the same methodology as was used to calculate the Initial Working Capital. The Closing Financial Statements and Buyer’s determination of the Closing Working Capital are then delivered to Seller, and, if Seller has not objected within the requisite time period to the Closing Working Capital calculation (stating the basis of the objection), the calculation is “binding and conclusive on the parties”. If Seller objects and the issues outstanding are unresolved, the “issues remaining in dispute” are to be submitted to the accountants for resolution “applying the principles, policies and practices referred to in Section 2.9(b).” The determination by the accountants of the issues remaining in dispute is “final, binding and conclusive on the parties” and is to be used in the calculation of the Closing Working Capital.

The procedure set forth in Section 2.9 does not provide for the accountants to act as arbitrators, and there is no separate arbitration provision governing disputes under the Model Agreement. See the Comment to Section 13.4. Section 2.9, however, provides that the determination by the accountants is to be “final, binding and conclusive” on the parties. To what extent will this determination be binding on the parties, arbitrable or confirmable by a court? This is largely a question of state law, except that the Federal Arbitration Act will preempt any state law that conflicts or stands as an obstacle to the purpose of the Act to favor arbitration. The issue is often addressed in the context of a motion to compel arbitration by one of the parties to

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the acquisition agreement. The court in Talegen Holdings, Inc. v. Fremont General Corp., No. 98 Civ. 0366 (DC), 1998 WL 513066, *3 (S.D.N.Y. Aug. 19, 1998), dealt with such a motion as follows:

In resolving a motion to compel arbitration under the Federal Arbitration Act ... , a court must: (1) determine whether the parties agreed to arbitrate; (2) ascertain the scope of that agreement to see if the claims raised in the lawsuit fall within the terms of the agreement; (3) if federal statutory claims are asserted, decide whether Congress has deemed those claims to be nonarbitrable; and (4) if some, but not all claims are to be arbitrated, determine whether to stay the balance of the proceedings pending arbitration.

It then stated that “[c]ourts have consistently found that purchase price adjustment dispute resolution provisions such as the one at issue here constitute enforceable arbitration agreements.” Id. The clauses providing for dispute resolution mechanisms need not expressly provide for arbitration in order for a court to determine that the parties have agreed to arbitration.

If a court determines that the parties agreed to arbitration, the extent to which arbitration will be compelled under the Federal Arbitration Act depends upon whether the provision is broadly or narrowly drawn. A broad clause creates a presumption of arbitrability, whereas a narrow clause allows a court to consider “whether the claims fall reasonably within the scope of that clause.” Id. Even with a narrow provision, “[b]ecause the [Federal Arbitration Act] embodies Congress’s strong preference for arbitration, ‘any doubts concerning the scope of arbitrable issues should be resolved in favor of arbitration’.” Id.; see also Wayrol PLC v. Ameritech Corp., No. 98 Civ. 8451 (DC), 1999 WL 259512 (S.D.N.Y. April 30, 1999); Advanstar Communications, Inc. v. Beckley-Cardy, Inc., No. 93 Civ. 4230 (KTD), 1994 WL 176981 at *3 (S.D.N.Y. May 6, 1994) (although a narrow clause must be construed in favor of arbitration, courts may not disregard boundaries set by the agreement).

The question of what comes within the arbitrable issues is a matter of law for a court. If the dispute arises over the accounting methods used in calculating the closing working capital or net worth, a court might compel arbitration as to those issues. See Advanstar, 1994 WL 176981 (clauses allowing arbitration of disagreements about balance sheet calculations “include disputes over the accounting methods used”). A court can disregard whether the claims might be characterized in another way. See Talegen at *17. On the other hand, some courts require that the provision include on its face the issue in dispute. In Gestetner Holdings, PLC v. Nashua Corp., 784 F. Supp. 78 (S.D.N.Y. 1992), the court held that an objection as to the closing net book value includes an objection to whether the closing balance sheet failed to comply with generally accepted accounting principles; however, the court did not rule on whether the initial balance sheet, for which the defendant argued that indemnification was the exclusive remedy, could also be considered an arbitrable dispute. See also Gelco Corp. v. Baker Indus., Inc., 779 F.2d 26 (8th Cir. 1985) (clause covering disputes concerning adjustments to closing financial statements did not encompass state court claims for breach of contract); Twin City Monorail, Inc. v. Robbins & Myers, Inc., 728 F.2d 1069 (8th Cir. 1984) (clause extended only to disputed inventory items and not to all disputes arising out of the contract); Basix Corp. v. Cubic Corp., No. 96 Civ. 2478, 1996 WL 517667 (S.D.N.Y. Sept. 11, 1996) (clause applied only to well defined class of disagreements over the closing balance sheet); Stena Line (U.K.) Ltd. v. Sea Containers Ltd., 758 F. Supp. 934 (S.D.N.Y. 1991) (only limited issues concerning impact of beginning balance

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sheet on later balance sheet are arbitrable); Medcom Holding Co. v. Baxter Travenol Lab., Inc., 689 F. Supp. 841 (N.D. III. 1988) (clause limited to accounts or items on balance sheet does not encompass objections to valuation of property or accounting principles by which property is valued).

The scope of the accountants’ authority in Section 2.9(d) is expressly limited to those issues remaining in dispute and does not extend more broadly to the Closing Financial Statements or to the calculation of the Initial Working Capital or the Closing Working Capital. The authority cited above suggests that, if there is a dispute over whether the financial statements from which the Initial Working Capital or the Closing Working Capital are calculated have been prepared in accordance with generally accepted accounting principles or reflect the consistent application of those principles, Buyer may not be able to resolve the matter under the procedure established in Section 2.9(c) and (d). Buyer might, however, be able to make a claim for indemnification based upon a breach of the financial statement representations and warranties in Section 3.4. If any of the items in the financial statements from which Initial Working Capital is computed are in error, the inaccuracy could affect the Adjustment Amount payable under Section 2.8. Again, Buyer’s recourse might be limited to a claim for indemnification. If the error is to the disadvantage of Seller, it may not be able to restate the financial statements or cause the Initial Working Capital to be adjusted and, therefore, would have no recourse for its own error. See Melun Indus., Inc. v. Strange, 898 F. Supp. 995 (S. D. N.Y. 1992).

In view of this authority, the buyer may wish to weigh the advantages and disadvantages of initially providing for a broad or narrow scope of issues to be considered by the accountants. By narrowing the issues, it will focus the accountants on the disputed accounting items and prevent them from opening up other matters concerning the preparation of the financial statements from which the working capital calculation is derived. Reconsideration of some of the broader accounting issues, however, might result in a different overall resolution for the parties. The buyer might also consider whether to provide that the accountants are to act as arbitrators, thereby addressing the question of arbitrability, at least as to the issues required to be submitted to the accountants. This may, however, have procedural or other implications under the Federal Arbitration Act or state law.

The phrase “issues remaining in dispute” in the second sentence of Section 2.9(d) limits the inquiry of the independent accountants to the specific unresolved items. The parties might consider parameters on the submission of issues in dispute to the independent accountants. For example, they could agree that, if the amount in dispute is less than a specified amount, they will split the difference and avoid the costs of the accountants’ fees and the time and effort involved in resolving the dispute. The parties may also want to structure an arrangement for the payment of amounts not in dispute.

Purchase-price adjustment mechanisms do not work in isolation, and the seller may want to include in these provisions a statement to the effect that any liabilities included in the calculation of the adjustment amount will not give the buyer any right to indemnification. The rationale for such a clause is that the buyer is protected from damages associated with such claims by the purchase-price adjustment.

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EXTRACT FROM MODEL STOCK PURCHASE AGREEMENT WITH COMMENTARY, COMMITTEE ON NEGOTIATED ACQUISITIONS,

SECTION OF BUSINESS LAW, AMERICAN BAR ASSOCIATION, 1995

2.2 PURCHASE PRICE

The purchase price (the “Purchase Price”) for the Shares will be $______________ plus the Adjustment Amount.

COMMENT

The purchase price and the method of its payment can take a wide variety of forms, an in- depth discussion of which is beyond the scope of this Commentary. The amount the Buyer is willing to pay for the Company depends on several factors, including the Company’s industry and stage of development, and can be based on some measure of historical or future revenues, earnings, cash flow, or book value (or some combination of revenues, earnings, cash flow, and book value), as well as the risks inherent in the Acquired Companies’ businesses.

The method of payment also depends on a variety of factors, including the Buyer’s ability to pay, the parties’ views on the value of the Company, the parties’ tolerance (or lack thereof) for risk, and the tax and accounting consequences to the parties (especially if the Buyer is a public company). The method of payment may include some combination of cash, debt, and stock and may also have a contingent component based on future performance. For example, if the Buyer does not have sufficient cash or wants to reduce its initial cash outlay, the Buyer could require that a portion of the purchase price be paid by a note. The Sellers may then seek to structure the transaction, if possible, so that it qualifies for treatment as an instalment sale under the Internal Revenue Code, which allows the Sellers to defer payment of their tax liability over the period during which the instalments are paid (with in some cases the current payment of interest on the deferred tax). If the method of payment includes a debt component, issues such as security, subordination, and covenants will have to be resolved. Similarly, if the method of payment includes a stock component, issues such as valuation and registration rights will have to be resolved.

If the Buyer and the Sellers cannot agree on the value of the Company, they may make a portion of the purchase price contingent on the performance of the Company after the acquisition. The contingent portion of the purchase price (often called an “earnout”) is commonly based on the Company’s earnings (or other agreed-upon criterion such as sales) over a specified period of time after the acquisition. Although an earnout may bridge a gap between the Buyer’s and the Sellers’ views of the value of the Company, constructing an earnout raises many issues, including how earnings will be determined, the formula for calculating the payment amount and how that amount will be paid (cash or stock), how the Acquired Companies’ businesses will be operated and who will have the authority to make major decisions, and the effect of a sale of the Buyer during the

earnout period. Resolving these issues may be more difficult than agreeing on a purchase price.

The Model Stock Purchase Agreement assumes that the parties have agreed to a fixed price, subject only to an adjustment based on changes in the Company’s consolidated stockholders’ equity between the date of the balance sheet and the date of closing (see Sections 2.5 and 2.6).

2.5 ADJUSTMENT AMOUNT

The Adjustment Amount (which may be a positive or negative number) will be equal to (a) the consolidated stockholders’ equity of the Acquired Companies as of the Closing Date determined in accordance with GAAP, minus (b) $______________.

COMMENT

The adjustment amount used in the Model Stock Purchase Agreement is based on the net worth or stockholders’ equity of the Company on a consolidated basis as reflected in the closing financial statements. Stockholders’ equity is the difference between assets and liabilities, for this purpose as reflected on the audited balance sheet included in the closing financial statements.

In most acquisitions, the purchase price is determined, at least in part, on the basis of the last audited consolidated financial statements and any interim financial statements of the Company delivered to the Buyer. The purchase price adjustment protects the Buyer against a diminution in the value of the Company during the period between the date of signing the acquisition agreement and the closing. If the closing financial statements differ substantially and adversely from the last audited financial statements and interim statements delivered to the Buyer, the Buyer should consider, as an alternative to the purchase price adjustment, remedies available to it under the Sellers’ representations concerning the financial statements and possibly under theories of fraud.

Purchase price adjustment provisions can include a de minimis “window” - a range of closing date stockholders’ equity values within which neither party pays a purchase price adjustment amount. Other alternative provisions include “caps,” “collars,” and “floors.” A “cap” is the upper limit on the adjustment amount to be paid by the Buyer; a “floor” is the upper limit on the adjustment amount to be refunded by the Sellers. A “collar” refers to the use of both a “cap” and a “floor.”

Parties applying “caps,” “collars,” and “floors” to purchase price adjustment provisions should consider the financial and contractual consequences of reaching the limits of the “cap” or “floor.” Is the “cap” or “floor” a risk allocation feature under which one party benefits and one party suffers with no further contractual remedies? Does the “cap” or “floor” instead require the parties to turn to other contractual provisions such as an “unwind” provision, a deferred payment provision, or the indemnity provisions? If the acquisition agreement is silent on the rights, for example, of the Buyer if a “floor” is reached, the Sellers may then take the risk that the Buyer will seek a remedy under the

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indemnity provisions for a breach of a representation such as the financial statements, accounts receivable, or no material adverse change representation.

The parties can also place a portion of the purchase price paid, or funds in excess of the purchase price, in escrow to facilitate payment of the adjustment amount.

The Model Stock Purchase Agreement defines the adjustment amount as “the consolidated stockholders’ equity of the Acquired Companies as of the Closing Date determined in accordance with GAAP” (less the portion of the purchase price paid in cash and notes at the closing). Both the Buyer and the Sellers should be aware of the flexibility permitted by GAAP (see the fourth paragraph of the Commentary to the definition of GAAP in Section 1). The parties may want to negotiate, or confirm in writing at the time the acquisition agreement is signed, the method of valuation of significant line items on the closing financial statements. The parties should also consider describing “past practice” in writing as a schedule to the acquisition agreement. Accountants for both parties should be involved in these discussions. If the parties agree on specific guidelines concerning the determination of stockholders’ equity for purposes of the adjustment amount, the acquisition agreement should specify that, in the event of a conflict between GAAP and the guidelines, the guidelines control.

2.6 ADJUSTMENT PROCEDURE

(a) Sellers will prepare and will cause _____________________, the Company’s certified public accountants, to audit consolidated financial statements (“Closing Financial Statements”) of the Company as of the Closing Date and for the period from the date of the Balance Sheet through the Closing Date, including a computation of consolidated stockholders’ equity as of the Closing Date. Sellers will deliver the Closing Financial Statements to Buyer within sixty days after the Closing Date. If within thirty days following delivery of the Closing Financial Statements, Buyer has not given Sellers notice of its objection to the Closing Financial Statements (such notice must contain a statement of the basis of Buyer’s objection), then the consolidated stockholders’ equity reflected in the Closing Financial Statements will be used in computing the Adjustment Amount. If Buyer gives such notice of objection, then the issues in dispute will be submitted to ________________, certified public accountants (the “Accountants”), for resolution. If issues in dispute are submitted to the Accountants for resolution, (i) each party will furnish to the Accountants such workpapers and other documents and information relating to the disputed issues as the Accountants may request and are available to that party or its Subsidiaries (or its independent public accountants), and will be afforded the opportunity to present to the Accountants any material relating to the determination and to discuss the determination with the Accountants; (ii) the determination by the Accountants, as set forth in a notice delivered to both parties by the Accountants, will be binding and conclusive on the parties; and (iii) Buyer and Sellers will each bear 50% of the fees of the Accountants for such determination.

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(b) On the tenth business day following the final determination of the Adjustment Amount, if the Purchase Price is greater than the aggregate of the payments made pursuant to Sections 2.4(b)(i) and 2.4(b)(iii) and the aggregate principal amount of the Promissory Notes, Buyer will pay the difference to Sellers, and if the Purchase Price is less than such aggregate amount, Sellers will pay the difference to Buyer. All payments will be made together with interest at _____% compounded daily beginning on the Closing Date and ending on the date of payment. Payments must be made in immediately available funds. Payments to Sellers must be made in the manner and will be allocated in the proportions set forth in Section 2.4(b)(i). Payments to Buyer must be made by wire transfer to such bank account as Buyer will specify.

COMMENT

Section 2.6 provides that the Sellers will prepare and cause the Company’s accountants to audit the closing financial statements. If the Sellers will no longer be affiliated with the Company (as employees, consultants, or otherwise) after the closing, the Buyer may be in a better position to do this. Because determination of stockholders’ equity under GAAP is not a science, parties frequently seek to have their own accountants make this determination. The initial determination will then be subject to objection, accompanied by an explanation of the objection, by the party not controlling the initial determination. Provisions establishing dispute resolution procedures should follow the provision for the initial determination and objection.

The Model Stock Purchase Agreement provides for dispute resolution by independent accountants previously agreed to by the parties; if the acquisition agreement does not specify who will serve as these independent accountants, it should contain provisions establishing the procedure for their selection. Often the acquisition agreement instructs these accountants to act as arbitrators and not as auditors. The phrase “issues in dispute” in the third sentence of paragraph (a) limits the inquiry of the independent accountants to the specific line items to which the objecting party has objected. The parties should consider setting parameters on the submission of issues in dispute to the independent accountants. For example, the parties could agree that if the amount in dispute is less than a specified amount, they will split the difference and avoid the cost of the accountants’ fees and the time and effort involved in resolving the dispute. The parties may want to add an exception for manifest error to the statement that the accountants’ decision will be binding and conclusive.

Under the Model Stock Purchase Agreement, the Buyer has the right to object to the initial determination of stockholders’ equity as of the closing date. Because the Sellers usually have a relationship with the Company’s accountants, the Buyer should assume that the accountants will resolve items involving the accountants’ judgment in favor of the Sellers. The Company’s accountants may seek to continue to represent the Company, however, and not the Sellers. Thus, the Sellers may, upon evaluating their relationship with the Company’s accountants, seek an objection right similar to that of the Buyer.

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Section 2.6(b) provides that any payments of the adjustment amount are to be made in immediately available funds. The parties may want to provide that a portion or all of the adjustment amount will be paid by adjusting the amount of the promissory notes. The Buyer should negotiate for a set off right under the promissory notes if the Sellers fail to pay the adjustment amount.

The Sellers may want to include in these provisions a statement to the effect that any liabilities included in the calculation of the adjustment amount will not constitute a breach of any of the Sellers’ representations in the acquisition agreement and will not give the Buyer any right to indemnification. The rationale for such a clause is that the Buyer is protected from damages associated with such liabilities by the purchase price adjustment.

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AMERICAN BAR ASSOCIATION SECTION OF BUSINESS LAW

2005 SPRING MEETING Nashville, Tennessee

PURCHASE PRICE ADJUSTMENTS, EARNOUTS AND OTHER PURCHASE PRICE PROVISIONS

Leigh Walton Bass, Berry & Sims PLC

Nashville, Tennessee

Kevin D. Kreb

PricewaterhouseCoopers LLP Chicago, Illinois

February 2005

Table of Contents

I. FORMS OF CONSIDERATION FORMS OF CONSIDERATION ...............................1 A. In General....................................................................................................................1 B. Cash Payment..............................................................................................................2 C. Payment by Stock........................................................................................................2

1. Valuation Issues ..................................................................................................2 2. Restrictions on Resale.........................................................................................4 3. Shareholder Approval .........................................................................................4 4. Tax Considerations .............................................................................................5

D. Payment by Promissory Note......................................................................................6 1. Set-Off Rights .....................................................................................................6 2. Tax Benefits ........................................................................................................6 3. Security for Payment of the Notes ......................................................................6

II. HOLDBACKS OF PURCHASE PRICE IN ESCROW....................................................7

A. Overview.....................................................................................................................7 B. Benefits and Risks.......................................................................................................7 C. Tax Treatment .............................................................................................................7

III. PURCHASE PRICE ADJUSTMENTS ..............................................................................8

A. Overview.....................................................................................................................8 B. Construction of the Post-Closing Adjustment.............................................................9 C. Typical Mechanics ....................................................................................................10 D. Drafting Considerations ............................................................................................11

1. Amount Paid at Closing....................................................................................11 2. Accounting Specifications ................................................................................12

a. “Preferable” versus “Acceptable” GAAP ................................................12 b. GAAP versus Consistency.......................................................................13 c. Interim versus Year-End Reporting. ........................................................13 d. Errors or Irregularities Discovered after Closing.....................................14 e. Materiality. ...............................................................................................14 f. Changes in Accounting Policies or Practices. ..........................................15 g. Hindsight..................................................................................................16 h. Right to Offset..........................................................................................16

3. Issues of Control ...............................................................................................17 4. Caps and Floors.................................................................................................18 5. Interplay Between the Post-Closing Adjustment and Indemnification.............18 6. Dispute Resolution: Designation of Independent Accountants ........................18 7. Mechanisms to Ensure Payment of the Adjustment Amount ...........................20

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IV. EARNOUTS ........................................................................................................................20 A. Overview...................................................................................................................20 B. Some Risks Associated with the Use of Earnout Provisions ....................................21 C. Drafting Issues...........................................................................................................21

1. Establishing the Earnout Benchmark; Types of Possible Benchmarks ............21 a. Financial Benchmarks..............................................................................21 b. Non-Financial Benchmarks .....................................................................22

2. The Formula for Calculating the Payment Amount..........................................22 3. The Length of the Earnout Period.....................................................................23 4. Determination of Whether the Threshold Has Been Satisfied..........................23

a. Determination of the Earnout...................................................................23 b. Accounting Issues ....................................................................................24

5. Form of Payment of Earnout Obligation ..........................................................28 a. Valuation Issues .......................................................................................28 b. Securities Issues .......................................................................................28 c. Related Tax Questions .............................................................................29

6. Operation of the Acquired Business During the Earnout Period......................29 a. Operation by the Buyer Post-closing .......................................................30 b. Operation by the Seller’s Management Team Post-closing.....................30 c. Protection Placed in the Acquisition Agreement .....................................30

7. Payment of Earnouts to Public Shareholders....................................................31 8. Shareholders Designated to Act for the Seller..................................................32 9. Sale of the Target During the Earnout Period...................................................32

10. Integration of the Target into the Buyer’s Other Businesses ...........................32 11. Averaging Periods of Strong Performance With Weak Performance ..............32 12. Dispute Resolution ...........................................................................................33 13. Registration Issues for Earnout Rights .............................................................33 14. Special Industry Limitations ............................................................................34

V. CONCLUSION ...................................................................................................................34

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PURCHASE PRICE ADJUSTMENTS, EARNOUTS AND OTHER PURCHASE PRICE PROVISIONS

by

Leigh Walton Bass, Berry & Sims PLC

Kevin D. Kreb

PriceWaterhouseCoopers LLP

February 2005

This article considers the various ways in which payment of the purchase price in an acquisition can be structured. Variations can occur in the types of consideration payable at the closing, and many acquisitions provide for a post-closing adjustment or true-up. Further, the acquisition may include an earnout payable over a considerable period of time after the closing. Each of these purchase price provisions significantly impacts the leverages of the parties, the tax and accounting treatment of the transaction, the securities laws ramifications of the acquisition and the relationship of the buyer and seller after the closing.

I. FORMS OF CONSIDERATION

A. In General

The purchase price in an acquisition is typically paid by cash, stock of the acquiring entity, installment notes, the assumption of indebtedness or some combination thereof. Factors that affect the way the purchase price is paid include:

• the buyer’s access to cash; • the seller’s desire or willingness to invest in the buyer’s business; • the seller’s desire for a tax-free transaction; • the structure of the transaction as a stock purchase, merger or asset

acquisition; and • the buyer’s desire to extend payments through notes, creating a source to

satisfy indemnification claims.

____________________ ©2005 Leigh Walton and Kevin D. Kreb. The authors express their appreciation to Bryan Metcalf, AnHumphreys Hamilton and Steven Morris of Bass, Berry & Sims for their assistance with this article. The authwish to thank William B. Payne of Dorsey & Whitney LLP for his thoughtful comments on this article.

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gelaors

B. Cash Payment

Payment by cash is appealing in its simplicity and because (absent a holdback to secure post-closing claims) it will largely terminate the relationship between the buyer and the seller at the closing. A cash payment, however, will result in the seller realizing an immediate gain for tax purposes on the transaction.

The Financial Accounting Standards Board (“FASB”) issued Statements of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations, in 2001. SFAS No. 141 eliminated the pooling of interests method of accounting for transactions initiated after June 30, 2001. SFAS No. 141 requires all business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting. See Jan R. Williams, 2004 Miller GAAP Guide, at 4.0. With the elimination of pooling of interests, cash-based transactions have increased, with cash being used as the sole consideration for the transaction or in combination with stock.

Cash payment, when chosen, may be made by bank cashier’s check, certified check or wire transfer. The seller generally will insist on same day funds through a wire transfer.

C. Payment by Stock

In transactions in which equity securities are used as consideration, complex issues of valuation are presented. Further, the securities issued in the transaction must be registered under the Securities Act of 1933, as amended (the “Securities Act”), or an exemption from registration must be available.

1. Valuation Issues

Once the parties agree to use stock as consideration and a purchase price has been arrived at, the parties must value the stock to be transferred. They may agree that the stock is to be valued at the market price as of the moment of their agreement on the price, as of the date the acquisition agreement is signed, as of the closing date or at or during some other time period. If the stock is not registered under the Securities Act, or if the transfer of the stock is otherwise restricted, the seller may demand a discount from market price. If the buyer’s stock will be registered under the Securities Act, the Securities and Exchange Commission (“SEC”) will insist that the number of shares to be issued to the seller’s shareholders be clearly indicated in the proxy statement for the meeting at which the transaction is approved, or be ascertainable from external sources at that time.

To avoid the obvious risk posed by using a single day’s stock price in the valuation, the parties typically choose to use an average market price of the buyer’s stock over some specified period of time, for example, the 10 trading days immediately preceding the third business day prior to the

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closing. To protect against extreme fluctuations in price, the parties will likely place an upper and lower limit – a collar – on the range within which the stock price may vary for the purposes of valuation. The collar may be defined by either share price or shares issuable in the transaction: for example, no greater than 1,500,000 shares to be issued but no fewer than 1,350,000; or a share price of no greater than $55, but no less than $45. Although it is most common for both components of the collar to be present in a transaction, occasionally deals are structured having only one component, the upper limit or the lower limit, depending upon the bargaining power and strategic positioning of the parties.

In a stock purchase price formula using both a collar and an average closing price to value a listed security, the parties might agree to the following provision:

“The aggregate number of shares of Buyer Common Stock issuable to Seller shall equal that number of whole shares of Buyer Common Stock equal to the quotient of (a) $100,000,000, divided by (b) the average of the closing prices of Buyer Common Stock as reported on the New York Stock Exchange for the 10 trading days ending on the date that is three Business Days prior to the Closing Date (the “Average Price”); provided, however, if the Average Price is less than $45, the calculation shall be made as if the Average Price were $45, and if the Average Price is greater than $55, the calculation shall be made as if the Average Price were $55.”

The parties also may agree that there is a right to terminate the contract if the price extends beyond the collar limits. For example, the definitive agreement may provide that in the event the purchase price falls below the lower limit, the buyer may, but is not required to, provide additional consideration, in cash or stock, to bring the purchase price up to the lower limit. If the buyer is unwilling to provide such additional consideration, the seller may terminate the agreement if it is unwilling to accept the lower purchase price. In drafting provisions of this type, it is important to consider the notification requirements of the parties. Once it is determined that the lower limit of the collar will not be met, must the buyer first notify the seller whether it is willing to provide additional consideration to increase the purchase price to the lower limit, or must the seller notify the buyer whether it will terminate the agreement if the purchase price is not increased to the lower limit? Such provisions should be clearly addressed in order to avoid uncertainties and will be subject to negotiation.

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Finally, as is discussed later in this article, many acquisition agreements contemplate a post-closing adjustment that can result in the buyer paying additional consideration, or the seller in effect refunding previously paid consideration to the buyer. If a portion of the consideration involved in the post-closing adjustment is stock, the mechanism for valuing the stock delivered in the adjustment should be specified.

2. Restrictions on Resale

Securities issued in an acquisition (like any other type of securities issuance) must be registered under the Securities Act, or an exemption from registration must be available. Typically Form S-4 is used for registration (although the use of Form S-1, S-2 or S-3 may be mandated if no shareholder approval is required or if a majority shareholder of the seller has agreed to support the transaction, thus assuring shareholder approval).

If the seller agrees to accept unregistered securities, a private placement exemption through Section 4(2) or Regulation D under the Securities Act is the typical route to securities laws compliance. When the seller’s shareholders receive stock that is issued under an exemption, they must hold the stock until it can be sold publicly under Rule 144 (typically a minimum one year holding period), another exemption from registration is available or the stock is registered. Even if received in a registered transaction, securities held by affiliates of a seller prior to the acquisition will, pursuant to Rule 145, be subject to the resale limitations of Rule 144 (other than the holding period limitations).

The seller may demand registration rights that obligate the buyer to register the seller’s resale of the stock. This provision may be constructed as a “demand registration right,” whereby the seller may require the buyer to register the securities upon demand, or a “piggyback registration right,” whereby the securities are registered as an add-on to another registration statement being filed by the buyer. Faced with the prospective expense of filing a registration statement for the stock, the buyer may resist such a provision or may seek to limit it. The buyer may limit the number of registrations that will be effected, may place time limits on the rights or may require that a minimum number of shares from the seller’s shareholders be available for sale. The seller may insist that no other registration rights be granted that are on terms more favorable than those granted to the seller’s shareholders and that the buyer pay all expenses (to the extent allowable under NASD regulations) of the registration.

3. Shareholder Approval

Approval of the buyer’s shareholders may be required for the issuance of the buyer’s stock as consideration for the acquisition. Approval of the buyer’s shareholders is necessary when the stock issued in the transaction

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is in excess of the buyer’s authorized shares or, in some instances, when the buyer’s shares are listed on the New York Stock Exchange (“NYSE”), the American Stock Exchange (“AMEX”) or the Nasdaq National Market (“Nasdaq”). The requirements for shareholder approval vary, but generally approval is necessary for transactions in which the buyer is issuing (or in the case of AMEX, has the potential to issue) 20% or more of its outstanding common stock, or if the issuance will for some other reason impact control of the buyer. The NYSE, AMEX and Nasdaq each have specific rules in effect in this regard.

Of course, state law also may require that the buyer’s shareholders approve the transaction. For example, under Section 6.21(f) of the Model Business Corporation Act, action by the shareholders of the surviving corporation in a merger is required if, among other conditions, the voting power of shares that are issued and issuable as a result of the merger will comprise more than 20% of the voting power of the shares of the corporation that were outstanding immediately before the transaction.

It is important to monitor a fluctuating purchase price involving the issuance of stock to determine if approval of the buyer’s shareholders is required. Upon execution of a definitive agreement including a purchase price based upon a fluctuating per share price, it may be anticipated that the price will remain high enough that the number of shares of buyer stock to be issued at closing will not reach the threshold requiring shareholder approval. However, if the buyer’s stock price drops, assuming the number of shares to be issued at closing is not first capped by the lower limit of the collar, the number of shares of buyer stock to be issued at closing could reach the threshold requiring shareholder approval. If obtaining shareholder approval is a concern, one alternative may be to pay the balance of the purchase price in cash.

4. Tax Considerations

In order to minimize the tax consequences of a transaction, an all stock transaction typically is structured as a reverse triangular merger. That is, the acquiring entity will set up a merger subsidiary that merges into the target. If a combination of cash and stock is used, a reverse triangular merger typically will be tax-free if the stock constitutes at least 80% of the aggregate consideration for the transaction. Because the value of the stock is determined on the closing date, parties intending their transactions to be tax-free under these provisions should provide some adjustment mechanism in the contract if market fluctuations cause the value of the stock in the deal to dip below 80% of the aggregate consideration. If the stock involved is less than 80% of the aggregate consideration, a forward triangular merger often will afford partially tax-free treatment. That is, the acquiring entity will set up a merger subsidiary and the target will merge into the merger subsidiary. If the stock involved falls below 45% of the

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aggregate consideration, the stock component of the transaction generally will be taxable unless a complex structure is used. In any reorganization, shareholders will pay tax on the lesser of their gain realized and the cash received; thus, it may not be worthwhile to structure a tax-free transaction with respect to the stock being issued if cash comprises a large portion of the deal consideration.

D. Payment by Promissory Note

Use of promissory notes as consideration can be attractive for several reasons. The buyer may wish to pay by note if it is cash-constrained or for some other reason wishes to lower its original cash outlay. By retaining a portion of the purchase price, the buyer retains leverage with the seller for payment of indemnification claims. Payment by note may also be beneficial to the seller for tax reasons.

1. Set-Off Rights

The buyer may desire to use non-negotiable installment notes as part of the consideration to create a source against which indemnification claims can be offset. Although the right of offset is automatic under most state laws, the buyer’s counsel is well advised to clearly establish the right in the promissory note.

2. Tax Benefits

If payment is made by note, the seller will generally report any gain from the sale on the installment method under §453 of the Internal Revenue Code of 1986, as amended. Reporting on the installment method permits the seller to defer a portion of its tax liability until it receives installment payments on the note. The note cannot be secured by cash or certain cash equivalents. Furthermore, the seller must make interest payments to the government on the deferred tax liability on installment obligations generally to the extent they exceed $5,000,000 in the year they arose. After much debate, in 2000 Congress repealed a statute making installment sale treatment available for accrual and cash basis taxpayers.

3. Security for Payment of the Notes

The seller may wish to negotiate security for payment of the note accepted in the acquisition. The seller may demand a security interest in the buyer’s assets, a letter of credit or a guarantee by a third party. The seller also may accept a pledge of the target’s stock acquired by buyer.

If this last technique is used, the seller should negotiate protections to ensure that the business, if returned in the event of default, has not been stripped of all of its value by the buyer. Provisions to protect against such a possibility include stipulating a minimum level of working capital to be

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maintained until the note is paid, prohibiting the buyer from engaging in the target’s line of business except through the target, restrictions on the sale of certain assets, restrictions on dividends from the target to the buyer and requiring the business of the target to be maintained in a separate entity.

II. HOLDBACKS OF PURCHASE PRICE IN ESCROW

A. Overview

The buyer may demand a readily accessible pool of money to cover post-closing indemnification claims and other specified contingencies. One common way to provide such a pool of money is an escrow arrangement providing that a part of the purchase price be placed in escrow, usually with an independent escrow agent, for a specified period of time after the closing. With the elimination of pooling transactions, restrictions regarding the types of contingencies and number of shares (previously, no more than 10%) with respect to which an escrow may be established also will be eliminated.

B. Benefits and Risks

The escrow fund established will provide greater ease of recovery for the buyer in the event of indemnification claims, alleviating concerns about the seller’s ongoing solvency and potential problems in locating the seller’s assets for executing judgments. Buyers should be aware that the seller will likely propose that the escrow fund be the sole remedy for the buyer’s post-closing claims. Sellers should realize that the existence of the escrow fund significantly changes the leverages for the post-closing resolution of disputes.

C. Tax Treatment

Funds paid into escrow and later paid to the seller generally will be taxed under the installment method described in I.D.2. above. In most escrow situations, the tax on payments received from escrow will be based on the presumption that all of the escrow amount will be paid to the Seller. Adjustments are made in the subsequent year if the seller receives less than the full amount.

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III. PURCHASE PRICE ADJUSTMENTS

A. Overview

Purchase price adjustments (as contrasted to earnouts, discussed later) are used when there is a fundamental agreement between the parties as to the value of the target, but when there is a period of time between the signing and closing of the acquisition. A target’s value is usually determined on the basis of the most recent financial information available at the time of pricing. Generally, the purpose of a purchase price adjustment provision is to reflect changes in certain values of the target between the signing of the acquisition agreement and the closing date. This period can be significant for a variety of reasons, including:

• a Hart-Scott-Rodino filing or other regulatory approvals are required;

• third party consents must be gathered;

• the buyer requires time to finance the transaction;

• securities are to be registered; and

• shareholders’ approval must be sought.

The length of the pre-closing period varies, but is often one to three months. Even in circumstances in which none of these factors is present, there is typically a gap in time between the latest available financial statements and the closing date, which may cause the parties to consider a post-closing adjustment. Further, in seasonal businesses, there are often large fluctuations in working capital balances that lead to the use of a post-closing adjustment.

These circumstances provide the primary rationale for the use of a post-closing adjustment, it bridges the gap between the financial condition of the seller at the time of signing the definitive purchase agreement and its condition as of the closing date. Thus the buyer receives the benefit of its bargain by receiving the agreed upon balance sheet (or an adjustment in the purchase price).

An additional rationale for use of a post-closing adjustment is that it effectively allocates the economic risks and profits of continued operations during the pre-closing period (at least in transactions other than asset purchases). During the pre-closing period, the seller typically manages the business being sold. The post-closing adjustment usually (but not always) allocates to the seller the economic risks and profits of continued operation of the target during this period. If a purchase price adjustment is not used, the earnings generated by the target between the signing and the closing would accrue to the benefit of the buyer, since most acquisition agreements prohibit the seller from making distributions during this period. Conversely, losses would be borne by the buyer absent a post-closing adjustment. A post-closing adjustment may also be structured to

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protect the buyer against potential seller abuses, such as selling inventory without replacement, accelerating the collection of accounts receivable, stretching payables and other manipulative practices.

A post-closing adjustment is not a substitute for a “material adverse change” closing condition, which allows the buyer to refuse to close if the target’s financial results have materially deteriorated. The adjustment only becomes operative if in fact the transaction closes; it allows the parties to fine tune the purchase price after the transaction has been consummated.

B. Construction of the Post-Closing Adjustment

A post-closing adjustment can be constructed in a variety of ways. The structure of the post-closing adjustment often varies depending on the theory under which the entire transaction is valued. These theories include applying a multiple of earnings or cash flows, measuring the fair value of assets, estimating the value based on amounts paid in other comparable transactions and calculating a value or adjusting the value based on information regarding potential synergies with the buyer’s existing businesses. Regardless of the theory used, the buyer will typically arrive at a purchase price based, in large measure, on information in the latest available financial statements and the earnings trend reflected therein. Thus a properly constructed post-closing adjustment assures that the business the buyer pays for is the business it ultimately receives at the closing. And regardless of the theory under which the business of the target is valued, cash is generally paid for on a dollar-for-dollar basis (or excluded from the acquisition in an asset deal and left with the seller). Thus an adjustment that takes into account the target’s current assets and its current liabilities at closing assures that the closing working capital is accounted for.

Common post-closing adjustments compare working capital, net asset value or net worth variances between the most recent financial statements available at signing and the closing date financial statements.

A recent survey of purchase price adjustments in private company acquisitions analyzed 43 publicly filed purchase agreements entered into in 2003 and 2004 with a transaction value in excess of $50 million. P. Sinka and E. Elsea, “Purchase Price Adjustments: A Survey,” The M&A Lawyer, Oct. 2004 (the “Survey”). The Survey found that the most common purchase price adjustment identified in the surveyed transactions was the net working capital adjustment, which is intended to reflect the change in the current assets and current liabilities from the signing date to the closing date. Working capital adjustments were used in more than 50% of the transactions reviewed. Other than working capital, none of the purchase price adjustment mechanisms identified in the Survey were used in more than 10% of the surveyed transactions. These other purchase price adjustments, however, give an indication of the wide variety of matters than can be measured and compared, such as net book value, tax liabilities, shareholders’

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equity, cash expenditures, net debt, net worth, capital expenditures and number of customers.

Commonly, post-closing adjustment clauses call for a dollar-for-dollar adjustment to reflect changes in the net working capital, net asset value or other measured financial data point between the pre-closing balance sheet and the closing date balance sheet.

C. Typical Mechanics

The essential concept of most post-closing adjustments is to compare a specified financial measure taken from the pre-execution financial statements (often referred to as a “reference balance sheet”) of the target to the same measure in the financial statements of the target prepared as of the closing date. The comparison can be made between balances in the reference balance sheet and the closing date balance sheet or the comparison can be made between a specified amount and the closing date balance sheet amount. In a transaction with a post-closing adjustment, the closing is often scheduled for a month-end (or, even better, a fiscal quarter-end) to avoid difficult cut-off issues. The closing date financials are then prepared as of this date so that the comparison to the reference balance sheet amount can be made. If a period end closing is not feasible, special procedures should be agreed to that deal with the cut-off issues.

A critical issue relating to the mechanics of the post-closing adjustment is the decision as to which party is charged with the preparation of the closing date financial statements. The buyer and its accountants often contend that they should prepare the closing date financial statements, since the buyer has assumed control of the business. The seller may argue that it should prepare the closing date financial statements since consistency with the pre-closing financials is of paramount importance. According to the Survey, in 60% of the agreements analyzed, the buyer was assigned the task of producing the post closing calculation. In 35% of the agreements, the seller was responsible and in 5%, the parties relied on financials prepared by an independent accounting firm.

Within a specified time period after the closing, usually between 30 and 90 days, the responsible party delivers the closing date financial statements (often only a balance sheet) to the other party, along with the preparer’s initial determination of the purchase price adjustment amount.

Most disputes arising out of acquisitions and divestitures that involve accounting and financial reporting issues result from the buyer’s preparation or review of the closing date balance sheet and its divergent presentation of the way the seller accounted for (or did not account for) items in the balance sheet. The buyer has increased opportunity after the closing to understand these issues because it now controls and operates the company it has purchased, thus allowing it access to information that it may not have had before closing. The buyer can examine the financial statements in more detail and use the knowledge of company personnel who are familiar with the company’s accounting systems, practices and

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procedures. In the presentation of a closing date balance sheet it prepares or by objecting to certain amounts or balances in the seller’s closing date balance sheet, the buyer is, in effect, proposing adjustments that, if proper, would reduce the purchase price.

Notice of Objection. Under most agreements, the party not responsible for preparing the closing date balance sheet has a specified period – often 30 to 60 days – during which it can object to items in the closing date balance sheet and propose an alternative purchase price adjustment. If objectionable items are discovered, the reviewing party generally must file a notice of objection within this time. For example, a contract may state, “the Seller may dispute any amounts reflected on the closing date balance sheet or the net asset value reflected thereon, provided that the Seller shall notify Buyer in writing of each disputed item, and specify the amount thereof in dispute, within 30 days of receipt of the Buyer’s proposed closing date balance sheet.”

Some agreements set forth the required form and scope of response and mandate that the notice of objection be specific, whereas some contracts have more general terms. Specific notices usually must identify and explain the item in dispute and require the objecting party to state the individual dollar amounts of all of its objections at that time. Some general clauses require only that the notice identify the objection, without disclosing details until a later date.

Parties often dispute whether the objecting party can submit new items after the initial objection and whether it can revise items included in the initial notice, and to what extent. In situations in which the contract is ambiguous, an independent trier of fact must decide the issue, reducing the predictability of outcome on this issue.

Preparers of closing date balance sheets have incentives to carefully define the parameters for the notice of objection, allow a short time period between the presentation of the closing date balance sheet and the required objection cut-off date, mandate complete and specific disclosure of the disputed items by the deadline, and allow little flexibility for changing the basic theory or amount of the buyer’s position. Parties who receive and review the closing date balance sheet generally prefer the opposite.

D. Drafting Considerations

1. Amount Paid at Closing

In many transactions, the buyer pays the fixed amount of the purchase price at closing, not reflecting any purchase price adjustment. Another possibility is for the buyer to pay at closing the fixed amount plus or minus an estimate of the purchase price adjustment, as determined by the seller employing the post-closing adjustment procedure to pre-closing financials that are more current than those available at signing. In either case, one party will have to settle with the other when the closing date

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financial statements are finalized and the purchase price adjustment is calculated. As discussed below, the mechanics of the payment at closing includes a consideration of whether a portion of the purchase price should be paid into escrow to ensure the expedited payment of the adjustment amount.

2. Accounting Specifications

The parties should be wary of merely stipulating that the adjustment amount will be determined in accordance with generally accepted accounting principles (“GAAP”) consistently applied with past practice. GAAP embraces a wide range of acceptable accounting practices. GAAP is also constantly in flux, with FASB bulletins presenting new guidelines on an ongoing basis. Described below are many of the accounting issues that are implicated in drafting a quality post-closing adjustment.

a. “Preferable” versus “Acceptable” GAAP

Most post-closing adjustments contain a clause requiring that the closing date balance sheet conform to GAAP consistently applied over a relevant period that predates the sale. As noted above, parties involved in transactions often mistakenly believe that GAAP clearly defines one right number, and that little or no disagreement can arise. Arguments often ensue as to whether the method the seller used is more appropriate than the method the buyer prefers. Such disputes may arise in at least two situations. First, the buyer may propose an adjustment to the closing date balance sheet based on an accounting method different from that applied by the seller. Second, the seller may have prepared the financial statements used in negotiating and executing the purchase agreement according to one accounting method and subsequently may have switched, often subtly, to a method more favorable to the seller before the closing. This would arguably result in a closing date balance sheet prepared using a different accounting method than the historical information provided to the buyer, although both may be acceptable methods under GAAP. Obviously, these differences have the potential to significantly affect the final purchase price.

In these scenarios, each party may make a reasonable argument for its case. The consistent use of an acceptable accounting method, however, usually will prevail over a claim to change to a preferable accounting method. If the financial statements’ preparer has consistently applied an accounting principle that is in accordance with GAAP, an accountant would not normally take exception. Accountants know that GAAP provides little, if any, guidance regarding more acceptable or preferable methods in the application

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of GAAP. Much uncertainty can be removed by specifying which among the various acceptable GAAP approaches is to be utilized.

b. GAAP versus Consistency.

Another common issue involves the concepts of GAAP and consistency. Conflicts often arise regarding whether GAAP or consistency takes precedence in applying an accounting method to a particular transaction or a particular account balance. When GAAP and consistency requirements appear to conflict, experts usually designate GAAP as the higher and controlling standard. Though important, consistency normally is a secondary consideration to the use of GAAP. For example, a seller may have used consistent, non-GAAP accounting. In that case, absent other pertinent, contractual provisions or intent of the parties, appropriate adjustments should be made to conform the financial statements with GAAP if GAAP is the agreed upon standard.

In some instances, an agreement may specify consistency with respect to certain items. In such a case, consistency may prevail over GAAP, especially if the agreement clearly specifies a non-GAAP presentation of such items.

In addition, disputes may arise over the application of the term consistent. For example, consider the following language: the company “consistently provides an allowance for bad debts,” versus “provides an allowance using a consistent calculation methodology,” versus “provides a consistent amount in the allowance.” Careful drafting is thus required to capture the parties’ intent.

c. Interim versus Year-End Reporting.

The acquisition agreement may mandate consistency between the pre-closing financial statements used in negotiations and the final financial statements at closing. Because most companies apply more rigorous and in-depth closing procedures at year-end, questions may arise regarding which procedures the preparer of the closing date balance sheet should apply. The interpretation of such an issue may differ depending on whether the closing date balance sheet or the financial statements used in negotiations were month- or period-end, but not regular reporting year-end. For example, if the financial statements used in negotiations were for an interim month-end, and the agreement calls for consistently applied accounting principles, on what basis should the closing date balance sheet be prepared if the closing date falls at year-end? Conversely, if the financial statements used in negotiations were the last year’s audited financial statements and the closing date is

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an interim date, on what basis should the closing date balance sheet be prepared? If these timing issues are present in the acquisition, the drafter should specify the degree of rigor to be used in the preparation of the financial statements forming the basis of the post-closing adjustment.

d. Errors or Irregularities Discovered after Closing

Sometimes disputes arise as a result of information that becomes available after the closing date, such as the discovery of previously unknown errors, irregularities or material departures from GAAP. Because parties usually do not anticipate errors in the financial statements, most agreements do not address the treatment of such issues. The handling of this situation depends on the circumstances of the error and its discovery. For example, if the financial statements used in the negotiation process contained the error, but the seller corrected it to its benefit in the closing date balance sheet, the buyer may object by arguing that the seller should not benefit from its own errors. If the buyer, however, detects an error detrimental to it in the closing date balance sheet and such error was not present in the financial statements used in the negotiations, the buyer generally should receive a purchase price adjustment. The circumstances surrounding the error – when it occurred, when it became known, when the seller corrected it – will influence how it should be treated in the purchase price adjustment.

e. Materiality.

Interpreting and applying the accounting concept of materiality to individual items, transactions, balance sheet or income statement line items, or the financial statements taken as a whole can result in dispute. In purchase price disputes, the buyer usually will claim that all purchase price adjustments, if deemed proper, should be awarded to it regardless of materiality, unless the contract contains a threshold, basket or other similar clause.

Agreements occasionally contain clauses indicating that post-closing adjustments will be made only if they exceed a specified dollar amount in the aggregate – a materiality threshold. The contract clause may provide that once the adjustments exceed such levels, the benefiting party receives the entire amount; or the clause may read that such party will receive only the amount by which the adjustments exceed the specified level (a basket or deductible limitation). A materiality level may also be implied through contract clauses. For instance, a contract may read that no post-closing adjustment is necessary if the net asset value changes less than 5% from the net asset value in the financial statements

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used in the negotiations process. This implies that the parties agreed upon a materiality level of 5% of the net asset value. In many true-up formulations, however, the purchase price is adjusted upward or downward based on the precise result of the post-closing adjustment.

Accountants have traditionally evaluated materiality with respect to the financial statements taken as a whole. Occasionally, however, a purchase agreement indicates that materiality applies on a line-item basis, thereby lowering the materiality threshold.

If the agreement does not address materiality in any context, either party may have a difficult time arguing that a materiality threshold should apply to proposed purchase price adjustments. The seller may argue that it represented that the financial statements would be prepared in accordance with GAAP, which contains the concept of materiality. Therefore, to the extent that the buyer proposes adjustments that are immaterial, either individually or in the aggregate, the seller may successfully argue that it did not violate the representations made in the purchase agreement. In contrast, the buyer will argue that material for financial statements of a going concern business means something different from material for balance sheets closing a purchase transaction. For the going concern, an item can be in error, but the same error occurring year after year will not significantly affect recurring operating income numbers and computations made on them. For a buyer, an upward change in purchase price of $250,000, for example, may be worth arguing about even though the amount would not be material to the financials as a whole. Carefully drawn purchase agreements will address the materiality standards to be used in balance sheets closing a purchase transaction.

f. Changes in Accounting Policies or Practices.

Buyers often will argue that sellers have changed their accounting policies or practices in preparing the closing financial statements, and that this change violates representations or covenants in the agreement. The following list includes common arguments with respect to balance sheet allowance or valuation accounts:

• inventory obsolescence or excess inventory;

• doubtful accounts receivable;

• returns and allowances; or

• estimated liability amounts.

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The process of deriving the balances in these accounts involve judgments that the seller may not closely review and adjust during interim periods. Examples of common disputes include a downward adjustment to an accrued liability by the seller in preparing the closing date balance sheet, or reducing a general portion of the allowance for doubtful accounts. Again, these disputes raise consistency issues. The seller may indicate that it reviews such accounts only periodically and at year-end, so that presenting a balance sheet in accordance with GAAP required the adjustment. The buyer may contend that the seller did not consistently apply the accounting practices because the seller did not adjust the accruals downward when it prepared the pre-closing financial statements used in negotiations. These issues arise so often that parties should anticipate them in drafting contracts. The following chart indicates the most common sources of controversy for major balance sheet items.

BALANCE SHEET ITEMS AND ISSUES OFTEN INVOLVED IN DISPUTES

Accounts Receivable Allowances

• Adequacy of Allowances • Consistency of Allowances (methodology

and amount) • Hindsight Issues

Inventory

• Allowances for Obsolescence • Excess Inventory • Interim versus Year-End Count and

Valuation Procedures • Application of Standard Costs

Accounts Payable

• Complete Recording • Cut-Off Procedures and Consistency • Materiality

Accruals

• Interim versus Year-End Recording Procedures

• Materiality, Consistency • Recognition and Treatment of Interim

“Smoothing” of Accruals for Annual Expenditures

Contingencies

• Management Judgment Issues • Corporate Provisions • Statement of Financial Accounting

Standards No. 5 – Accounting for Contingencies

Revenue Recognition

• Deliveries under Long-Term Production Contracts

• Recording of Revenue under Government, Construction or Other Long-Term Contracts

• Recording of Revenue and Amortization of Cost Relating to Intangibles

• Deferral and Subsequent Recognition of Income

Capitalization Issues

• Capitalization of Development Costs • Deferral and Subsequent Recognition of

Income Capitalization of Tangible and Intangible Assets: Amortization Periods

• Consistency

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g. Hindsight.

Often, a buyer may contend that allowances reflected in the closing date balance sheet (such as those for bad debts) are inadequate and were therefore not stated in accordance with GAAP. For example, a buyer may argue that a seller’s $100,000 bad debt allowance was inadequate because the buyer has learned post-closing that $200,000 of accounts receivable are uncollectible. The buyer may have a valid argument if it can prove that information justifying a $200,000 allowance was available to the seller when it prepared and finalized the closing date balance sheet. For instance, the auditors may have identified this exposure and recommended an allowance of $200,000. If the buyer does not have reasonable evidentiary indications that information or knowledge existed prior to the preparation of the closing date balance sheet, it will likely rely on hindsight. Generally, the buyer’s use of hindsight beyond the issuance date of the financial statements is not persuasive, especially if the seller’s method to calculate the amount prospectively conforms with GAAP and the seller’s historical practices.

h. Right to Offset.

Though not written into purchase agreements, sellers often claim a right to offset as a defense against paying purchase price adjustments proposed by a buyer that has objected to balances or items in a closing date balance sheet prepared by the seller. Buyers typically will review the closing date balance sheet and identify areas or accounts that contain, in their view, overstated assets or understated liabilities. Acceptance of these adjustments would result in purchase price adjustments favorable to the buyer.

Because buyers seek to reduce the purchase price, they may identify only those items favorable to them, even though they may be aware of contractually required adjustments that would be unfavorable to them. For example, in its post-closing review of a closing date balance sheet prepared by a seller, a buyer might note that the vacation liability is under-accrued by $300,000 and that the worker’s compensation liability is over-accrued by $300,000. The buyer may ignore the over-accrual and claim $300,000 in a purchase price adjustment relating to the under-accrual associated with the vacation liability. This may lead the seller to claim the right to offset an under-accrual by a corresponding over-accrual. The seller may argue that this right to offset must exist to prevent the buyer from selectively objecting to the closing date balance sheet. In some instances, the seller may have been aware of both the over-accrual and under-accrual, but chose not to record the offsetting adjustment.

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The seller, additionally, may claim that the financial statements, taken as a whole, accord with GAAP, because the items offset each other.

Because agreements seldom provide for rights to offset, it may be difficult for the trier of fact to ascertain the intent of the parties and decide whether to adjust the purchase price in the event the parties do not settle the issue. Careful drafting can reduce uncertainty with regard to offsets.

3. Issues of Control

Issues of control arise in situations in which the party in control of the operations can potentially manipulate accounting and financial reporting to its benefit through the post-closing adjustment process. For example, in a management buyout, the buyer in effect runs the company during the period between signing the agreement and the post-closing adjustment. This time period presents an opportunity (whether exercised consciously or subconsciously) for management to manipulate the accounting and financial reporting to benefit its members through the post-closing adjustment.

Alternatively, when a seller operates the company during the stub period between the date of signing the agreement and the closing date, it may take advantage of its control and clean up the balance sheet to the buyer’s detriment. Buyers recognize this potential and therefore require several provisions in the form of representations, warranties or covenants in the contract to prevent the sellers from doing so. Buyers are cautioned not to place undue reliance on general covenants, such as the requirement that the seller operate the target in the ordinary course of business between the signing and the closing. First, this provision at best protects against manipulation after the signing (and not before). Second, proving that a practice does not comport with the seller’s ordinary course of business is difficult. If a particular form of manipulation is feared, carefully crafted restrictive covenants should be considered. Further, these carefully crafted representations should be bolstered with a post-closing adjustment that reflects changes occurring in the stub period, regardless whether they occur in the ordinary course or are the result of manipulation.

Conversely, it should be noted that the post-closing adjustment is not a substitute for thoughtful representations and warranties. If the seller generates or preserves cash by cutting back on discretionary expenses, the result will be an increase in cash but not necessarily an offsetting increase in accounts payable. Thus for example, the seller might decide to cut back on advertising expenses resulting in a short-term increase in cash but no change in accounts payable. Under a working capital post-closing adjustment, the purchase price will increase even though the business is arguably worse off and in fact may suffer lower revenues in the future because of the failure to advertise. Thus, the manipulation is rewarded by the post-closing

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adjustment. Only a representation can provide the buyer with a remedy in this situation. See M. Tresnowski, “Working Capital Purchase Price Adjustments – How to Avoid Getting Burned,” The M&A Lawyer, Oct. 2004.

Issues of control are almost inevitably present when the target is a division or subsidiary of the seller. In this context, working capital is managed centrally and thus not part of a “closed system.” Thus the opportunity for significant movements in working capital is present and should be anticipated by careful drafting. Similarly, in this situation, the buyer should guard against disappearing intercompany assets, such as deferred tax assets.

4. Caps and Floors

Although relatively uncommon, the purchase price adjustment provision may contain a provision for a “cap,” which is an upper limit on the adjustment amount that may be paid out by the buyer and a “floor” that limits the adjustment amount that may be refunded by the seller.

Some risks are inherent in employing caps and floors. Parties should consider whether the use of a cap or a floor will grossly disadvantage one party if no other contractual remedies are provided. Employment of a cap or a floor may give rise to a risk that the party thus constrained will turn instead to contractual remedies in “unwind” provisions, deferred payment provisions and indemnity provisions.

5. Interplay Between the Post-Closing Adjustment and Indemnification

Carefully crafted acquisition agreements will explicitly deal with the impact that the post-closing adjustment has on the indemnification provisions of the agreement. Sellers should insist that buyers not be allowed to “double dip” by a recovery first under the post-closing adjustment and then again as indemnification. For example, if an error in the pre-closing date balance sheet line items of inventory or accounts receivable causes a net working capital post-closing adjustment, the seller should stipulate that this error should not also give rise to indemnification for a breach of the representation that these line items are stated in accordance with GAAP. The buyer should be allowed to recover the damage only once. The buyer may respond, however, that its loss from the inaccurate inventory or accounts receivable line item is greater that the mere impact on the post-closing adjustment, and insist upon collection the full loss, offset by the amount of the post-closing adjustment.

6. Dispute Resolution: Designation of Independent Accountants

Because it is not uncommon for disagreements to arise in the determination of the post-closing adjustment, the parties often agree upon a dispute resolution mechanism in the acquisition agreement rather than forcing the

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parties to resort to litigation. A common provision for dispute resolution is to designate a firm of independent accountants to review the closing date financial statements. These accountants may act as auditors (who review the financial data and provide an audit of the information) or as arbitrators (who make a determination as to the proper resolution of the disputes that have arisen regarding the closing date financials). If the identity of the independent accountants is not stipulated by the parties, the parties should specify the procedure for their selection.

The lawyers drafting the provision should state whether the independent accountants are to examine only the disputed line items, or whether they may review the entire closing financial statements. The Model Stock Purchase Agreement with Commentary, published in 1995 by the Committee on Negotiated Acquisitions, Section of Business Law of the American Bar Association (the “Committee”), provides for submission only of the “issues in dispute” to the independent accountants, effectively eliminating this uncertainty. Model Stock Purchase Agreement, § 2.6(a). Likewise, the Model Asset Purchase Agreement with Commentary, published in 2001 by the Committee, provides only for the submission of “issues remaining in dispute” after negotiations between the parties to the independent accountants. Model Asset Purchase Agreement, § 2.9(d).

To avoid the cost of third-party accountants’ fees on smaller issues, the parties may set financial limits on the issues that may be submitted to the third-party accountants for review. They may provide that they will split the amount in dispute or ignore those smaller issues.

Other issues to be considered in drafting the dispute resolution provision include:

• Should the arbitrator be required to have industry experience?

• Will the arbitration process include discovery and written submissions:?

• Will the arbitration be final and binding?

• What time frame allowing for negotiations should precede the arbitration and how long should the arbitration process take?

• Will interest accrue during the arbitration period?

• What rules should apply to the arbitration process?

In any event the dispute resolution provisions should clearly designate the party who is responsible for the payment of the expenses of the dispute

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resolution. Typically the costs are split, or the non-prevailing party is held responsible.

7. Mechanisms to Ensure Payment of the Adjustment Amount

The parties may place part of the purchase price in escrow to ensure expedited payment of an adjustment amount. If a promissory note has been used to finance the sale, the parties may agree to increase or decrease, as appropriate, the payments under the note to reflect the results of the purchase price adjustment.

IV. EARNOUTS

A. Overview

An earnout provision makes a portion of the purchase price contingent upon the acquired company reaching certain milestones during a specified period after the closing. The benchmarks used are typically financial, such as net revenues, net income, a cash flow measure or earnings per share. Non-financial benchmarks are appropriate in some circumstances. When the benchmark being measured reaches a negotiated threshold, an earnout payment is triggered.

Earnouts (as opposed to typical post-closing purchase price adjustments) are most often utilized when the buyer and seller cannot agree on the value of the target. They are particularly useful in dynamic or volatile industries, or when the buyer’s projections for the target are fundamentally more pessimistic than those of the seller. An earnout arrangement rewards the seller if its projections are accurate, while protecting the buyer from overpaying if they are not. Buyers can use earnouts as a source from which they can offset indemnification claims. An earnout also may be attractive to a buyer desiring to bridge a financing gap.

In situations in which the seller’s management will continue to run the target after the closing, an earnout arrangement may be used by the buyer to motivate management with performance incentives. If the earnout is used in this context, however, the earnout may be characterized as compensation rather than payment for the business and, as discussed later in this article, there may be accounting implications for the buyer.

Earnouts are used in transactions large and small, involving acquisitions of private and, to a lesser extent, public companies. Earnout arrangements are most likely to be used when the target is private since market valuations assist in the valuation of the public target. If an earnout is used to compensate public company shareholders, logistical problems will ensue unless careful planning is employed. To facilitate payments, a paying agent should be employed to disburse payments when received by the buyer. As discussed below under “Registration Issues for Earnout Rights”

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and to minimize logistical issues, typically earnout rights are structured so as to be non-transferable (except under the laws of descent and distribution).

B. Some Risks Associated with the Use of Earnout Provisions

If inappropriately drafted, an earnout can hinder a purchaser’s efforts to reorient or restructure the target, misappropriate future value to the wrong party or motivate the earnout’s recipients to focus on short-term goals that will maximize the earnout. Further, earnouts have great potential for engendering later disputes about the contingent payment. Disputes often arise when the seller suspects that the buyer is using different accounting techniques during the post-closing period to diminish the payout, or is artificially depressing revenues or earnings during the earnout period. The seller also fears that the buyer simply will not run the business successfully. Buyers face the risk that the payout formula will overcompensate the seller in some unforeseen way, due to other acquisitions or a change in the buyer’s post-acquisition business plan that essentially has nothing to do with the target. These fears, many legitimate, should cause counsel for the buyer and the seller to carefully craft the earnout provisions. The Model Asset Purchase Agreement with Commentary contains as an attachment a separate earnout agreement that provides drafting guidance. Since each earnout is unique, reliance on forms must be measured.

C. Drafting Issues

1. Establishing the Earnout Benchmark; Types of Possible Benchmarks

Earnout benchmarks may be financial or non-financial in nature, or both. In choosing milestones, and in drafting the acquisition agreement, the parties should identify and deal with any post-closing contingencies that could potentially alter the target’s ability to meet the earnout benchmarks.

a. Financial Benchmarks

Common financial benchmarks include the target’s net revenue; net income; cash flow; earnings before interest and taxes or “EBIT”; earnings before interest, taxes, depreciation and amortization or “EBITDA”; earnings per share; and net equity benchmarks.

Revenue-based benchmarks are often thought to be more attractive to sellers, since they will not be affected by operating expenses or acquisitions. The buyer’s post-closing accounting practices will likely have less impact on revenue than other items. Buyers are more likely to agree to a revenue–based benchmarks if costs of goods sold and overhead have little variability. Generally, however, buyers oppose revenue-based benchmarks because they provide no incentive to the earnout recipients to control expenses, and may provide an incentive to generate short-term sales that may prove to be unprofitable. Buyers generally favor net income benchmarks on the ground that they are the best indicator of the target’s success.

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Parties often use EBIT or EBITDA measures as milestones in order to allay sellers’ concerns about net income measures. EBIT and EBITDA reflect the cost of goods and services, selling expenses and general and administrative expenses, and thus are more difficult to manipulate. They are additionally desirable because they exclude interest, taxes, depreciation and amortization, which may vary based on the buyer’s capital structure or the way in which the acquisition is financed. Finally, for a transaction that is initially valued using a multiple of post-closing cash flow, the use of EBIT or EBITDA for the earnout is logical to determine what is in essence deferred purchase price.

Regardless of the financial benchmark chosen, the parties should carefully analyze the potential of the earnout to distort the incentive for producing long-term, sustainable growth. For example, as noted above, a revenue target may tempt the earnout recipients to book unprofitable business. An earnout based on cash flow or income could incentivize the earnout recipient to slash expenses (e.g. marketing and advertising costs) to bolster short-term profitability at the expense of long-term growth.

b. Non-Financial Benchmarks

Non-financial benchmarks often are used in acquisitions of development-stage companies. These companies may be difficult to value, due in part to their high growth rates, and are particularly suited to the use of non-financial milestones. In some industries, non-financial milestones may be the best indicator of fair value. Non-financial benchmarks may also serve the purpose of giving operational focus to the target.

A non-financial benchmark could be completion by the company of a core product or new product, inclusion of a favorable article in a publication that meets specific criteria or the receipt of a “best technology” or “best in show” award for the company’s technology or product. See Spencer G. Feldman, The Use of Performance (Non Economic) Earn-outs in Computer Company Acquisitions, INSIGHTS, August 1996.

2. The Formula for Calculating the Payment Amount

For financial benchmarks, the parties may stipulate the flat amount of consideration to be paid if the threshold is met. More typically, the buyer will pay the seller a specified percentage of the amount by which the target’s performance surpasses the threshold. For example, the buyer may make an annual payment to the seller equal to a percentage by which the target’s EBITDA for the year exceeds the threshold EBITDA agreed to by the

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parties. The payment also may be adjusted so that any shortfall in EBITDA for a previous year will reduce the payment otherwise due for the current year. An often difficult negotiation ensues regarding whether payments are prorated if the threshold is only partially achieved. This negotiation is sometimes settled by establishing a minimum hurdle before any payment will be made and providing a sliding scale or proration after that hurdle is achieved. For non-financial thresholds, the parties must agree upon an amount of cash consideration or a number of shares of stock that will be delivered for each milestone that is met. In any event, the payout is often capped at a specified amount.

Care must be taken to specify with particularity the source of the earnout –whether the threshold is to be applied to a product line, the entire target, the division into which the target is absorbed or some other source.

Lenders will often consider the recipient of an earnout an equity holder and seek to subordinate the payment to the lender's unsecured obligations, including seeking to limit payments while the lender's debt is outstanding. The seller will object strenuously to such a limitation, likely making its objection known early in the negotiation. On the other end of the spectrum, the seller may demand credit enhancement (for example a letter of credit) for the earnout. These negotiations will turn on the leverage of the parties and the financial position of the buyer.

3. The Length of the Earnout Period

Most earnout periods conclude after the expiration of a specified length of time – generally between two and five years after the closing The appropriate length will be determined based on how long it will take to measure the projected value of the target or the period during which the buyer desires to incentivize the former owners. On occasion the earnout is payable upon the occurrence of a specific event, such as the sale of the target, a change in control of the buyer or the termination of the earnout recipient's employment. Because earnouts may affect the flexibility of the post-closing operation of the target, and few subsequent purchasers of a business will accept assets burdened by an earnout, it is usually advisable to the purchaser to have a buyout option for the earnout. Crafting the valuation of the earnout buyout is generally difficult. Often parties rely on a multiple of historic payments or an expert valuation of the target.

4. Determination of Whether the Threshold Has Been Satisfied

a. Determination of the Earnout

The seller should insist that the buyer maintain separate books and records for the target, division or other source of the earnout throughout the earnout period. The buyer should covenant that these

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financial records will be made available for review upon reasonable notice.

The buyer and its accountants typically will make the initial determination of whether the milestones have been reached. The seller then will review the calculations and challenge them if necessary. In certain situations, it may be appropriate to require that the results of the earnout period be audited.

b. Accounting Issues

For financial milestones, the parties should stipulate with as much detail as possible the accounting principles that will be used to calculate whether the thresholds have been met. As noted above, GAAP embraces a wide range of acceptable accounting practices, and is consistently in a state of flux. The ability to manipulate the results of an earnout through adjustment to GAAP is often legitimately of great concern to the seller. Particular care in delineating the calculation principles should be used if the threshold is a non-GAAP financial measure, such as EBIT or EBITDA. The parties thus should incorporate into the acquisition agreement a description of the accounting principles to be employed. Listed below are specific accounting issues that may arise:

(1) Consistency of Practice in Post-closing Accounting

A problem may arise in the form of movement of revenue and expenses by the party in control of the target after closing. The lawyers drafting the earnout provision should address this possibility and stipulate that post-closing accounting in this regard should not vary from prior practice. Special care must be taken, however, if the target was fundamentally different in the hands of the seller than the way it will be treated by the buyer (e.g., if the seller was an S corporation or compensation expense of the target as a C corporation was artificially high). Diligence into the pre-sale accounting policies of the seller will clarify past practice and reveal any areas of potential dispute. The parties should consider specifying whether changes in GAAP promulgated by the FASB after closing will affect the determination of the earnout.

(2) Potential Exclusions in Calculating the Payout and Other Possible Adjustments

• The seller should seek to exclude all transaction, restructuring and integration related expenses that are

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charged against the earnings upon which the earnout is calculated.

• When net income is used as the performance yardstick, parties almost always adjust for heightened depreciation caused by a write-up in assets obtained in the acquisition. Prior to the FASB’s adoption of SFAS No. 142, Goodwill and Other Intangible Assets, effective June 30, 2001, parties also almost always added back goodwill amortization in calculating an earnout based on net income. SFAS No. 142 eliminates the amortization of goodwill for calendar year companies for (a) goodwill acquired after June 30, 2001, and (b) for goodwill existing on June 30, 2001, after December 31, 2001. Instead, SFAS No. 142 requires an annual impairment test based on a comparison of the fair value of each reporting unit that houses goodwill acquired to the carrying amount of the reporting unit’s assets, including goodwill. Parties should consider the impact of the annual impairment tests in determining the earnout with respect to a transaction.

• When net income, EBIT or EBITDA are used as the performance measures, the seller should ascertain what administrative or general overhead expenses the buyer will allocate to the target after closing and determine how those expenses will impact the post-closing figures. For example, the allocation of corporate headquarters’ expenses and services allocated among affiliates should be carefully considered.

• The seller will likely attempt to exclude executive compensation expense allocated to the target.

• The seller’s counsel also may argue that indebtedness resulting from the acquisition allotted to the target after closing should be excluded when calculating the earnout. If interest is excluded, care should be taken to exclude expenses associated with financings and prepayment penalties. The exclusion that covers the initial acquisition indebtedness should also cover subsequent refinancings.

• The parties also may desire to exclude extraordinary gains and losses.

• Intercompany transactions between the target and the buyer or its affiliates also require adjustment to reflect the amounts that the target would have realized or paid if

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dealing with an independent third party on an arm’s length basis. If an intercompany charge from the parent (even if characterized as a management fee) is actually a distribution of profits, the payment should not be treated as an expense in the calculation of the earnout.

• While most exclusions from the earnout calculation are demanded by the seller, the purchaser should consider whether exclusions are appropriate. In some situations it may be appropriate for synergies arising out of the combination to be excluded from the earnout. Particularly if the buyer intends to use the target as a platform for future acquisitions, revenue, income or cash flow from these acquisitions may need to be excluded in the earnout calculation.

(3) Payments Pursuant to Tax-sharing Agreements

In most situations the target, once acquired, will become a party to a tax-sharing agreement with the buyer’s taxpayer group, or become a part of the buyer’s consolidated tax reporting group. The seller’s counsel should assure that payments made by the target pursuant to the agreement or as a member of the group do not have unanticipated effects on the attainment of the earnout thresholds.

(4) Accounting Treatment of the Contingent Consideration When Linked with Future Employment

A difficult accounting issue arises in those transactions in which contingent consideration is linked with the continued employment of the seller’s management. In transactions in which the contingency is based on the future earnings of the seller and the management of the seller enters into employment contracts with the new entity, the question arises whether the substance of the additional payments is truly a payment for the seller or rather a salary expense in the form of bonuses based on production. The issue is particularly relevant to acquisitions of small businesses.

In 1995, the FASB’s Emerging Issues Task Force reached a consensus on this issue in EITF 95-8, Accounting for Contingent Consideration Paid to the Shareholders of an Acquired Enterprise in a Purchased Business Combination. The consensus opinion notes that the following factors should be considered when evaluating the propriety of accounting for contingent consideration based on earnings:

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• reasons for contingent payment provisions; • the formula for determining contingent

considerations; • treatment of the contingent payment for tax

purposes; • linkage of payment of contingent consideration

with continued employment; • a composition of the shareholder group; and • other arrangements with shareholders, such as

noncompetes, consulting agreements and leases.

The determination as to whether payment of contingent consideration represents purchase price or compensation is based on facts and circumstances. The EITF notes that if a contingent payment arrangement is automatically forfeited if employment terminates, a strong indicator exists that the arrangement is, in substance, compensation. The EITF goes on to note, however, that the absence of linkage between continued employment and payment of contingent consideration does not necessarily imply that the payment of a contingency represents purchase price. Another factor is the proportionality of the seller’s right to receive earnout payment compared to the seller’s ownership interest. If proportionality exists, the earnout is more likely to be characterized as a deferred payment. If proportionality is lacking, then the earnout is more likely to be compensatory in nature. See Kimberly Blanchard, The Taxman Cometh, BUSINESS LAW TODAY, May/June 1997, at 61.

It is important to note that an earnout must be treated consistently as to avoid re-characterization. “As a threshold manner, an earnout should be treated as compensatory only if the seller actually performs services for the buyer after the sale or gives an economically meaningful covenant not to compete.” Kimberly Blanchard, The Taxman Cometh, supra, at 60.

The same principles that are relevant for the accounting characterization of the earnout payment apply to the tax treatment of the payments. Earnout payments to sellers who participate in running the business of the target during the earnout period may be treated, not as a capital gains, but as ordinary income.

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(5) Other Issues to be Considered

Other potential areas for variation that should be addressed include inventory valuation methods (LIFO versus FIFO, as well as the manner of treating inventory as obsolete), depreciation schedules, accounting for retirement and welfare benefits and reserves for bad debts. The parties should carefully consider whether there are matters of heightened concern or specific to the target's industry, often mandating that the parties specify the accounting methodology to be used.

5. Form of Payment of Earnout Obligation

Cash is often used as the earnout payment, but not infrequently the contingent consideration is stock. The use of cash may be a problem when the target is thriving and the buyer’s other businesses are performing poorly. On the other hand, the use of stock to satisfy the earnout may dilute the buyer’s earnings per share. Additionally, the use of stock raises various valuation, securities and tax issues. The purchaser may be required to specify the maximum number of shares that will be issued as part of the earnout arrangement for securities and tax reasons that are detailed below.

a. Valuation Issues

The parties to the acquisition agreement must determine the date as of which the stock used in the earnout will be valued, which will likely be at either the time of the closing or the time of issuance. If the time of the closing is selected, the buyer likely risks an increase in the acquisition price caused by a run-up in the stock price between closing and the issuance.

The seller runs the risk that the buyer will issue additional common stock during the earnout period that is priced lower than the market price or the per share value assigned in the acquisition. Counsel for the seller may suggest a provision designed to protect against dilution of the shares that are earned but have not yet been distributed.

b. Securities Issues

The stock that is issued in an earnout must, of course, be registered or exempt from registration. Affiliates of the target who receive stock and affiliates of the buyer must abide by the selling restrictions of Rules 145(d) and 144, respectively, of the Securities Act.

Practitioners should examine Rule 144(d)(3)(iii), under which the earnout stock may be deemed to have been acquired at the time of the transaction’s closing for purposes of calculating the holding periods

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of Rule 144 if the issuer or affiliate was then committed to issue the securities subject only to conditions other than the payment of further consideration for such securities. An agreement to remain employed or not to compete entered into in connection with a transaction, or services performed pursuant to such an agreement, are not deemed payment of further consideration. See also Medeva PLC, 1993 SEC No-Act LEXIS 1145 (concluding that the holding period for shares issued as deferred consideration commenced on the date the target shareholders elected to receive payment in shares rather than cash).

Additionally, in connection with the listing of the buyer’s stock at the time of the acquisition, a securities exchange will likely require that the buyer specify a limit on the number of its shares to be issued as contingent consideration.

c. Related Tax Questions

If the acquisition is structured as a tax-free reorganization, the use of contingent consideration may cause difficulties for the parties. In all types of tax-free reorganizations, there are limits on the amount of cash or other property (other than stock) that can pass as consideration. The permissible amounts vary by transaction form. Care must be taken to limit cash earnout payments to that allowed under the applicable reorganization type or to pay the earnout in additional stock that meets the applicable requirements.

Similar to escrow payments, amounts paid to the seller in years following the year of sale generally will be taxed on the installment method described above. The specific treatment will depend on whether there is a stated maximum earnout amount or simply a period over which the earnout payments will be made.

With respect to otherwise tax-free transactions, the Original Issue Discount Rules of Section 483 of the Internal Revenue Code require that some portion of the deferred consideration, if made in stock, must be allocated to interest, reportable as such by the seller and deductible as such by the buyer. The remaining portion of the stock is generally treated as additional tax-free consideration emanating from the original purchase. The IRS has issued ruling guidelines relating to the treatment of this contingent stock in Rev. Proc. 84-42, 1984-1 C.B. 52.

6. Operation of the Acquired Business During the Earnout Period

Both the buyer and the seller may fear mismanagement during the earnout period that could affect the payout.

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a. Operation by the Buyer Post-closing

The seller typically has concerns that the target will not be properly managed after the closing In situations in which the seller’s management team will not be retained post-closing, the seller likely will require that the buyer operate the target in the ordinary course of business consistent with past practice, and will attempt to reserve, through contractual covenants, some authority regarding major decisions made during the earnout period. The seller will likely demand that the target be operated as a distinct business entity or division so that its results can be verified. The seller may require that the buyer adequately fund the target during the earnout period so that it will be able to capitalize on opportunities presented to it. It is not uncommon for the seller to establish minimum absolute funding levels. The earnout may be crafted to acknowledge the parties’ agreement or intent to exploit specified opportunities. Any limitation of the buyer’s freedom to run the target as circumstances require likely will be resisted.

b. Operation by the Seller’s Management Team Post-closing

Less commonly, the seller’s management will continue to operate the target post-closing. In this situation, the buyer’s risk is that the seller’s management team will operate the business so as to unfairly maximize the payout amount. Counsel for the buyer should attempt to provide appropriate controls over the target, including a mechanism for reviewing decisions that can affect the payout.

c. Protection Placed in the Acquisition Agreement

The parties also may wish to include detailed post-closing operational procedures in the acquisition agreement in order to avoid uncertainty. For example, the buyer might covenant to operate the company consistent with past practice subject to certain exceptions, or the buyer might agree to restrictive covenants that prevent the target from taking specified actions (such as making large expenditures) during the earnout period.

In Horizon Holdings, LLC v. Genmar Holdings, Inc., 244 F. Supp. 2d 1250, 1257-58 (D. Kan. 2003), the court held that when evaluating the principles of good faith and fair dealing, a court may imply terms to honor the parties reasonable expectations. In Horizon, the seller had remained on staff as president of the new entity in an attempt to realize the $5.2 million earnout. The earnout was defined in the agreement as part of the purchase price. The seller had been assured that he would be given autonomy as president and that he had a realistic opportunity to receive the earnout. However, upon acquiring

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Horizon, the buyer interfered with business operations and prevented the seller from meeting the earnout threshold. In sweeping language, the court held that it could imply terms in an agreement to honor the parties reasonable expectations when those obligations were omitted from the text of the contract. In determining whether to imply terms in an agreement, the court noted that the proper focus was on “what the parties likely would have done if they had considered the issue involved.” The court stated that the jury could have readily concluded that the parties would have agreed, had they thought about it, that the buyer would not be permitted to undermine the president’s authority, to abandon the companies brand name, or to mandate production of a rival product thereby impairing the realization of the earnout. The jury award of $2.5 million was upheld.

A key lesson to be learned from the Horizon Holdings case is that the parties should be explicit in crafting the expectations for the post-closing conduct of the parties to circumvent a court setting the ground rules.

In another recent earnout case, Richmond v. Peters, et al., 155 F.3d 1215 (6th Cir. 1998), plaintiff sold his business to defendant with the price and payments to be determined, in substantial part, by reference to the profits of the continuing business in excess of a base-level amount. The agreement between them provided that the business was to be managed in accordance with “sound business practices.”

Plaintiff claimed that defendant breached their agreement and further breached a fiduciary duty owed by defendant to the seller. On motion for judgment as a matter of law after plaintiff presented its case, the trial court ruled that Ohio law imposed no fiduciary duty upon defendant and that plaintiff had presented no evidence that defendant had breached any provision of the agreement.

The court held that the facts of the case should be reviewed with respect to the contract claim. It is significant, however, that the trial court found, and the appellate court agreed that, at least under Ohio law, the earnout agreement created no implied fiduciary duty between the parties.

7. Payment of Earnouts to Public Shareholders

Payment of earnouts to public shareholders of a seller that does not survive the transaction can be a logistical problem. One common solution is to establish a paying agent to disburse earnout payments to the seller’s former shareholders. This paying agent may handle any disputes with the buyer during the earnout period as well.

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8. Shareholders Designated to Act for the Seller

In situations in which the entire seller is sold to a buyer in a transaction with an earnout, the parties should consider establishing a committee to act on behalf of the persons who were shareholders of the seller at the closing. The committee would speak for the shareholders on matters relating to the earnout and indemnification. The provisions establishing the committee should delineate its powers and how it can act. Funds should be set aside to cover the expenses of the committee and its counsel. Often, the acquisition agreement simply will specify that the buyer will communicate with the committee, or shareholders’ representative, post-closing. In such case, the obligations of the committee to the shareholders will be addressed in a separate shareholders’ representative agreement.

9. Sale of the Target During the Earnout Period

The parties should determine whether the target or a portion thereof may be sold to a third party during the earnout period, and the effect of such a sale should it take place. A similar problem arises when a third party acquires the buyer during the earnout period. As suggested above, the lawyers for the seller may suggest that the third party buyer be obligated to pay off some or all of the earnout amount at the time of the second sale.

10. Integration of the Target into the Buyer’s Other Businesses

The parties must decide how to calculate the earnout if the target should be merged into similar entities owned by the buyer. The difficulty of measuring performance in this case may make buyers reluctant to fully integrate the acquired business into the rest of the buyer’s business. A parallel difficulty arises when the buyer acquires additional, similar businesses during the earnout period. In these situations, the buyer and seller must work with accountants to formulate a plan for segregating the financial statements that form the basis of the target’s earnout thresholds. This segregation can preclude the buyer from achieving the economies of scale and synergies it anticipated in consummating the acquisitions. One solution is to assess the financial performance of the whole group and, for purposes of calculating the earnout, assign to the target its pro rata share of the overall amount. Alternatively, some buyers pay off the sellers during the earnout period to end the arrangement early.

11. Averaging Periods of Strong Performance With Weak Performance The parties must decide whether performance well above threshold levels in

one part of the earnout period may be applied to supplement a lesser performance during another part of the earnout period.

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12. Dispute Resolution Disputes regarding earnouts are commonplace, and the lawyers drafting the earnout provision are well advised to consider the appropriate form of dispute resolution under the circumstances. Many earnouts require binding arbitration of disagreements that the parties cannot resolve within a brief period of time. Arbitration is favored over litigation because the former generally is faster, less expensive and a better forum within which to deal with complex financial issues. However, the growing perception that arbitrators render “split the baby” decisions that attempt to satisfy both sides has caused some advisors to favor litigation as a more predictable source of appropriate outcome. If litigation is favored, jurisdiction and venue should be specified. All provisions regarding dispute resolution should be detailed and carefully crafted anticipating all plausible scenarios.

13. Registration Issues for Earnout Rights

Under certain circumstances earnout rights may be deemed securities under the Securities Act. To prevent the necessity of registration, acquisition agreements usually prohibit any transfer of the right to the earnout payment and assert that the right is not an investment contract or other type of security.

In a series of no-action letters, the SEC evaluated whether or not specific earnout agreements constitute a security.1 The SEC emphasized that the facts of any particular situation must be evaluated closely, but it concentrated on the following factors when deciding that a particular earnout did not constitute a security:

• The earnout right was granted to the sellers as part of the consideration for the sale of their business and neither the purchasers nor the sellers viewed the right as involving an “investment” by the sellers;

• The earnout right did not represent an ownership interest in the purchaser and was not evidenced by any certificates;

• The earnout right could not be transferred except by operation of law; and

• The earnout right did not entitle the owner to voting or dividend rights.

1 For further information, refer to Great Western Financial Corp., SEC No-Action Letter, No. 042583014 (April 4, 1983); Northwestern Mutual Life Insurance Co., SEC No-Action Letter, No. 030783002 (March 3, 1983); Lifemark Corp., SEC No-Action Letter, No. 112381006 (November 17, 1981); and Kaiser Aetna, SEC No-Action Letter, No. CCH19730730010 (July 30, 1973).

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14. Special Industry Limitations

Advisors to parties desiring to structure an earnout are cautioned to ascertain the legality of the arrangement under the regulatory laws applicable to the transaction. For example, under the federal self-referral statute (commonly known as “Stark”) a hospital may not pay for a physician practice it acquires in installments or through an earnout (assuming the physicians will refer to the hospital after the transaction). The prohibition’s rationale is to eliminate a physician’s motivation to refer to the hospital, thereby enhancing the financial strength of the hospital so it can pay the earnout. Other industry-specific requirements may affect the ability to structure acquisitions with earnouts.

V. CONCLUSION

There are many forms of consideration paid in acquisitions, all with their own advantages and disadvantages. The most common forms of payment are cash, stocks, promissory notes, the assumption of indebtedness or some combination thereof. The parties should pay close attention to the accounting, tax, securities laws and practical consequences of each form of consideration. Importantly, the chosen form of consideration may affect the leverage between the parties after the closing.

In many transactions, some form of purchase price adjustment is appropriate. Even when there is fundamental agreement between the parties as to the purchase price, if there is lag time between the pricing and closing, some form of “true-up” may be appropriate.

Earnouts are usually employed when there is a disagreement as to the value of the target, but may also be useful in other scenarios such as a performance incentive. Parties should take great care in crafting the earnout. They should specify, in detail, the nature of the hurdle giving rise to the earnout obligation, the accounting methods that will be used in ascertaining whether the earnout has been achieved, the inclusions and exclusions from the earnout calculation and who will determine whether the earnout threshold had been met. It is essential that all possible scenarios be explored as the earnout is crafted to avoid future conflict.

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Purchase Price Adjustment Bibliography

COMMITTEE ON NEGOTIATED ACQUISITIONS, MODEL ASSET PURCHASE AGREEMENT WITH COMMENTARY, pp 58-64, AMERICAN BAR ASSOCIATION (2001)

COMMITTEE ON NEGOTIATED ACQUISITIONS, MODEL STOCK PURCHASE AGREEMENT WITH COMMENTARY, pp 42-46, AMERICAN BAR ASSOCIATION (1995)

DILLEN, CHRISTOPHER D. AND PLETCHER, BRETT A., Ch.5. Structuring the M&A Exit Transaction, C. Selected Additional Purchase Price Topics, 2. Purchase Price Adjustment (pp 5-79-5-81), THE ACQUISITION AND SALE OF THE EMERGING GROWTH COMPANY: THE M&A EXIT, GLASSER LEGALWORKS (2004)

HALLER, MARK W., KREB, KEVIN D., PERKS, BENJAMIN, W. AND RIORDAN, THOMAS K., Mergers, Acquisitions, and Divestitures: The Nature of Disputes and the Role of the Financial Expert, LITIGATION SERVICES HANDBOOK-THE ROLE OF THE FINANCIAL EXPERT

HARPER, ROBERT T., Financial and Accounting Provisions in Acquisition Agreements—Purchase Price Adjustment Mechanisms, AMERICAN BAR ASSOCIATION, SECTION OF BUSINESS LAW, 1998 SPRING MEETING (April 1998)

ISAACS, JEFFREY S. AND WISEMAN, STEPHEN M., The Pitfalls of Purchase Price Adjustment Provisions, ACC DOCKET (September 2004)

KLING, LOU R. AND NUGENT, EILEEN T., §17.02 Post-Closing Adjustments, NEGOTIATED ACQUISITIONS OF COMPANIES, SUBSIDIARIES AND DIVISIONS

LIDBURY, JAMES T., Drafting Acquisition Agreements, Drafting Corporate Agreements 1998-1999, CORPORATE LAW AND PRACTICE COURSE HANDBOOK SERIES, PRACTISING LAW INSTITUTE (1998)

MALT, R. BRADFORD, Corporate Mergers and Acquisitions: Discussion Outline of Purchase Price Considerations, 20TH ANNUAL ADVANCED ALI-ABA COURSE STUDY (September 9-10, 2004)

MALT, R. BRADFORD, Selected Materials on Acquisition Basics, Part IX. Discussion Outline of Purchase Price Considerations, C. Post-Closing Adjustments, ACQUISITIONS & DIVESTITURES, BUSINESS LAWS, INC.

SCHECTOR, DAVID, Avoiding or Resolving Purchase Price Disputes, THE CPA JOURNAL ONLINE (March 1993)

SINHA, PANKAJ AND ELSEA, ERIK, Purchase Price Adjustments: A Survey, THE M&A LAWYER (October 2004)

THOYER, JUDITH R. AND KORRY, ALEXANDRA D., Drafting and Negotiation of Agreements Relating to the Sale of a Division, Advanced Doing Deals, PRACTISING LAW INSTITUTE (June 5-6, 1997)

TRESNOWSKI, MARK B., Working Capital Purchase Price Adjustments—How to Avoid Getting Burned, THE M&A LAWYER (October 2004)

WARYJAS, MARYANN A., 501 Negotiating the Acquisition Agreement—Post-Closing Purchase Price Adjustments—and 557 Negotiating the Purchase Price—Post-Closing Purchase Price Adjustments—Drafting Corporate Agreements 2004-2005, PLI CORPORATE LAW AND PRACTICE COURSE HANDBOOK SERIES, PRACTISING LAW INSTITUTE (December 2004-January 2005)

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SAMPLE CLAUSES REGARDING ADJUSTMENTS FOR EXPENSES AND REVENUES FROM TENANTS

PLUS WORKING CAPITAL ADJUSTMENT

Section 8.2 Adjustments.

(1) The Purchase Price shall be adjusted in accordance with the Purchaser’s Proportionate Interest as of the Closing Date for all items of income and expense and other items adjusted in accordance with usual commercial practice for adjustment between a vendor and purchaser with respect to the purchase and sale of assets comparable to the Issuer’s Assets (with the Closing Date itself being allocated to the Purchaser). Without limiting the foregoing, the adjustments shall include interest under the Fixed Rate Mortgages, any holdback by mortgagees under the Fixed Rate Mortgages and mortgages pursuant to the Required Refinancing Transactions, less the costs associated with the release of such holdbacks, to the extent the same are applicable and appropriate, realty taxes, local improvement charges, other taxes, assessments and recoveries, resolved Assessment Appeals, operating costs, additional rent, landlord recoveries from Tenants, utility deposits, current rents, prepaid rents, interest accruing to Tenants, if any, on any amounts prepaid by the Tenants under any of the Leases and landlord's contributions to promotional funds collected from Tenants and interest thereon, if any.

(2) Any inducement (being all tenant inducements, tenant allowances and rent free periods and any and all costs of any lease takeover, assumption, assignment or other similar commitments payable pursuant to any of the Leases in existence as of the date hereof with the exception of those leases entered into in accordance with the terms of Section 5.1(c) including commissions, fees and similar costs related thereto, and excepting any such inducements, allowances, costs or commitments where the same arise as a result of amendments or renewals effected pursuant to Section 5.1(b)) applicable on or following the Closing Date shall be the responsibility of the Current Limited Partners or, if not paid by the Current Limited Partners by Closing, the Purchaser’s Proportionate Interest thereof shall be paid to the Purchaser by way of adjustment on the Closing Date, all without duplication.

(3) The adjustments contemplated by Section 8.2(1) and Section 8.2(2) shall be set out in a statement of estimated adjustments (the “Statement of Estimated Adjustments”) to be delivered to the Purchaser in draft no later than five (5) Business Days prior to Closing. With respect to matters which cannot be determined conclusively on or before the Closing Date, the Statement of Estimated Adjustments shall reflect estimated adjustments arrived at by the Current Limited Partners and the Purchaser, acting reasonably, subject to readjustment pursuant to the Statement of Readjustments. The Statement of Estimated Adjustments shall be based upon the most recently available management financial statement prepared by and shall, in addition to the matters contemplated by Section 8.2(1) and Section 8.2(2) above, set out a reasonable estimate of Net Working Capital (excluding any items already adjusted for in the Statement of Estimated Adjustments) as at the Closing Date (the “Estimated Net Working Capital Amount”). In the event the Estimated Net Working Capital Amount is a negative amount (the “Estimated Net Working Capital Deficiency”), a cash amount equal to the Estimated Net Working Capital Deficiency will be retained by the Issuer out of its available cash or will be paid by the Current Limited Partners to the Issuer.

(4) All available cash of the Issuer (excluding cash in the amount, if any, of the Estimated Net Working Capital Deficiency) shall be distributed by the Issuer to the Current Limited Partners on Closing.

(5) A statement of readjustments (the “Statement of Readjustments”) shall be prepared by and settled among the Purchaser and the Current Limited Partners, acting reasonably, and the appropriate readjustments to the Statement of Estimated Adjustments shall be made not later than 6 months after the Closing Date unless the parties otherwise agree. The Statement of Readjustments shall include a statement of Net Working Capital (excluding any items already adjusted for on the Statement of Readjustments) as of the Closing Date (the “Closing Net Working Capital Amount”). In the event the Closing Net Working Capital Amount exceeds the Estimated Net Working Capital Amount, the difference shall be paid by the Issuer to the Current Limited Partners. In the event the Closing Net Working Capital Amount is less than the Estimated Net Working Capital Amount, the difference shall be paid by the Current Limited Partners to the Issuer.

(6) There shall be no adjustment under this Section 8.2 for security deposits remitted by Tenants under the Leases or other amounts of a similar nature which are neither income nor expense to the Issuer, provided that all such amounts in respect of which there is to be no adjustment as aforesaid shall be retained by the Issuer on Closing.

(7) The parties hereto acknowledge and agree that the purchase price under a Offering Transaction shall be adjusted in a manner consistent with the adjustments contemplated by this Section 8.2.

(8) For clarity and for the purposes of this Section 8.2, it is agreed that the costs to be borne by the Issuer with respect to leasing costs noted in Section 8.2(2) hereof referable, in turn, to Section 5.1(b) and Section 5.1(c) hereof, the costs referred to in Section 6.3(e) hereof and the costs referred to in Section 11.6(3) hereof shall be borne by the Issuer on the basis that such costs shall be borne exclusively by , the Accredited Investors, if applicable, and the Purchaser in their respective proportionate shares under the Limited Partnership Agreement.

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SAMPLE CLAUSES REGARDING WORKING CAPITAL ADJUSTMENT PLUS EARNOUT

1.1 Subject to the provisions of Sections 1.2, 1.6, 1.7, 1.8 and 1.12 below, the purchase price for the Purchased Shares (the “Purchase Price”) shall be ____________ dollars ($___________), which shall be paid as follows:

(a) forthwith following the execution of this Agreement, $____________ shall be paid by the Purchaser to the Vendors’ Solicitors to be held in trust pursuant to an escrow agreement substantially in the form attached hereto as Schedule 1.1(a) hereof (the “Escrow Agreement”), by certified cheque (the “Escrow Amount”), which Escrow Amount shall be held in an interest-bearing trust account, with the interest earned being credited in accordance with the terms and provisions of the Escrow Agreement;

(b) at the Time of Closing, $_________ shall be paid by delivery of a promissory note to be executed and delivered by the Purchaser to the Vendors (the “Promissory Note”), which Promissory Note shall provide for interest to accrue on the principal amount outstanding thereunder from time to time at a rate of 6% per annum, calculated and payable quarterly, in arrears, with payment of principal on the second anniversary of the Closing Date; and

(c) at the Time of Closing and subject to Section1.12, the Escrow Amount (including interest earned thereon) shall be released from escrow upon and subject to the terms and conditions of the Escrow Agreement, and paid to the Vendors.

All payments to be made to the Vendors pursuant to this Section 1.1 shall be allocated and paid to the Vendors, or as they may direct, in accordance with the percentage allocation set out in Schedule 1.1.

1.2 In the event the Working Capital of the Corporation (prior to commencement of the

Purchaser Restructuring Plan) is less than $___________ on the Reorganization Date, the Purchase Price shall be decreased by the amount by which the Working Capital is less than $___________ (the “Working Capital Shortfall”). Within thirty (30) days following the Reorganization Date, the Vendors shall, at their sole expense, deliver to the Purchaser a balance sheet of the Corporation as at the Reorganization Date (the “Vendor’s Balance Sheet”), which Vendor’s Balance Sheet shall be prepared by the Vendors’ accountants in accordance with generally accepted accounting principals applied consistently with past practice. The Purchaser shall cause the general partner of the Successor Partnership to provide to the Vendors access to all documents, agreements and other business records of the Corporation in its possession as may be necessary or desirable in order that the Vendor’s accountants may prepare the Vendor’s Balance Sheet, and shall otherwise provide to the Vendors all such reasonable co-operation as the Vendors may require in order to prepare the Vendor’s Balance Sheet. In the event that the Purchaser disputes the amount of the Working Capital of the Corporation as calculated based on the Vendor’s Balance Sheet (the “Vendor’s Working Capital Amount”), the Purchaser shall so advise the Vendor of such dispute within ten (10) days of receiving the Vendor’s Balance Sheet

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(the “Dispute Period”). In the event that the Purchaser does not advise the Vendors that it disputes the Vendor’s Working Capital Amount prior to the expiry of the Dispute Period, the Vendor’s Working Capital Amount shall be deemed final and binding on the parties for the purposes of this Agreement and any Working Capital Shortfall shall be paid by the Vendors to the Purchaser forthwith by certified cheque. In the event that the Purchaser delivers a Dispute Notice within the time period allowed for the same herein, the Purchaser shall retain Deloitte & Touche to prepare an audited statement of Working Capital of the Corporation as of the Reorganization Date (prior to commencement of the Purchaser Restructuring Plan) (the “Working Capital Statement”). Such Working Capital Statement shall be prepared and delivered to the Vendors and the Purchaser within ninety (90) days following the Reorganization Date, and the cost of the preparation of such Working Capital Statement shall be paid by the Purchaser, provided that, should the Working Capital of the Corporation as set forth in the Working Capital Statement (as finally determined) be less than 98% of the Vendors’ Working Capital Amount, the Vendors shall pay the cost of the preparation of the Working Capital Statement. It is hereby acknowledged and agreed that the Vendors shall reflect a contingent liability in the amount of $____________ on the Vendor’s Balance Sheet, in connection with the Actions disclosed to the Purchaser hereunder. It is further expressly acknowledged that the Vendor’s Balance Sheet shall include, as a contingent liability, a provision for bad debt in respect of any Accounts Receivable which the Vendors believe may be uncollectible as at the Reorganization Date. Notwithstanding anything herein contained, and provided that the Vendors have complied with their obligations relating to the bad debt provision as outlined above, and further provided that the Vendors have not breached the representations contained in Paragraph 4.14 hereof, the Vendors shall have no liability to the Purchaser hereunder in the event that any Accounts Receivable are not collected.

1.3 The parties shall have a period of fifteen (15) days from the date on which the Working Capital Statement is received from Deloitte & Touche, as provided in Section 1.2, to review the same. If no objection to the Working Capital Statement is given by one party hereto to the others within such fifteen (15) day period, the Working Capital Statement shall be deemed to have been approved as of the last day of such fifteen (15) day period, and any Working Capital Shortfall shall be determined based on the Working Capital of the Corporation, as calculated based on the Working Capital Statement. If any party objects to the Working Capital Statement within such fifteen (15) day period by giving notice to the other parties setting out in reasonable detail the nature of such objection, the parties agree to attempt to resolve the matters in dispute within fifteen (15) days from the date such notice is given.

1.4 If all matters in dispute are resolved by the parties, the Working Capital Shortfall shall be the amount agreed upon by the parties. If the parties cannot resolve all matters in dispute within such fifteen (15) day period, all unresolved matters shall be submitted to arbitration for resolution in accordance with the provisions of Section ___, and the Working Capital Shortfall, if any, shall be the amount determined by the arbitrator.

1.5 As security for payment by the Purchaser to the Vendors of the portion of the Purchase Price referred to in Subsection 1.1(b), together with interest thereon (as evidenced by the

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Promissory Note) and any and all other obligations of the Purchaser hereunder or otherwise relating to the transactions described herein, the Purchaser shall cause the Successor Partnership to execute and deliver at the Time of Closing a guarantee issued by the Successor Partnership, which guarantee shall be secured by a general security agreement pursuant to the Personal Property Security Act (Ontario) pursuant to which such Successor Partnership shall grant to the Vendors a security interest in the assets of the Successor Partnership, which guarantee and security agreement shall be in a form acceptable to the Vendors and the Purchaser, each acting reasonably. The said security interest shall be subordinated to and rank subsequent to any and all security granted or to be granted by the Purchaser to any Canadian Schedule A Chartered Bank (whether in respect of financing to complete the transactions contemplated in this agreement or financing to enable the Purchaser to continue to carry on the Business, provided that the principal amount advanced in connection with any such financings shall not exceed an aggregate of $_______________). The Vendors hereby covenant and agree that they shall enter into, execute and deliver to the Purchaser and to any such lenders any inter-creditor or similar agreement which may be required by any such lenders containing such terms and provisions as are acceptable to the Vendors and such lenders, each acting reasonably.

1.6 The Purchase Price shall be increased in the following circumstances:

(a) the Purchase Price shall increase by an amount equal to 15% of the aggregate Gross Sales of the Successor Partnership (before taking into account any sales attributable to any acquisition of a business after the Closing Date) in excess of;

(i) $___________ for the fiscal period commencing on May 1st, 2004 and ending April 30th, 2005; and

(ii) $___________ for the fiscal period commencing on May 1st, 2005 and ending April 30th, 2006;

provided that the increase in the Purchase Price pursuant to this subsection 1.6(a) shall not exceed $_________ in the aggregate; and

(b) the Purchase Price shall be increased by an amount equal to 50% of the EBITDA of the Successor Partnership (before taking into account the EBITDA attributable to any acquisition of a business after the Closing Date) in excess of $_________ for each of the periods set out in 1.6(a)(i), and 1.6(a)(ii), respectively, provided that the increase in the Purchase Price pursuant to this Section 1.6(b) shall not exceed $__________ in the aggregate.

1.7 In the event that the EBITDA of the Successor Partnership for the period from May 1st, 2004 to April 30th, 2005, as finally determined in accordance with the provisions hereof (the “1st Year EBITDA Amount”), is below $____________, the principal amount payable by the Purchaser to the Vendors under the Promissory Note shall be reduced (retroactive to May 1st, 2005) by an amount derived by applying the following formula:

($_________ – 1st Year EBITDA Amount) x 4.23,

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up to a maximum reduction of $___________. For greater certainty, no reduction of the principal amount owing under the Promissory Note pursuant to the provisions of Paragraph 1.7 hereof shall affect any payments due under the Promissory Note during any period prior to the effective date of such reduction.

1.8 Notwithstanding anything herein contained, in the event that the 1st Year EBITDA Amount is less than $__________, the amounts payable by the Purchaser pursuant to the provisions of Paragraph 1.6 hereof, if any, shall be reduced by an amount derived by applying the following formula:

($___________ – 1st Year EBITDA Amount) x 4.23,

up to maximum reduction of $_________.

1.9 The Vendors shall have the right, at their sole cost and expense, and within sixty (60) days of April 30th, 2005, to cause an audit to be conducted of the EBITDA amount of the Successor Partnership for the period from May 1st, 2004 to April 30th, 2005, which audit shall be conducted by Deloitte & Touche, or such other firm of auditors independent of the parties hereto as the parties hereto may mutually agree. The Purchaser shall, and shall cause the Successor Partnership, to provide to the auditors access to all documents, agreements and other business records of the Successor Partnership as may be necessary or desirable in order that the auditors may conduct such audit, and shall otherwise provide, and cause the Successor Partnership to provide all such reasonable co-operation and assistance as the auditors may require in order to complete said audit. The said auditor shall complete the audit and deliver an audited statement of EBITDA of the Successor Partnership for the period from May 1st, 2004 to April 30th, 2005 (the “EBITDA Statement”) within one hundred and twenty (120) days of April 30th, 2005. The parties shall have a period of fifteen (15) days from the date on which the EBITDA Statement is received from the auditor to review the same. If no objection to the EBITDA Statement is given by a party hereto to the others within such fifteen (15) day period, the EBITDA Statement shall be deemed to have been approved by the parties hereto, and the EBITDA of the Successor Partnership for the period from May 1st, 2004 to April 30th, 2005 shall be the amount as shown in the EBITDA Statement. If any party objects to the EBITDA Statement within such fifteen (15) day period by giving notice to the other parties setting out in reasonable detail the nature of such objection, the parties agree to attempt to resolve the matters in dispute within fifteen (15) days from the date of such notice.

1.10 If all matters in dispute are resolved by the parties, the EBITDA of the Successor Partnership for the period from May 1st, 2004 to April 30th, 2005 shall be the amount agreed upon by the parties. If the parties cannot resolve all matters in dispute within such fifteen (15) day period, all unresolved matters shall be submitted to arbitration in accordance with the provisions of Section 13.17, and the EBITDA of the Successor Partnership for the period from May 1st, 2004 to April 30th, 2005 shall be the amount determined by the arbitrator.

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1.11 The Purchaser shall pay any increase in the Purchase Price pursuant to Paragraphs 1.6(a) and 1.6(b) by certified cheque or wire transfer within 30 days of determining that an amount is payable to the Vendors pursuant to such paragraphs. For the purposes of Section 1.6, the Purchaser shall deliver to the Vendor internally prepared annual financial statements of the Successor Partnership by June 30th of each fiscal period, which financial statements shall be prepared in accordance with generally accepted accounting principals applied consistently with past practice.

1.12 The Purchase Price for the Purchased Shares shall be decreased by the amount of Long Term Liabilities on the Closing Date. On the Closing Date and subject to completion of the transaction contemplated by this Agreement, the Purchaser and the Vendors shall cause the Corporation to pay in full the Long Term Liabilities on such date by directing the Vendor's Solicitors to use a portion of the Escrow Amount to pay the Long Term Liabilities with the balance to be dealt with in accordance with Section 1.1

1.13 The Purchaser acknowledges that a portion of the consideration for the Purchased Shares is to be satisfied by the contingent payments described in Paragraph 1.6 hereof. Accordingly, the Purchaser covenants and agrees to act honestly and in good faith and to manage the Successor Partnership from the Reorganization Date to February 28th, 2006 as a prudent owner would manage the Successor Partnership, with a view to earning profits.

SAMPLE CLAUSES REGARDING INVENTORIES AND TENANT RECEIPTS AND EXPENSES ADJUSTMENTS

3.1 The purchase price for the Purchased Assets (the "Purchase Price") shall be a sum equal to the aggregate of the following amounts:

(a) for all of the Purchased Assets other than the Inventory, the Prepaid Expenses and Petty Cash, Dollars ($ ), payable at the Time of Closing;

(b) for the Inventory, the value thereof as determined based on the provisions set forth in paragraph 3.2 hereof, and payable in accordance therewith; and

(c) for the Prepaid Expenses and Petty Cash, an amount equal to the face amount thereof, respectively, payable at the Time of Closing,

less any downward adjustments to the Purchase Price as may be required pursuant to the provisions hereof.

3.2 The parties shall jointly conduct a physical count of: (i) all Inventory (other than the samples) located in the Leased Premises, (ii) all Inventory (other than the samples) located at the Warehouse, (iii) all Ticketing Inventory and (iv) all Non-Purchased Inventory, after close of business on the day prior to the Date of Closing. Such physical count shall be completed in accordance with the provisions of Schedule "3.2" attached hereto, by an independent service provider, with all costs incurred in respect thereof to be borne equally by the Vendor and Purchaser. The Inventory so counted shall be valued at the Cost Price thereof, and the aggregate Cost Price of the Inventory so counted (the "Inventory Purchase Price") shall be paid by the Purchaser to the Vendor, by certified cheque, bank draft or other means of immediately available funds as follows:

(a) at the Closing, the Vendor shall deliver a statement to the Purchaser setting out the Cost Price of all Inventory in respect of which the Vendor shall have paid the supplier thereof therefor prior to the Time of Closing (the "Vendor's Inventory Statement");

(b) on Closing, the Purchaser shall pay to the Vendor an estimated amount in respect of the Inventory Purchase Price relating to all Inventory described in the Vendor's Inventory Statement, equal to the Cost Price thereof, as reflected on the Vendor's Inventory Statement (the "Estimated Purchase Price for Inventory"). For the purposes of the calculation of the Estimated Purchase Price for Inventory, the quantity of all Moving Inventory shall be deemed to be that reflected in the Vendor's purchase order documentation and other relevant records relating to such Moving Inventory;

(c) from time to time and at any time following the Time of Closing, and upon the written request of the Purchaser, the Vendor shall deliver to the Purchaser all of the documentation and records used by the Vendor to produce the Vendor's Inventory Statement (including without limitation, all of the documentation and records used to calculate the Cost Price of all Inventory described in the Vendor's Inventory Statement), together with satisfactory evidence that the Vendor has paid and discharged in full the Cost Price of all such Inventory described in the Vendor's Inventory Statement, and any

and all such other documents and records as the Purchaser may reasonably request in order to verify the amount payable for all Inventory described in the Vendor's Inventory Statement; and

(d) in respect of any portion of the Inventory (save and except for such Inventory that the Purchaser has agreed to pay the supplier thereof directly, in accordance with the provisions of this Agreement) for which the Vendor has not yet paid the supplier thereof, the Purchaser shall forthwith pay the Cost Price of such Inventory to the Vendor upon the Vendor providing to the Purchaser satisfactory evidence: (i) that it has paid the subject supplier for said Inventory, and (ii) as to the calculation of the Cost Price of such Inventory.

The Vendor and the Purchaser agree that subsequent to Closing, they shall make any adjustments between them to the amounts paid by the Purchaser to the Vendor for Inventory as may be necessary in order to account for the following:

(a) any Inventory for which the Purchaser paid the Vendor the Cost Price thereof, but which the Purchaser did not receive from the Vendor or the supplier thereof on or subsequent to the Date of Closing for any reason whatsoever, including without limitation, due to the Vendor having sold the subject Inventory prior to the Date of Closing;

(b) any Inventory for which the Purchaser paid the supplier thereof directly and which was delivered to the Vendor prior to Closing, but which the Purchaser did not receive from the Vendor on or subsequent to the Date of Closing for any reason whatsoever, including without limitation, due to the Vendor having sold the subject Inventory prior to the Date of Closing; and

(c) any Inventory for which the Vendor paid the supplier thereof, and which the Purchaser did receive on or subsequent to the Date of Closing, but for which the Vendor did not receive the Cost Price thereof from the Purchaser.

Such adjustments shall be paid by certified cheque, bank draft or other means of immediately available funds.

For greater certainty, no value shall be assigned to any of the samples of merchandise on hand, all of which samples shall form part of the Inventory.

4.6 The parties hereto expressly acknowledge their intention and agreement that all amounts payable to or by the tenants thereof under the Leases which relate to the period prior to the Date of Closing are for the account of the Vendor and, subject to as may be otherwise provided herein, all amounts payable to or by the tenants thereof under the Leases which relate to the period on or after the Date of Closing (in this paragraph the "Post-Closing Period") are for the account of the Purchaser. As such, the parties hereto agree as follows:

(a) in the event that, subsequent to Closing, it is determined that the tenant under a particular Lease, prior to Closing, paid amounts to the landlord thereof or to any third party which they may be owing, which amounts are in relation to the operation of the

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Business during the Post-Closing Period (in this paragraph the "Post-Closing Payments"), including without limitation, in respect of rent, percentage rent, prepaid rent, security deposits, taxes (including contribution by tenants to property taxes) common area maintenance charges, utility charges, business taxes, merchants' association and advertising fees and other occupancy costs, fuel, telephone and other utility charges and provided that such Post-Closing Payments are not included in the Prepaid Expenses or are otherwise not the responsibility of the Vendor as provided herein, the Purchaser shall, within ten (10) Business Days of becoming aware of the payment of said Post-Closing Payments, pay to the Vendor an amount equal to the Post-Closing Payments;

(b) in the event that, subsequent to Closing, it is determined that the tenant under a particular Lease has not paid amounts to the landlord thereof or to a third party to which they may be owing (other than amounts being contested in good faith by the Vendor, as described in Schedule 6.17 hereof), which amounts are in relation to the operation of the Business during the period prior to the Date of Closing (in this paragraph the "Pre-Closing Amounts"), including without limitation, in respect of rent, percentage rent, prepaid rent, security deposits, taxes (including contribution by tenants to property taxes) common area maintenance charges, utility charges, business taxes, merchants' association and advertising fees and other occupancy costs, fuel, telephone and other utility charges, the Vendor shall pay to the Purchaser, within ten (10) Business Days of receiving proof of payment by the Purchaser of the Pre-Closing Amounts, an amount equal to the Pre-Closing Amounts, provided that such Pre-Closing amounts are not the responsibility of the Purchaser hereunder;

(c) in the event that, subsequent to the Closing, the tenant under a particular Lease receives an amount from the landlord of said Lease or from a third party, which amount is in respect of the operation of the Business during the Pre-Closing Period, and provided that said amount is not included in the Prepaid Expenses, the Purchaser shall, within ten (10) Business Days of receiving said amount, pay to the Vendor an amount equal to the amount of said receipt;

(d) in the event that, subsequent to the Closing, it is determined that the tenant under a particular Lease had received, prior to Closing, an amount from landlord of said Lease, or from a third party, which amount is in respect of the operation of the Business during the Post-Closing Period (in this paragraph the "Pre-Closing Receipt"), the Vendor shall, within ten (10) Business Days of being advised in of the Pre-Closing Receipt, pay to the Purchaser an amount equal to the amount of the Pre-Closing Receipt; and

(e) in respect of determining the obligations of the Vendor and the Purchaser under this paragraph 4.6 as regards to matters associated with percentage rent, the percentage rent liability relating to any particular Lease shall (save and except as may be otherwise expressly set forth herein) be apportioned between the Vendor and the Purchaser pro-rata, having regard to the sales achieved during the period in respect of which the subject percentage rent relates which is prior to the Date of Closing as against the sales achieved during the period in respect of which the subject percentage rent relates which is from and after the Date of Closing.

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SAMPLE CLAUSES REGARDING ACCOUNTS RECEIVABLE, INVENTORIES, PREPAID EXPENSES AND FIXED ASSETS ADJUSTMENTS

3.4 Amount of Purchase Price

The Purchase Price payable by the Purchaser to the Vendors for the Purchased Assets shall be equal to the aggregate of (i) the amount finally determined in accordance with Section 3.7 hereof in respect of the Accounts Receivable, (ii) the amount finally determined in accordance with Section 3.7 hereof in respect of the Inventory, (iii) the amount finally determined in accordance with Section 3.7 hereof in respect of the Prepaid Expenses, (iv) the amount finally determined in accordance with Section 3.7 hereof in respect of the Fixed Assets, (allocated in the manner set forth in Schedule “3.6”) and (v) $__________ being the agreed price for the balance of the Purchased Assets.

3.5 Payment of Purchase Price

Subject to any adjustment contemplated herein, at the Time of Closing, the Purchase Price shall be paid and satisfied as follows:

(a) the Purchaser shall pay the sum of ___________ Dollars ($________) (the “Deposit”), by cash or certified cheque, to the Escrow Agent by way of deposit upon the execution of this Agreement by all the parties hereto, to be held by the Escrow Agent in accordance with the terms of the escrow agreement (the “Escrow Agreement”) annexed hereto as Schedule “3.5(a)”);

(b) as to an amount equal thereto, by the assumption by the Purchaser at the Time of Closing of the Assumed Indebtedness, as provided for in Section 3.10 hereof;

(c) as to ___________ Dollars ($____________) by payment thereof to the Escrow Agent at the Time of Closing, to be held and disbursed by the Escrow Agent in accordance with the terms of the Escrow Agreement; and

(d) as to the balance of the Purchase Price, such amount shall be paid by the Purchaser to the Vendors by certified cheque or in immediately available funds at the Time of Closing.

3.7 Valuation of Accounts Receivable, Inventory, Prepaid Expenses and Fixed Assets

(a) For the purposes of Section 3.5 hereof, and more particularly, determining the amount of the Purchase Price payable at the Time of Closing and the amount of the Assumed Indebtedness, the Vendors and the Purchaser hereby acknowledge that:

(i) the purchase price for the Accounts Receivable shall be estimated to be $___________;

(ii) the purchase price for the Inventory shall be estimated to be $__________;

(iii) the purchase price for the Prepaid Expenses shall be estimated to be $_________;

(iv) the purchase price for the Fixed Assets shall be estimated to be $__________;

(v) the amount of the Assumed Indebtedness shall be estimated to be $___________;

(the aggregate of the amounts set out in paragraphs (3.7(a)(i) – (iv), inclusive, less the amount set out in paragraph 3.7(a)(v) is hereby referred to as the “Estimated Value of the Accounts Receivable, Inventory, Prepaid Expenses and Fixed Assets Net of Assumed Indebtedness”).

(b) In order to determine the final amount to be paid by the Purchaser to the Vendor for the Accounts Receivable, Inventory, Prepaid Expenses and Fixed Assets and the final amount of the Assumed Indebtedness to be assumed by the Purchaser (collectively, the “Adjusted Amounts”), the Auditors shall prepare a statement, at 12:01 a.m. on the Date of Closing, for delivery to the Vendors and the Purchaser within 45 days following the Date of Closing (the “Statement”) setting forth the amount of each Adjusted Amount. For these purposes, (i) the amount of the Accounts Receivable shall be determined in accordance with generally accepted accounting principles and consistent with past practice but with no reserve made for uncollectible Accounts Receivable; (ii) the Inventory shall be physically counted as of 12:01 a.m. on the Closing Date and valued in accordance with generally accepted accounting principles and consistent with past practice; (iii) only those Prepaid Expenses of the type and nature that have been reflected as an asset of the Vendors on their balance sheets in accordance with generally accepted accounting principles and consistent with past practice shall be calculated; (iv) the amount for Fixed Assets shall be the aggregate of $__________ and the value of any Fixed Assets purchased during the Interim Period (but excluding, at the option of the Purchaser, those purchases during the Interim Period in breach of the covenants of the Vendors contained herein) less the value of any Fixed Assets sold during the Interim Period; and (v) the amount for Assumed Indebtedness shall be determined in accordance with generally accepted accounting principles and consistent with past practice. For these purposes, the Vendors and Purchaser covenant and agree to give the Auditors access to all of the books and records of the Businesses as they may reasonably require and shall instruct the Auditors to perform such tests and reviews as they deem necessary or appropriate in order to provide an audit opinion in respect of the items set out in the Statement. The parties hereto shall instruct the Auditors to cooperate with representatives of the parties as the Statement is being prepared and to keep the parties apprised as to the status of the preparation thereof. Forthwith thereafter, the Vendors and the Purchaser shall review and, if in agreement with the matters therein contained, approve the Statement. All costs of the Auditors associated with the preparation and finalization of the Statement shall be borne by the Vendors. If either the Purchaser or the Vendors shall have any objections to any part of the Statement then such party shall set forth such objections in writing with reasonable particularity in a notice to be delivered to the other of them within fifteen (15) Business Days following receipt of such Statement.

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If such objections cannot be resolved between the Vendors and the Purchaser within ten (10) Business Days following receipt of such notice then either of the Vendors or the Purchaser may request that an arbitrator (for the purposes of this Article, the “Arbitrator”) render a decision with respect to such matters in dispute between the Vendors and the Purchaser as are particularized in such notice and the Arbitrator shall, if necessary, determine the amount of any Adjusted Amount in accordance with the terms hereof. The decision of the Arbitrator shall be given to the Purchaser and the Vendors as soon as possible and shall be conclusive and binding upon the parties hereto, save and except for clerical errors or omissions. The Arbitrator shall be determined in accordance with Article 15 hereof. The Arbitrator shall determine the party or parties responsible for the fees and expenses of the Arbitrator. The amount of the Accounts Receivable, determined as aforesaid, shall be subject to adjustment, if any, in accordance with paragraph (c) below. The amount of the Inventory, Prepaid Expenses, Fixed Assets and Assumed Indebtedness determined as aforesaid, shall be final and binding for the purposes hereof.

(c) For the purposes of finally determining the amount of Accounts Receivable, if the aggregate amount collected by the Purchaser on account of the Accounts Receivable on or before the date which is 90 days following the Closing Date is less than the value ascribed to such Accounts Receivable in the Statement, determined as aforesaid, the amount payable by the Purchaser for the Accounts Receivable, in accordance with the terms hereof shall be reduced by an amount equal to such deficiency. The Purchaser shall use its best efforts to collect all of the Accounts Receivable in a timely fashion, in a manner consistent with past practice, and shall provide the Vendors with a report, within 10 business days of the end of each month, detailing the outstanding Accounts Receivable. Any payment received by the Purchaser with respect to the Accounts Receivable which does not specify the specific invoice of the Vendors to which such payment relates shall be applied to the oldest Accounts Receivable due from the person making such payment. The Vendors shall have the inspection rights provided for in Section 9.7 in order to, among other things, verify the amount of Accounts Receivable collected for these purposes. All Accounts Receivable which are not collected on or before the 90th day from the Date of Closing, shall be transferred and assigned by the Purchaser, free and clear of any Encumbrance, to the Vendors as soon as practicable following such date. The Vendors covenant and agree to inform the Purchaser of the manner in which the Vendors intend to pursue the collection of those Accounts Receivable assigned back to the Vendors prior to taking any such action. The parties hereto covenant and agree to cooperate with each other in connection with the collection of those Accounts Receivable assigned back to the Vendors.

(d) If the aggregate amount (the “Final Amount”) of (i) the Accounts Receivable, less any reductions pursuant to paragraph (c), as finally determined, (ii) the Inventory, as finally determined, (iii) the Prepaid Expenses, as finally determined, and (iv) the Fixed Assets, as finally determined, less the Assumed Indebtedness, as finally determined, is less than the Estimated Value of the Accounts Receivable, Inventory, Prepaid Expenses and Fixed Assets Net of Assumed Indebtedness then the Holdback Amount shall be adjusted accordingly and paid by the Escrow Agent to the Vendors and/or the Purchaser in accordance with the Escrow Agreement. In the event that the Estimated Value of the Accounts Receivable, Inventory, Prepaid Expenses and Fixed Assets Net of Assumed

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Indebtedness exceeds the Final Amount by more than the Holdback Amount, then the difference (the “Difference”) shall be forthwith paid by certified cheque or wire transfer by the Vendors to the Purchaser. In the event that the Difference, if any, is not received by the Purchaser within five (5) Business Days of the calculation thereof, then the Purchaser shall be entitled, in addition to any other rights it might have, to set-off such amount against amounts owing by the Purchaser to the Vendors pursuant to this Agreement or any other agreement entered into pursuant to the terms of this Agreement. In the event that the Final Amount exceeds the Estimated Value of the Accounts Receivable, Inventory, Prepaid Expenses and Fixed Assets Net of Assumed Indebtedness, then the difference shall be forthwith paid by certified cheque or wire transfer by the Purchaser to the Vendors.

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SAMPLE CLAUSES REGARDING NET BOOK VALUE, EARNINGS, ACCOUNTS RECEIVABLE AND WORK IN PROGRESS ADJUSTMENTS

2.2 Purchase Price

The aggregate purchase price (the “Purchase Price”) payable by the Purchasers for the Purchased Stock shall be an amount equal to the sum of the following amounts:

(a) 76.9% of the Net Book Value on the Adjustment Date (the “Purchase Price NBV”; plus

(b) 76.9% of the amount which is equal to 117% of the EBIT of the Corporation in respect of the 12 month period ended on the Adjustment Date (the “Purchase Price EBIT”).

The Purchase Price shall be allocated between the Vendors in the manner set out on Schedule 2.2, being each such Vendor’s proportionate interest in the Purchase Price.

The Purchasers shall pay to the Vendors at the Time of Closing an amount equal to $_________ being an estimate of the Purchase Price (the “Estimated Purchase Price”), which amount shall be paid in accordance with the provisions of Section 2.5 and shall be subject to adjustment in accordance with the provisions of Section 2.3. The Estimated Purchase Price has been calculated as shown in Schedule 2.2(a).

2.3 Adjustments

The amount paid on account of the Purchase Price as referenced in Section 2.2 shall be adjusted in accordance with this Section, as follows:

(a) Net Book Value and EBIT Adjustment

If the aggregate of the Purchase Price NBV and the Purchase Price EBIT, calculated using the Post-Closing Statements, subject to the Unbilled WIP Adjustment, to be prepared and delivered to the parties pursuant to Subsection 2.4(a), shall be more than $___________, the Purchase Price shall be increased by the amount of such excess and the Purchasers shall pay to the Vendors an amount equal to the amount of such excess in accordance with Section 2.6. If the aggregate of the Purchase Price NBV and the Purchase Price EBIT, calculated using the said Post-Closing Statements, subject to the Unbilled WIP Adjustment, shall be less than $_________, the Purchase Price shall be decreased by the amount of such deficit and the Vendors shall pay to the Purchasers an amount equal to such deficit in accordance with Section 2.6. For greater certainty, if the aggregate of the Purchase Price NBV and the Purchase Price EBIT, calculated using the said Post-Closing Statements, subject to the Unbilled WIP Adjustment, shall be equal to $__________, there shall be no adjustment under this Subsection. The adjustment (if any) pursuant to this Subsection is herein called the “Net Book Value and EBIT Adjustment”.

(b) A/R Adjustment

It is expressly acknowledged and agreed by the Vendors that it is the Vendors’ expectation that all accounts receivable listed on the Post-Closing A/R List (the “A/R”) shall be collected within 180 days after the Adjustment Date (the “A/R Collection Period”). If, by the opening of business on the 180th day after the Adjustment Date, less than 97% of the total amount of the A/R has been collected by the Purchasers or the Corporation, then the Purchase Price shall be decreased and reduced by the amount of the uncollected A/R. In the event of such downward adjustment to the Purchase Price, it is expressly agreed that the Purchase Price shall be increased by 50% of the amount of any A/R not collected prior to expiry of the A/R Collection Period, but which is collected prior to the third anniversary date of the Date of Closing (the “Delinquent Receivables”), which amount shall be net of any costs of collection incurred in collecting the said accounts receivables (including the net amount of any income, sales or similar taxes incurred or payable in connection with the Delinquent Receivables).

In addition, in the event that the Corporation collects, at any time within a period of three years following the Adjustment Date, any accounts receivable relating to the period of operations of the Corporation prior to the Adjustment Date, but which accounts receivable were not included on the Post Closing A/R List (the “Collected Unlisted Receivables”), the Purchasers shall pay to the Vendors, the amount of any such Collected Unlisted Receivables, net of any costs of collection incurred in collecting the said Collected Unlisted Receivables, (including the net amount of any income, sales or similar taxes incurred or payable in connection with the Collected Unlisted Receivables) (the “Unlisted Receivables Purchase Price Increase”). In the event that any amounts remain owing under the Promissory Note at the time that any Collected Unlisted Receivables are collected, the Principal Vendor’s Pro Rata Share of the Unlisted Receivables Purchase Price Increase related thereto shall be added to the last amounts payable under the Promissory Note, and the Purchasers shall pay to each Ancillary Vendor its respective Pro Rata Share of the Unlisted Receivables Purchase Price Increase. In the event that no amounts remain owing under the Promissory Note at the time that any Collected Unlisted Receivables are collected, the Purchasers shall pay to each Vendor its respective Pro Rata Share of the Unlisted Receivables Purchase Price Increase.

All adjustments (if any) made pursuant to this Subsection 2.3(b) are herein called the “A/R Adjustments”.

(c) WIP Adjustment

(i) By the opening of business on the 60th day after the Adjustment Date, all of the Billable Value of the WIP listed in the Post-Closing WIP List shall be invoiced and billed. The Billable Value of any WIP listed in the Post-Closing WIP List that is not invoiced and billed by the 60th day after the Adjustment Date shall not be included in determining the amount of WIP as at the Adjustment Date for the purpose of any calculation or determination hereunder based on the Post-Closing Statements, including the calculation of the Net Book Value and EBIT Adjustment; and

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(ii) If the aggregate amount of all WIP listed in the Post-Closing WIP List and collected by the opening of business on the 181st calendar day after the respective actual date of billing of each WIP listed in the Post-Closing WIP List is less than 97% of the total amount of the Billable Value of the WIP listed in the Post-Closing WIP List which has been invoiced and billed by the opening of business on the 60th day after the Adjustment Date shall not have been collected in full (the “Uncollected WIP A/R”), then the Purchase Price shall be decreased and reduced by the uncollected amount thereof, on a dollar-for-dollar basis. In the event of such downward adjustment to the Purchase Price, it is expressly agreed that the Purchase Price shall be increased by 50% of the amount of any Uncollected WIP A/R which is collected on or prior to the third anniversary of the Date of Closing, which amount shall be net of any costs of collection incurred in collecting the said Uncollected WIP A/R (including the net amount of any income, sales or similar taxes incurred or payable in connection with the Uncollected WIP A/R).

All adjustments (if any) made pursuant to Subsection 2.3(c)(ii) are herein called the “WIP Adjustments”.

For greater certainty, all adjustments provided for in this Section 2.3 are cumulative, in that the total increase (if any) to the Purchase Price arising from the said adjustments shall be net of the total reductions (if any) to that amount arising from such adjustments, and vice-versa.

2.4 Post-Closing Statements and Declaration relating to A/R Adjustments and WIP Adjustments

(a) Post-Closing Statements

As soon as practicable, and in any event, within 65 days after the Adjustment Date, the Principal Vendor shall instruct and cause the Accountants to prepare and deliver to the parties and to the Purchasers’ Accountants the Post-Closing Statements and calculation of the Unbilled WIP Adjustment in accordance with the provisions hereof. If the Purchasers have any objections to any part of the Post-Closing Statements or calculation of the Unbilled WIP Adjustment, then the Purchasers shall set out in such objections in writing with reasonable particularity in a notice (the “Objection Notice”) to be delivered to the Principal Vendor within 10 Business Days of the date the Post-Closing Statements and calculation of the Unbilled WIP Adjustment are delivered to the Purchasers and the Purchasers’ Accountants. Such 10 Business Day period is referred to herein as the “Objection Period”. If the Purchasers deliver an Objection Notice within the Objection Period, and the matters at issue are not resolved by the Purchasers and the Principal Vendor in writing within 10 Business Days following receipt by the Principal Vendor of the Objection Notice, the matters in dispute shall be submitted to a Florida office of Ernst & Young jointly designated by the Principal Vendor and Purchasers or, if no Florida office of Ernst & Young is thus jointly designated or willing to serve, then to another independent U.S. firm of certified public accountants that is jointly selected by the Accountants and the Purchasers’ Accountants for resolution. The firm of certified public accountants appointed as foresaid to determine the matters in dispute is herein referred to as the “Expert”. The decision of the Expert shall be rendered as soon as

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possible but in any event within 10 Business Days of its engagement and shall be conclusive and binding upon the parties hereto, and no appeal shall lie therefrom. Any part of the Post-Closing Statements and calculation of the Unbilled WIP Adjustment not objected to by the Purchasers within the Objection Period, or, if objected to, resolved in writing by the Purchasers and the Principal Vendor without the necessity of proceeding to the Expert to resolve matters in dispute shall be conclusive and binding upon the parties hereto, and no appeal shall lie therefrom. For the purposes of this Agreement, the Post-Closing Statements and calculation of the Unbilled WIP Adjustment shall be deemed to have become final and binding on the parties hereto, on the latest of the following dates (the “Settlement Date”):

(i) the first to occur of: (A) the giving of written notice by the Purchasers to the Principal Vendor stating that the Purchasers accept the Post-Closing Statements and calculation of the Unbilled WIP Adjustment, as delivered by the Accountants, and (B) 11:59 o’clock p.m. (U.S. EasternTime) on the last day of the Objection Period, if no Objection Notice is delivered to the Principal Vendor before such time; and

(ii) if an Objection Notice is delivered to the Principal Vendor before 11:59 o’clock p.m. (U.S. EasternTime) on the last day of the Objection Period, the first to occur of:

(A) the Business Day on which the last of the objections made by the Purchasers are resolved in writing by the Purchasers and the Principal Vendor without the necessity of proceeding to the Expert to resolve such objections; or

(B) the Business Day on which the Expert’s decision is delivered to the parties.

The Accountants shall issue and deliver to the parties and the Corporation the Post-Closing Statements as finally determined in accordance with this Section 2.4(a), together with their audit report in respect of the Post-Closing Statements within 10 days of the Settlement Date.

The Accountants, the Purchasers’ Accountants and the Expert, if appointed, shall be provided with all reasonable access to the books, records and other information relating to the Corporation and the Subsidiary as the Accountants, the Purchasers’ Accountants or Expert, as applicable, may reasonably request, from time to time, for the purpose of reviewing all transactions and financial books, records and accounts required in connection with their preparation of and review of the Post-Closing Statements and calculation of the Unbilled WIP Adjustment.

The fees and expenses of the Accountants in connection with the preparation of the Post-Closing Statements and calculation of the Unbilled WIP Adjustment shall be borne by the Vendors. The fees and expenses of the Purchasers’ Accountants for reviewing and participating in the matters referred to in this

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Section 2.4(a) shall be borne by the Purchasers. The fees and expenses of the Expert in connection with the matters referred to in this Section 2.4(a) shall be borne 50% by the Vendors, and 50% by the Purchasers.

(b) Calculations re: A/R Adjustments and WIP Adjustments and Assignment

(i) On the 185th day following the Adjustment Date, the Principal Vendor shall instruct and cause the Accountants to prepare and deliver to the parties and to the Purchasers’ Accountants a calculation of the A/R Adjustments (if any) required to be made pursuant to Subsection 2.3(b) relating to A/R;

(ii) Within 5 Business Days of the collection of any Delinquent Receivables, or as soon as reasonably practical thereafter, the Principal Vendor shall instruct and cause the Accountants to prepare and deliver to the parties and to the Purchasers’ Accountants a calculation setting forth that part of the A/R Adjustments (if any) required to be made pursuant to the Subsection 2.3(b) relating to the collected Delinquent Receivables;

(iii) On the 185th day following the Adjustment Date, the Principal Vendor shall instruct and cause the Accountants to prepare and deliver to the parties and to the Purchasers’ Accountants a calculation setting forth the amount of the WIP Adjustment (if any) required to be made pursuant to Subsection 2.3(c)(ii), provided that within 5 Business Days of the collection of any Uncollected WIP A/R, the Principal Vendor shall instruct and cause the Accountants to prepare and deliver to the parties and to the Purchasers’ Accountants a calculation setting forth that part of the WIP Adjustments required to be made pursuant to the Subsection 2.3(c)(ii) relating to the collected Uncollected WIP A/R;

(iv) Within 5 Business Days of the collection of any Collected Unlisted Receivables, or as soon as reasonably practical thereafter, the Principal Vendor shall instruct and cause the Accountants to prepare and deliver to the parties and to the Purchasers’ Accountants a calculation setting forth the amount of the Unlisted Receivables Purchase Price Increase required to be made pursuant to the Subsection 2.3(b) relating to the Collected Unlisted Receivables;

in each case, together with reasonable particulars of how the said adjustments were determined. The Accountants shall be entitled to reasonable access to the books and records of the Corporation for the purpose of preparing such calculations.

If the Purchasers have any objection to any part of any calculation of the Accountants delivered pursuant to this Section 2.4(b), then the Purchasers shall set out in such objections in writing with reasonably particularity in a notice (the “Calculation Objection Note”) to be delivered to the Principal Vendor within 10 Business Days of the date such calculation is delivered to the Purchasers and the Purchasers’ Accountants. Such 10 Business Day period is referred to herein as the “Calculation Objection Period”. If the Purchasers deliver a Calculation

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Objection Notice within the Calculation Objection Period, and the matters at issue are not resolved by the Purchasers and the Principal Vendor in writing within 10 Business Days following receipt by the Principal Vendor of the Calculation Objection Notice, the matters in dispute shall be submitted to a Florida office of Ernst & Young jointly designated by the Principal Vendor and Purchasers or, if no Florida office of Ernst & Young is thus jointly designated or willing to serve, then to another independent U.S. firm of certified public accountants that is jointly selected by the Accountants and the Purchasers’ Accountants for resolution. The firm of certified public accountants appointed as foresaid to determine the matters in dispute is herein referred to as the “Calculation Expert”. The decision of the Calculation Expert shall be rendered as soon as possible but in any event within 10 Business Days of its engagement and shall be conclusive and binding upon the parties hereto, and no appeal shall lie therefrom. Any part of a calculation not objected to by the Purchasers within the Calculation Objection Period applicable to such calculation, or, if objected to, resolved by the Purchasers and the Principal Vendor in writing without the necessity of proceeding to the Calculation Expert to resolve matters in dispute shall be conclusive and binding upon the parties hereto, and no appeal shall lie thereform. For the purposes of this Agreement each calculation under this Section 2.4(b) shall be deemed to have become final and binding on the parties hereto, on the latest of the following dates:

(i) the first to occur of: (A) the giving of written notice by the Purchasers to the Principal Vendor stating that the Purchasers accept the applicable calculation, as delivered by the Accountants, and (b) 11:59 o’clock p.m. (U.S. EasternTime) on the last day of the Calculation Objection Period applicable to such calculation, if no Calculation Objection Notice is delivered to the Principal Vendor before such time; and

(ii) if a Calculation Objection Notice is delivered to the Principal Vendor before 11:59 o’clock p.m. (U.S. EasternTime) on the last day of the Calculation Objection Period applicable to the calculation, the first to occur of:

(A) the Business Day on which the last of the objections made by the Purchasers are resolved in writing by the Purchasers and the Principal Vendor without the necessity of proceeding to the Calculation Expert to resolve such objections; or

(B) the Business Day on which the Calculation Expert’s decision is delivered to the parties.

The Accountants, the Purchasers’ Accountants and the Calculation Expert, if appointed, shall be provided with all reasonable access to the books, records and other information relating to the Corporation and the Subsidiary as the Accountants, the Purchasers’ Accountants or Calculation Expert, as applicable, may reasonably request, from time to time, for the purpose of reviewing all transactions and financial books, records and accounts required in connection

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with their preparation of and review of the calculations required under this Section 2.4(b).

The fees and expenses of the Accountants in connection with the matters in this Section 2.4(b) shall be borne by the Vendors. The fees and expenses of the Purchasers’ Accountants for reviewing and participating in the matters referred to in this Section 2.4(b) shall be borne by the Purchasers. The fees and expenses of the Calculation Expert in connection with the matters referred to in this Section 2.4(b) shall be borne 50% by the Vendors, and 50% by the Purchasers.

2.5 Payment of Purchase Price and Adjustments

Out of the Estimated Purchase Price, a total of $__________ shall be paid to the Principal Vendor, and a total of $______________ (the “Ancillary Vendors Closing Payment”) shall be paid to the Ancillary Vendors in the proportions indicated in Schedule 2.2(b). The Estimated Purchase Price shall be paid and satisfied at the Time of Closing by the Purchasers to the Vendors as follows:

(a) an amount equal to $____________, by certified cheque, bank draft, wire transfer or other means of immediately available funds (the “Closing Funds”), $____________ of which shall be paid to the Principal Vendor at the Time of Closing and $________ of which shall be paid to the Ancillary Vendors and to the Escrow Agent at the Time of Closing according to the provisions of Section 2.5(c);

(b) an amount equal to $___________, by delivery of a promissory note made by the Purchasers jointly and severally to and in favour of the Principal Vendor in the form of Schedule 2.5(b) (the “Promissory Note”), which Promissory Note shall:

(i) provide for interest to accrue on the principal amount outstanding thereunder from time to time at a rate equal to the Prime Rate, calculated and payable annually, in arrears,

(ii) contain adjustment provisions as set forth in Section 2.6,

(iii) provide for principal and accrued interest to be repaid in the following instalments:

(A) $________, plus accrued interest on such amount, to be due one year from the Closing Date;

(B) $________, plus accrued interest on such amount, to be due two years from the Closing Date; and

(C) $_________, plus accrued interest on such amount, to be due three years from the Closing Date.

The Promissory Note and the Purchasers’ obligations in respect thereof shall be secured as provided in Section 2.7 below.

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(c) Notwithstanding the foregoing, it is expressly agreed that the amount of the Purchase Price which is payable to the Ancillary Vendors in the proportions set out in Schedule 2.2(b) shall be paid as set out in the following paragraphs (i), (ii) and (iii) and in Section 2.6:

(i) an amount equal to fifty (50%) percent of the Ancillary Vendors Closing Payment shall be paid at the Time of Closing, and the balance of the Ancillary Vendors Closing Payment (the “Escrow Funds”) shall be paid to the Escrow Agent, to be disbursed by it as set out in subparagraphs (ii) and (iii) below and in accordance with the Escrow Agreement;

(ii) the Escrow Agent shall pay fifty (50%) percent of the Escrow Funds paid to it pursuant to Section 2.5(c)(i) (“Tranche 1 Funds”) to the Ancillary Vendors at the time that the Net Book Value and EBIT Adjustment is made or upon it being finally determined that no such adjustments are required in accordance with this Agreement; provided that, in the event that the Net Book Value and EBIT Adjustment result in the Ancillary Vendors having to make a payment to the Purchasers in accordance with the provisions of Subsection 2.6(b) hereof, the amount of such payment shall be deducted from such portion of the Ancillary Vendors Closing Payment as is described in this Subsection 2.5(c)(ii) hereof, and the amount so deducted shall be paid by the Escrow Agent to the Purchasers. In the event that the amount of the payment the Ancillary Vendors are required to make to the Purchasers is in excess of the amount described in this Subsection 2.5(c)(ii), the excess amount shall be deducted from the amount which would otherwise be payable to the Ancillary Vendors under Subsection 2.5(c)(iii) hereof, and the amount so deducted shall be paid by the Escrow Agent to the Purchasers. In the event that the amount of the payment the Ancillary Vendors are required to make to the Purchasers in accordance with the provisions of Subsection 2.6(b) hereof is in excess of the aggregate of the amounts described in Subsections 2.5(c)(ii) and (iii) hereof, no payments shall be made by the Escrow Agent to the Ancillary Vendors under Subsections 2.5(c)(ii) or (iii) hereof and under the Escrow Agreement, and all amounts held by the Escrow Agent shall be paid to the Purchasers.

(iii) the Escrow Agent shall pay the other fifty (50%) percent of the Escrow Funds paid to it pursuant to Section 2.5(c)(i) (“Tranche 2 Funds”) to the Ancillary Vendors at the time that the A/R Adjustments contemplated by Subsection 2.3(b) are made or upon it being finally determined that no such adjustments are required in accordance with this Agreement; provided that, in the event that the said A/R Adjustments result in the Ancillary Vendors having to make a payment to the Purchasers in accordance with the provisions of Subsection 2.6(b) hereof, the amount of such payment shall be deducted from such portion of the Ancillary Vendors Closing Payment as is described in this Subsection 2.5(c)(iii) hereof, and the amount so deducted shall be paid by the Escrow Agent to the Purchasers. In the event that the amount of the payment the Ancillary Vendors are required to make to the Purchasers is in excess of the aggregate amount payable under this Subsection 2.5(c)(iii) hereof, no payments

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shall be made by the Escrow Agent to the Ancillary Vendors under Subsections 2.5(c)(iii) hereof or under the Escrow Agreement and all amounts held by the Escrow Agent shall be paid to the Purchasers.

At the Time of Closing, the Principal Vendor, the Purchasers and the Escrow Agent shall enter into an escrow agreement (the “Escrow Agreement”), pursuant to which the Escrow Agent shall agree to hold the Escrow Funds on the foregoing terms.

The Escrow Agreement will authorize the Escrow Agent to pay the Tranche 1 Funds to the Ancillary Vendors on the 10th day after the anticipated date (to be set out in the Escrow Agreement) on which the Net Book Value and EBIT Adjustment is finally determined (or finally determined not to be required) in accordance with this Agreement (the “Tranche 1 Release Date”) unless: (A) such final determination with respect to the Net Book Value and EBIT Adjustment has not been made at least 10 days prior to the Tranche 1 Release Date, or (B) based upon such final determination, the Tranche 1 Funds are not exclusively payable to the Ancillary Vendors, and, in the case of either (A) or (B), the Escrow Agent receives a notice in writing to that effect from either the Principal Vendor or the Purchasers prior to the Tranche 1 Release Date. If the Escrow Agent receives such notice from the Principal Vendor or the Purchasers, the Escrow Agent shall not release the Tranche 1 Funds to the Ancillary Vendors on the Tranche 1 Release Date unless jointly directed by the Principal Vendor and the Purchasers to do so, and the Purchasers and the Principal Vendor shall jointly direct the Escrow Agent, by no later than the 5th day following the final determination with respect to the Net Book Value and EBIT Adjustment, to pay the Tranche 1 Funds (and the Tranche 2 Funds, if applicable), to the parties entitled thereto as provided in Section 2.5(c)(ii).

The Escrow Agreement will authorize the Escrow Agent to pay the Tranche 2 Funds to the Ancillary Vendors on the 10th day after the anticipated date (to be set out in the Escrow Agreement) on which the A/R Adjustments contemplated by Section 2.3(b) are finally determined (or finally determined not to be required) in accordance with this agreement (the “Tranche 2 Release Date”), unless: (A) such final determination with respect to such A/R Adjustments has not been made at least 10 days prior to the Tranche 2 Release Date, or (B) based upon such final determination, the Tranche 2 Funds are not exclusively payable to the Ancillary Vendors, and, in the case of either (A) or (B), the Escrow Agent receives a notice in writing to that effect from either the Principal Vendor or the Purchasers prior to the Tranche 2 Release Date. If the Escrow Agent receives such notice from the Principal Vendor or the Purchasers, the Escrow Agent shall not release the Tranche 2 Funds to the Ancillary Vendors on the Tranche 2 Release Date unless jointly directed by the Principal Vendor and the Purchasers to do so, and the Purchasers and the Principal Vendor shall jointly direct the Escrow Agent, by no later than the 5th day following the final determination with respect to such A/R Adjustments, to pay the Tranche 2 Funds to the parties entitled thereto as provided in Section 2.5(c)(iii).

2.6 Adjustments

(a) In the event that the amount paid on account of the Purchase Price pursuant to Section 2.5 is adjusted upward as a result of a Net Book Value and EBIT Adjustment, a

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WIP Adjustment and/or an A/R Adjustment, the amount payable under the Promissory Note shall be increased by the amount of the Principal Vendor’s Pro Rata Share of the Net Book Value and EBIT Adjustment, the WIP Adjustment and/or the A/R Adjustment, as the case may be, and such increased amount shall be added to the final instalment payable under the Promissory Note. The Ancillary Vendors’ Pro Rata Share of such upward adjustment shall be paid by the Purchasers to the Ancillary Vendors by certified cheque, bank draft or other means of immediately available funds within 10 days after such determination.

(b) In the event that the amount paid on account of the Purchase Price pursuant to Section 2.5 is adjusted downward as a result of a Net Book Value and EBIT Adjustment, a WIP Adjustment and/or an A/R Adjustment, the amount payable under the Promissory Note shall be decreased by the amount of the Principal Vendor’s Pro Rata Share of the Net Book Value and EBIT Adjustment, the WIP Adjustment and/or the A/R Adjustment, as the case may be (the “Decreased Amount”). The Decreased Amount shall be deducted from the next instalment payable under the Promissory Note. The Ancillary Vendors’ Pro Rata Share of such downward adjustment shall be paid by the Ancillary Vendors to the Purchasers in the manner provided in Section 2.5(c)(ii) and 2.5(c)(iii), to the extent of the Escrow Funds held by the Escrow Agent.

(c) In the event that Decreased Amount is in excess of the amounts still owing under the Promissory Note, the Promissory Note shall be deemed satisfied in full and cancelled, and the Principal Vendor shall forthwith pay over to the Purchasers an amount equal to the amount of such excess, by certified cheque, bank draft or other means of immediately available funds. In the event that the Ancillary Vendors’ Pro Rata Share of any downward adjustment under Section 2.6(b) is in excess of the Escrow Funds held by the Escrow Agent, each Ancillary Vendor shall forthwith pay over to the Purchasers an amount equal to such Ancillary Vendor’s proportionate share of the excess (based on the proportion that the amount of the Purchase Price payable to such Ancillary Vendor bears to the aggregate Purchase Price payable to all Ancillary Vendors, as set out in Schedule 2.2 hereof), by certified cheque, bank draft or other means of immediately available funds.

2.7 Security for Payment of the Promissory Note

At the Time of Closing, the Purchasers shall deliver or cause to be delivered to the Principal Vendor an irrevocable standby letter of credit issued by a Canadian chartered bank or U.S. bank acceptable to the Principal Vendor (the "Issuing Bank"), acting reasonably, and confirmed by a U.S. bank acceptable to the Principal Vendor (the "Confirming Bank"), acting reasonably, in form and substance satisfactory to the Principal Vendor, acting reasonably, securing an amount equal to the Principal Amount of the Promissory Note (as used herein, the term "Principal Amount" shall have the meaning defined in the Promissory Note), as such Principal Amount is adjusted in accordance with the terms of the Promissory Note and this Agreement, that will be outstanding at the Time of Closing, and which letter of credit may be drawn upon, to the extent of any amount due and payable under the Promissory Note that the Purchasers have failed to pay when due (including, without limitation, amounts due by acceleration of the Promissory Note in accordance with its terms), unilaterally by the Principal

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Vendor without any consent from or other action by or documentation from the Purchasers (a) in the event that the Purchasers fail to pay when due any amount outstanding under the Promissory Note or (b) immediately upon the occurrence of any Event of Default (as defined in the Promissory Note), and which letter of credit shall remain outstanding and securing the Promissory Note and all amounts due thereunder at all times to the full extent of the outstanding Principal Amount as adjusted pursuant to the Promissory Note and this Agreement (the “Letter of Credit”). It is expressly agreed by the Purchasers and the Principal Vendor that the Letter of Credit shall include provisions specifying that: i) partial draws shall be allowed under the Letter of Credit, and each partial draw shall have the effect of reducing the face amount of the Letter of Credit in the amount of such partial draw (subject to upward or downward adjustments of the Principal Amount as provided in clause ii) below); ii) the face amount of the Letter of Credit shall be adjusted upward or downward, on a dollar for dollar basis, to the extent that the Principal Amount owing under the Promissory Note is adjusted upward or downward in accordance with the provisions of this Agreement and the Promissory Note, iii) the face amount of the Letter of Credit shall be adjusted downward, on a dollar for dollar basis, to the extent that the Principal Amount owing under the Promissory Note is paid and satisfied by the Purchasers (subject to the adjustments of the Principal Amount and the face amount of the Letter of Credit referenced in clause ii) above), iv) any upward or downward adjustments to the face amount of the Letter of Credit shall be effected by the Purchasers and the Principal Vendor submitting a joint notice in writing to the Issuing Bank and the Confirming Bank specifying the amount of such upward or downward adjustment, or in such other manner as the Issuing Bank and the Confirming Bank may require and which is mutually acceptable and agreed to in writing the Purchasers and the Principal Vendor, each acting reasonably (the "Joint Notice"). Each of the Purchasers, jointly and severally, and the Principal Vendor hereby covenant and agree to submit a Joint Notice to the Issuing Bank and the Confirming Bank within 10 Business Days after: A) a payment of principal being received by the Principal Vendor under the Promissory Note, and B) an upward or downward adjustment to the principal amount owing under the Promissory Note being mutually agreed upon by the Purchasers and the Principal Vendors or being otherwise finally determined in accordance with the provisions of this Agreement and the Promissory Note. Failure or refusal of either of the Purchasers timely to submit a Joint Notice to the Issuing Bank and the Confirming Bank in accordance with the covenant contained in the preceding sentence of this Section 2.7 shall constitute an Event of Default (as defined in the Promissory Note), with the consequence of accelerating the Promissory Note as provided therein and entitling the Principal Vendor immediately to draw upon the Letter of Credit in the full accelerated amount of the Promissory Note in accordance with its terms. In addition, and without limiting the foregoing, failure or refusal of either the Principal Vendor or the Purchasers timely to submit a Joint Notice to the Issuing Bank and the Confirming Bank in accordance with the covenant contained in this Section 2.7 shall entitle the non-breaching party or parties to obtain injunctive or other equitable relief in a court of competent jurisdiction, compelling such breaching party or parties forthwith to submit the Joint Notice in compliance with such covenant in this Section 2.7, it being stipulated and agreed among the parties that failure or refusal by either the Principal Vendor or the Purchasers timely to comply with such covenant to submit the Joint Notice hereunder will constitute irreparable harm to such other party or parties. A draft Letter of Credit provided by the Issuing Bank shall be presented by the Purchasers to the Principal Vendor for the Principal Vendor’s review and approval (acting reasonably) by no later than 7 days prior to the Closing Date, and the Letter of Credit shall be issued by the Issuing Bank and confirmed by the

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Confirming Bank at or prior to the Time of Closing in the form so approved by the Principal Vendor prior to the Time of Closing.

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SAMPLE CLAUSES REGARDING EXPENSE RECOVERIES ADJUSTMENT

1.1 The following shall apply with respect to Expense Recoveries (as hereinafter defined):

(a) The parties acknowledge that under certain Leases certain payments, such as realty taxes and operating costs, although paid by the landlord, are charged to the Tenants and are collected in monthly instalments on the basis of the landlord’s estimates (such payments are herein called “Expense Recoveries”). These estimated Expense Recoveries are subject to adjustments with the Tenants when the total amounts of same are finally determined. It is therefore agreed that with respect to Expense Recoveries pertaining to the Real Property in respect of 2004, adjustments shall be made as between the Vendors and the Purchaser as follows:

(i) on the Closing Date, the Vendors shall provide or cause to be provided to the Purchaser a statement outlining the amounts of Expense Recoveries collected from each Tenant, as well as the amounts expended on account of Expense Recoveries by the Partnership since the beginning of January 1, 2004;

(ii) if such statement indicates that the Partnership has collected more on account of Expense Recoveries than it has expended on account of Expense Recoveries, then the amount of such difference shall be credited to the Purchaser on closing; and

(iii) if the Partnership has collected less from the Tenants than it has expended on account of Expense Recoveries, then the amount of such difference shall not be credited to the Vendors but shall be paid by the Purchaser to the Vendors if, as and when the same may be received by the Purchaser.

(b) The Vendors shall provide or cause to be provided to the Purchaser a reconciliation statement for the 2004 calendar year outlining the amount of Expense Recoveries collected from each Tenant and the amount owed by each Tenant or to each Tenant (as the case may be) on account of Expense Recoveries for such year. The Vendors and the Purchaser shall co-operate with each other in order to allow for such reconciliation statement to be delivered to Tenants on or before March 31, 2004. The Purchaser agrees to use reasonable commercial efforts to cause Tenants which must make payments to the landlord pursuant to such reconciliation statement to make those payments to the Purchaser as soon as possible after delivery of such statement.

(c) The Vendors shall, at no expense to the Vendors, co-operate with the Purchaser in the Purchaser adjusting with the Tenants in respect of Expense Recoveries for the 2004 calendar year, including, without limiting the generality of the foregoing, if a Tenant disputes any statement or financial information provided by the Vendors.

(d) It is agreed that adjustments with the Tenants in respect of Expense Recoveries and any readjustments which may be required as a result thereof between the Purchaser and the Vendors shall take place as soon as reasonably possible after all information with respect to the Expense Recoveries for such calendar year in which the Closing Date occurs has been prepared and delivered and, in any event, on or before September 30, 2005.

(e) The Vendors shall be responsible to make all adjustments with the Tenants on account of Expense Recoveries for the 2003 calendar year.

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SAMPLE CLAUSES REGARDING SIMPLE WORKING CAPITAL ADJUSTMENT

(i) There shall be a dollar for dollar adjustment to the Purchase Price equal to the aggregate of the total dollar value of accounts receivable, cash on hand, letters of credit lodged as security and prepaid expenses of the partnership in respect of the Real Property as of the Closing Date, minus the aggregate of the total dollar value of accounts payable, accrued liabilities and Taxes payable (collectively, the “Working Capital Adjustment”), all in accordance with GAAP and consistent with the Partnership’s past practices;

(ii) For the purposes of determining the amounts payable by the Purchaser to the Vendors at the Time of Closing, the parties shall calculate an estimate of the Working Capital Adjustment (the “Estimated Working Capital Adjustment”) based on the working capital shown in an estimated balance sheet of the Partnership to be delivered to the Purchaser five (5) days before the Closing Date (the “Estimated Balance Sheet”);

(iii) Within five (5) Business Days following the completion of the transactions contemplated by the SPA, the Vendors shall deliver to the Purchaser the balance sheet of the Partnership prepared as at the Closing Date (the “Closing Balance Sheet”), at which time Working Capital Adjustment shall be readjusted and paid as follows:

(A) if the Working Capital Adjustment exceeds the Estimated Working Capital Adjustment, then the Purchaser shall pay the amount of such excess to the Vendors; and

(B) if the Estimated Working Capital Adjustment exceeds the Working Capital Adjustment, then the Vendors shall pay the amount of such excess to the Purchaser.