Purchase Price Adjustment

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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 AGREEMENTWITH 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($______) plus or minus the Adjustment Amount and (b) the assumption of the AssumedLiabilities. In accordance with Section 2.7(b), at the Closing, the Purchase Price, prior toadjustment on account of the Adjustment Amount, shall be delivered by Buyer to Seller asfollows: (a) ______ dollars ($______) by wire transfer; (b) ______ dollars ($______) payablein the form of the Promissory Note; (c) ______ dollars ($______) paid to the escrow agentpursuant to the Escrow Agreement; and (d) the balance of the Purchase Price by theexecution and delivery of the Assignment and Assumption Agreement. The AdjustmentAmount 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 theassets 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) aswell 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, theassumption 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 thetax 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 bemore 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 theBalance 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 beequal to the amount determined by subtracting the Closing Working Capital from theInitial Working Capital. If the Adjustment Amount is positive, the Adjustment Amountshall 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 InitialWorking 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 PromissoryNote, which interest shall begin accruing on the Closing Date and end on the date that thepayment is made. Within three (3) business days after the calculation of the ClosingWorking 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 inthis Section 2.8.

COMMENT

The Model Agreement contains a purchase-price adjustment mechanism to modify thePurchase 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 partiesto 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 provisionsto achieve their objectives.

In the absence of a purchase-price adjustment mechanism such as the one employed inthe 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 suchliabilities 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, whichshall 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 respectto the Assumed Liabilities shall be prorated as of the Closing Date. Seller shallassign to Buyer all unused deposits with respect to the Assumed Liabilities and shallreceive a credit in the amount thereof with respect to the Purchase Price.

(b) Ad Valorem Taxes. Ad valorem real and tangible personal property taxeswith respect to the Assets for the calendar year in which the Closing occurs shall beprorated between Seller and Buyer as of the Closing Date on the basis of noapplicable 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 theClosing Date, then the taxes with respect to such Assets for the preceding calendaryear, on the basis of no applicable discount, shall be used to calculate suchprorations, with known changes in valuation or millage applied. The prorated taxesshall be an adjustment to the amount of cash due from Buyer at the Closing. If theactual amount of any such taxes varies by more than dollars ($ ) fromestimates used at the Closing to prorate such taxes, then the parties shall reproratesuch taxes within ten (10) days following request by either party based on the actualamount 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 yardsticksavailable 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 besubject 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 anadjustment 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 opportunityfor 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-priceadjustment. 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 bysubtracting the current liabilities of Seller included in the Assumed Liabilities as ofthat date from the current assets of Seller included in the Assets as of that date. TheWorking Capital of Seller as of the date of the Balance Sheet (the “Initial WorkingCapital”) was ______ dollars ($______).

(b) Buyer shall prepare financial statements (“Closing Financial Statements”) ofSeller as of the Effective Time and for the period from the date of the Balance Sheetthrough the Effective Time on the same basis and applying the same accountingprinciples, policies and practices that were used in preparing the Balance Sheet,including the principles, policies and practices set forth on Exhibit 2.9. Buyer shallthen determine the Working Capital as of the Effective Time minus accruals inaccordance with GAAP in respect of liabilities to be incurred by Buyer after theEffective Time (the “Closing Working Capital”) based upon the Closing FinancialStatements and using the same methodology as was used to calculate the InitialWorking Capital. Buyer shall deliver the Closing Financial Statements and its

determination of the Closing Working Capital to Seller within sixty (60) daysfollowing the Closing Date.

(c) If within thirty (30) days following delivery of the Closing FinancialStatements and the Closing Working Capital calculation Seller has not given Buyerwritten notice of its objection as to the Closing Working Capital calculation (whichnotice 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 incomputing the Adjustment Amount.

(d) If Seller duly gives Buyer such notice of objection, and if Seller and Buyerfail to resolve the issues outstanding with respect to the Closing FinancialStatements 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 theissues remaining in dispute to ______, independent public accountants (the“Independent Accountants”) for resolution applying the principles, policies andpractices referred to in Section 2.9(b). If issues are submitted to the IndependentAccountants for resolution, (i) Seller and Buyer shall furnish or cause to befurnished to the Independent Accountants such work papers and other documentsand information relating to the disputed issues as the Independent Accountants mayrequest and are available to that party or its agents and shall be afforded theopportunity to present to the Independent Accountants any material relating to thedisputed issues and to discuss the issues with the Independent Accountants; (ii) thedetermination by the Independent Accountants, as set forth in a notice to bedelivered to both Seller and Buyer within sixty (60) days of the submission to theIndependent Accountants of the issues remaining in dispute, shall be final, bindingand conclusive on the parties and shall be used in the calculation of the ClosingWorking Capital; and (iii) Seller and Buyer will each bear fifty percent (50%) of thefees 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 takesuch repurchases into account when determining the adjustment amount. The Model Agreement

provides that Buyer will prepare the Closing Financial Statements and calculate the WorkingCapital 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 adjustmentamount 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 theaccounting 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 toissue 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-UponProcedures 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-priceadjustment 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 withrespect 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 disputesconcerning the post-closing adjustments vary in acquisition agreements. Section 2.9 provides

that Buyer will determine the Closing Working Capital based upon the Closing FinancialStatements 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 theClosing 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 forresolution “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 asarbitrators, and there is no separate arbitration provision governing disputes under the ModelAgreement. 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 asfollows:

In resolving a motion to compel arbitration under the Federal Arbitration Act ... , a courtmust: (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 thoseclaims 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 anarrow 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 ofarbitration, 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. Ifthe dispute arises over the accounting methods used in calculating the closing working capital ornet 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 generallyaccepted 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 (8thCir. 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 andnot 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 notencompass 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 consistentapplication 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 iscomputed 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 InitialWorking 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 submittedto 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 mightconsider 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 paymentof 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. Therationale 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 AGREEMENTWITH 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 ofrevenues, 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 lackthereof) 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 reduceits 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 itqualifies for treatment as an instalment sale under the Internal Revenue Code, whichallows 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 deferredtax). 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 willhave 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 assales) 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 consolidatedstockholders’ 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 beequal to (a) the consolidated stockholders’ equity of the Acquired Companies as of theClosing 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 theclosing 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 thelast 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 statementsdiffer 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’ representationsconcerning 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 priceadjustment 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 provisionsshould 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 “theconsolidated 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 thedefinition 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 considerdescribing “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 purposesof 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’scertified public accountants, to audit consolidated financial statements (“ClosingFinancial Statements”) of the Company as of the Closing Date and for the periodfrom the date of the Balance Sheet through the Closing Date, including acomputation of consolidated stockholders’ equity as of the Closing Date. Sellers willdeliver the Closing Financial Statements to Buyer within sixty days after the

Closing Date. If within thirty days following delivery of the Closing FinancialStatements, Buyer has not given Sellers notice of its objection to the ClosingFinancial Statements (such notice must contain a statement of the basis of Buyer’sobjection), then the consolidated stockholders’ equity reflected in the ClosingFinancial Statements will be used in computing the Adjustment Amount. If Buyergives 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 partywill furnish to the Accountants such workpapers and other documents andinformation relating to the disputed issues as the Accountants may request and areavailable to that party or its Subsidiaries (or its independent public accountants),

and will be afforded the opportunity to present to the Accountants any materialrelating to the determination and to discuss the determination with theAccountants; (ii) the determination by the Accountants, as set forth in a noticedelivered to both parties by the Accountants, will be binding and conclusive on theparties; and (iii) Buyer and Sellers will each bear 50% of the fees of the Accountantsfor such determination.

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(b) On the tenth business day following the final determination of theAdjustment Amount, if the Purchase Price is greater than the aggregate of thepayments made pursuant to Sections 2.4(b)(i) and 2.4(b)(iii) and the aggregateprincipal 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 ofpayment. Payments must be made in immediately available funds. Payments toSellers must be made in the manner and will be allocated in the proportions setforth in Section 2.4(b)(i). Payments to Buyer must be made by wire transfer to suchbank 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 ina 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 notspecify 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 shouldconsider 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 Sellersusually 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 theadjustment 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 priceadjustment.

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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. KrebPricewaterhouseCoopers LLP

Chicago, Illinois

February 2005



Table of Contents

I. FORMS OF CONSIDERATION FORMS OF CONSIDERATION...............................1

A. In General....................................................................................................................1B. Cash Payment..............................................................................................................2C. Payment by Stock........................................................................................................2

1. Valuation Issues..................................................................................................22. Restrictions on Resale.........................................................................................43. Shareholder Approval .........................................................................................44. Tax Considerations .............................................................................................5

D. Payment by Promissory Note......................................................................................61. Set-Off Rights .....................................................................................................62. Tax Benefits ........................................................................................................6

3. Security for Payment of the Notes ......................................................................6

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

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

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

A. Overview.....................................................................................................................8

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

1. Amount Paid at Closing....................................................................................112. Accounting Specifications ................................................................................12

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

g. Hindsight..................................................................................................16h. Right to Offset..........................................................................................16

3. Issues of Control ...............................................................................................174. Caps and Floors.................................................................................................185. Interplay Between the Post-Closing Adjustment and Indemnification.............186. Dispute Resolution: Designation of Independent Accountants ........................187. Mechanisms to Ensure Payment of the Adjustment Amount ...........................20

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IV. EARNOUTS ........................................................................................................................20

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

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

2. The Formula for Calculating the Payment Amount..........................................223. The Length of the Earnout Period.....................................................................234. 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 ..........................................................28a. Valuation Issues .......................................................................................28 b. Securities Issues.......................................................................................28

c. Related Tax Questions .............................................................................296. Operation of the Acquired Business During the Earnout Period......................29a. Operation by the Buyer Post-closing .......................................................30 b. Operation by the Seller’s Management Team Post-closing.....................30c. Protection Placed in the Acquisition Agreement .....................................30

7. Payment of Earnouts to Public Shareholders....................................................318. Shareholders Designated to Act for the Seller..................................................329. Sale of the Target During the Earnout Period...................................................32

10. Integration of the Target into the Buyer’s Other Businesses ...........................3211. Averaging Periods of Strong Performance With Weak Performance..............3212. Dispute Resolution ...........................................................................................3313. Registration Issues for Earnout Rights .............................................................3314. Special Industry Limitations ............................................................................34

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

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PURCHASE PRICE ADJUSTMENTS, EARNOUTS

AND OTHER PURCHASE PRICE PROVISIONS

by

Leigh WaltonBass, Berry & Sims PLC

Kevin D. KrebPriceWaterhouseCoopers 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 theclosing, and many acquisitions provide for a post-closing adjustment or true-up. Further, theacquisition 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 taxand accounting treatment of the transaction, the securities laws ramifications of the acquisitionand 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 theacquiring entity, installment notes, the assumption of indebtedness or somecombination thereof. Factors that affect the way the purchase price is paidinclude:

• 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 assetacquisition; and

• the buyer’s desire to extend payments through notes, creating a source tosatisfy indemnification claims.

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

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B. Cash Payment

Payment by cash is appealing in its simplicity and because (absent a holdback tosecure 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 theseller realizing an immediate gain for tax purposes on the transaction.

The Financial Accounting Standards Board (“FASB”) issued Statements ofFinancial Accounting Standards (“SFAS”) No. 141, Business Combinations, in2001. SFAS No. 141 eliminated the pooling of interests method of accounting fortransactions initiated after June 30, 2001. SFAS No. 141 requires all businesscombinations initiated after June 30, 2001 to be accounted for using the purchasemethod of accounting. See Jan R. Williams, 2004 Miller GAAP Guide, at 4.0.With the elimination of pooling of interests, cash-based transactions haveincreased, with cash being used as the sole consideration for the transaction or incombination with stock.

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

C. Payment by Stock

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

1. Valuation Issues

Once the parties agree to use stock as consideration and a purchase pricehas 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 themoment of their agreement on the price, as of the date the acquisitionagreement 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 thetransfer of the stock is otherwise restricted, the seller may demand adiscount from market price. If the buyer’s stock will be registered underthe Securities Act, the Securities and Exchange Commission (“SEC”) willinsist that the number of shares to be issued to the seller’s shareholders beclearly indicated in the proxy statement for the meeting at which thetransaction is approved, or be ascertainable from external sources at thattime.

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

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closing. To protect against extreme fluctuations in price, the parties willlikely place an upper and lower limit – a collar – on the range withinwhich the stock price may vary for the purposes of valuation. The collarmay 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 onecomponent, 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 averageclosing price to value a listed security, the parties might agree to thefollowing provision:

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

were $55.”

The parties also may agree that there is a right to terminate the contract ifthe price extends beyond the collar limits. For example, the definitiveagreement may provide that in the event the purchase price falls below thelower limit, the buyer may, but is not required to, provide additionalconsideration, in cash or stock, to bring the purchase price up to the lowerlimit. If the buyer is unwilling to provide such additional consideration,the seller may terminate the agreement if it is unwilling to accept thelower purchase price. In drafting provisions of this type, it is important toconsider 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 notifythe seller whether it is willing to provide additional consideration toincrease 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 notincreased to the lower limit? Such provisions should be clearly addressedin order to avoid uncertainties and will be subject to negotiation.

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Finally, as is discussed later in this article, many acquisition agreementscontemplate a post-closing adjustment that can result in the buyer payingadditional consideration, or the seller in effect refunding previously paidconsideration to the buyer. If a portion of the consideration involved inthe 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 securitiesissuance) must be registered under the Securities Act, or an exemptionfrom registration must be available. Typically Form S-4 is used forregistration (although the use of Form S-1, S-2 or S-3 may be mandated ifno shareholder approval is required or if a majority shareholder of theseller has agreed to support the transaction, thus assuring shareholderapproval).

If the seller agrees to accept unregistered securities, a private placementexemption through Section 4(2) or Regulation D under the Securities Actis the typical route to securities laws compliance. When the seller’sshareholders receive stock that is issued under an exemption, they musthold the stock until it can be sold publicly under Rule 144 (typically aminimum one year holding period), another exemption from registration isavailable or the stock is registered. Even if received in a registeredtransaction, securities held by affiliates of a seller prior to the acquisitionwill, 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 toregister the seller’s resale of the stock. This provision may be constructedas a “demand registration right,” whereby the seller may require the buyerto register the securities upon demand, or a “piggyback registration right,”whereby the securities are registered as an add-on to another registrationstatement being filed by the buyer. Faced with the prospective expense offiling 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 ofregistrations that will be effected, may place time limits on the rights ormay require that a minimum number of shares from the seller’sshareholders be available for sale. The seller may insist that no other

registration rights be granted that are on terms more favorable than thosegranted to the seller’s shareholders and that the buyer pay all expenses (tothe extent allowable under NASD regulations) of the registration.

3. Shareholder Approval

Approval of the buyer’s shareholders may be required for the issuance ofthe 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, whenthe 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, butgenerally approval is necessary for transactions in which the buyer is

issuing (or in the case of AMEX, has the potential to issue) 20% or moreof its outstanding common stock, or if the issuance will for some otherreason impact control of the buyer. The NYSE, AMEX and Nasdaq eachhave specific rules in effect in this regard.

Of course, state law also may require that the buyer’s shareholdersapprove the transaction. For example, under Section 6.21(f) of the Model Business Corporation Act , action by the shareholders of the survivingcorporation 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 willcomprise more than 20% of the voting power of the shares of thecorporation that were outstanding immediately before the transaction.

It is important to monitor a fluctuating purchase price involving theissuance of stock to determine if approval of the buyer’s shareholders isrequired. Upon execution of a definitive agreement including a purchase price based upon a fluctuating per share price, it may be anticipated thatthe price will remain high enough that the number of shares of buyer stockto be issued at closing will not reach the threshold requiring shareholderapproval. However, if the buyer’s stock price drops, assuming the numberof shares to be issued at closing is not first capped by the lower limit of thecollar, the number of shares of buyer stock to be issued at closing couldreach 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 stocktransaction typically is structured as a reverse triangular merger. That is,the acquiring entity will set up a merger subsidiary that merges into thetarget. If a combination of cash and stock is used, a reverse triangularmerger typically will be tax-free if the stock constitutes at least 80% of theaggregate consideration for the transaction. Because the value of the stock

is determined on the closing date, parties intending their transactions to betax-free under these provisions should provide some adjustmentmechanism in the contract if market fluctuations cause the value of thestock in the deal to dip below 80% of the aggregate consideration. If thestock involved is less than 80% of the aggregate consideration, a forwardtriangular merger often will afford partially tax-free treatment. That is, theacquiring entity will set up a merger subsidiary and the target will mergeinto the merger subsidiary. If the stock involved falls below 45% of the

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aggregate consideration, the stock component of the transaction generallywill be taxable unless a complex structure is used. In any reorganization,shareholders will pay tax on the lesser of their gain realized and the cashreceived; thus, it may not be worthwhile to structure a tax-free transactionwith 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 otherreason wishes to lower its original cash outlay. By retaining a portion of the purchase price, the buyer retains leverage with the seller for payment ofindemnification claims. Payment by note may also be beneficial to the seller fortax reasons.

1. Set-Off Rights

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

2. Tax Benefits

If payment is made by note, the seller will generally report any gain fromthe sale on the installment method under §453 of the Internal Revenue

Code of 1986, as amended. Reporting on the installment method permitsthe 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 cashequivalents. Furthermore, the seller must make interest payments to thegovernment on the deferred tax liability on installment obligationsgenerally to the extent they exceed $5,000,000 in the year they arose.After much debate, in 2000 Congress repealed a statute makinginstallment 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 acceptedin 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 selleralso may accept a pledge of the target’s stock acquired by buyer.

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

6



maintained until the note is paid, prohibiting the buyer from engaging inthe target’s line of business except through the target, restrictions on thesale of certain assets, restrictions on dividends from the target to the buyerand requiring the business of the target to be maintained in a separateentity.

II. HOLDBACKS OF PURCHASE PRICE IN ESCROW

A. Overview

The buyer may demand a readily accessible pool of money to cover post-closingindemnification claims and other specified contingencies. One common way to provide such a pool of money is an escrow arrangement providing that a part ofthe 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 ofshares (previously, no more than 10%) with respect to which an escrow may beestablished also will be eliminated.

B. Benefits and Risks

The escrow fund established will provide greater ease of recovery for the buyer inthe event of indemnification claims, alleviating concerns about the seller’songoing solvency and potential problems in locating the seller’s assets forexecuting judgments. Buyers should be aware that the seller will likely proposethat 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 changesthe 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 underthe installment method described in I.D.2. above. In most escrow situations, thetax on payments received from escrow will be based on the presumption that allof the escrow amount will be paid to the Seller. Adjustments are made in thesubsequent 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 thetarget, but when there is a period of time between the signing and closing of theacquisition. A target’s value is usually determined on the basis of the most recentfinancial information available at the time of pricing. Generally, the purpose of a purchase price adjustment provision is to reflect changes in certain values of thetarget 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 typicallya gap in time between the latest available financial statements and the closingdate, 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-closingadjustment, it bridges the gap between the financial condition of the seller at thetime of signing the definitive purchase agreement and its condition as of theclosing date. Thus the buyer receives the benefit of its bargain by receiving theagreed upon balance sheet (or an adjustment in the purchase price).

An additional rationale for use of a post-closing adjustment is that it effectivelyallocates 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 theeconomic 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 distributionsduring this period. Conversely, losses would be borne by the buyer absent a post-closing adjustment. A post-closing adjustment may also be structured to

8



protect the buyer against potential seller abuses, such as selling inventory withoutreplacement, 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’sfinancial results have materially deteriorated. The adjustment only becomesoperative 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 structureof the post-closing adjustment often varies depending on the theory under whichthe entire transaction is valued. These theories include applying a multiple ofearnings 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 willtypically arrive at a purchase price based, in large measure, on information in thelatest 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 regardlessof 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 assetdeal and left with the seller). Thus an adjustment that takes into account thetarget’s current assets and its current liabilities at closing assures that the closingworking capital is accounted for.

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

A recent survey of purchase price adjustments in private company acquisitionsanalyzed 43 publicly filed purchase agreements entered into in 2003 and 2004with 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 adjustmentidentified in the surveyed transactions was the net working capital adjustment,

which is intended to reflect the change in the current assets and current liabilitiesfrom the signing date to the closing date. Working capital adjustments were usedin more than 50% of the transactions reviewed. Other than working capital, noneof the purchase price adjustment mechanisms identified in the Survey were usedin more than 10% of the surveyed transactions. These other purchase priceadjustments, however, give an indication of the wide variety of matters than can be measured and compared, such as net book value, tax liabilities, shareholders’

9



equity, cash expenditures, net debt, net worth, capital expenditures and number ofcustomers.

Commonly, post-closing adjustment clauses call for a dollar-for-dollar adjustmentto reflect changes in the net working capital, net asset value or other measuredfinancial 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 specifiedfinancial measure taken from the pre-execution financial statements (oftenreferred to as a “reference balance sheet”) of the target to the same measure in thefinancial statements of the target prepared as of the closing date. The comparisoncan 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 theclosing date balance sheet amount. In a transaction with a post-closing

adjustment, the closing is often scheduled for a month-end (or, even better, afiscal quarter-end) to avoid difficult cut-off issues. The closing date financials arethen prepared as of this date so that the comparison to the reference balance sheetamount can be made. If a period end closing is not feasible, special proceduresshould be agreed to that deal with the cut-off issues.

A critical issue relating to the mechanics of the post-closing adjustment is thedecision as to which party is charged with the preparation of the closing datefinancial statements. The buyer and its accountants often contend that theyshould prepare the closing date financial statements, since the buyer has assumedcontrol 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 agreementsanalyzed, the buyer was assigned the task of producing the post closingcalculation. 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 ofthe purchase price adjustment amount.

Most disputes arising out of acquisitions and divestitures that involve accountingand financial reporting issues result from the buyer’s preparation or review of theclosing date balance sheet and its divergent presentation of the way the selleraccounted for (or did not account for) items in the balance sheet. The buyer hasincreased opportunity after the closing to understand these issues because it nowcontrols and operates the company it has purchased, thus allowing it access toinformation that it may not have had before closing. The buyer can examine thefinancial statements in more detail and use the knowledge of company personnelwho 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 byobjecting 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 60days – during which it can object to items in the closing date balance sheet and propose an alternative purchase price adjustment. If objectionable items arediscovered, the reviewing party generally must file a notice of objection withinthis time. For example, a contract may state, “the Seller may dispute any amountsreflected 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, andspecify 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 mandatethat the notice of objection be specific, whereas some contracts have more generalterms. Specific notices usually must identify and explain the item in dispute andrequire the objecting party to state the individual dollar amounts of all of itsobjections at that time. Some general clauses require only that the notice identifythe objection, without disclosing details until a later date.

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

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-offdate, mandate complete and specific disclosure of the disputed items by thedeadline, 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 sheetgenerally 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 orminus an estimate of the purchase price adjustment, as determined by theseller employing the post-closing adjustment procedure to pre-closingfinancials that are more current than those available at signing. In eithercase, one party will have to settle with the other when the closing date

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

b. GAAP versus Consistency.

Another common issue involves the concepts of GAAP andconsistency. Conflicts often arise regarding whether GAAP orconsistency takes precedence in applying an accounting method toa particular transaction or a particular account balance. WhenGAAP and consistency requirements appear to conflict, expertsusually designate GAAP as the higher and controlling standard.Though important, consistency normally is a secondaryconsideration to the use of GAAP. For example, a seller may haveused 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 financialstatements with GAAP if GAAP is the agreed upon standard.

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

In addition, disputes may arise over the application of the termconsistent . For example, consider the following language: thecompany “consistently provides an allowance for bad debts,”versus “provides an allowance using a consistent calculationmethodology,” 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 finalfinancial statements at closing. Because most companies applymore rigorous and in-depth closing procedures at year-end,questions may arise regarding which procedures the preparer of theclosing date balance sheet should apply. The interpretation of such

an issue may differ depending on whether the closing date balancesheet or the financial statements used in negotiations were month-or period-end, but not regular reporting year-end. For example, ifthe financial statements used in negotiations were for an interimmonth-end, and the agreement calls for consistently appliedaccounting 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 werethe 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 becomesavailable after the closing date, such as the discovery of previouslyunknown errors, irregularities or material departures from GAAP.Because parties usually do not anticipate errors in the financialstatements, most agreements do not address the treatment of suchissues. The handling of this situation depends on the circumstancesof the error and its discovery. For example, if the financialstatements used in the negotiation process contained the error, butthe seller corrected it to its benefit in the closing date balancesheet, the buyer may object by arguing that the seller should not benefit from its own errors. If the buyer, however, detects an errordetrimental to it in the closing date balance sheet and such errorwas 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, whenit became known, when the seller corrected it – will influence howit should be treated in the purchase price adjustment.

e. Materiality.

Interpreting and applying the accounting concept of materiality toindividual items, transactions, balance sheet or income statementline items, or the financial statements taken as a whole can result indispute. In purchase price disputes, the buyer usually will claimthat all purchase price adjustments, if deemed proper, should beawarded to it regardless of materiality, unless the contract containsa threshold, basket or other similar clause.

Agreements occasionally contain clauses indicating that post-closing adjustments will be made only if they exceed a specifieddollar amount in the aggregate – a materiality threshold. The

contract clause may provide that once the adjustments exceed suchlevels, the benefiting party receives the entire amount; or theclause may read that such party will receive only the amount bywhich the adjustments exceed the specified level (a basket ordeductible limitation). A materiality level may also be impliedthrough contract clauses. For instance, a contract may read that no post-closing adjustment is necessary if the net asset value changesless than 5% from the net asset value in the financial statements

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

Accountants have traditionally evaluated materiality with respectto the financial statements taken as a whole. Occasionally,however, a purchase agreement indicates that materiality applieson 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 thresholdshould apply to proposed purchase price adjustments. The sellermay argue that it represented that the financial statements would be prepared in accordance with GAAP, which contains the concept ofmateriality. Therefore, to the extent that the buyer proposesadjustments that are immaterial, either individually or in theaggregate, the seller may successfully argue that it did not violatethe representations made in the purchase agreement. In contrast,the buyer will argue that material for financial statements of agoing concern business means something different from material for balance sheets closing a purchase transaction. For the goingconcern, an item can be in error, but the same error occurring yearafter year will not significantly affect recurring operating incomenumbers and computations made on them. For a buyer, an upwardchange in purchase price of $250,000, for example, may be wortharguing about even though the amount would not be material to the

financials as a whole. Carefully drawn purchase agreements willaddress the materiality standards to be used in balance sheetsclosing 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 theagreement. The following list includes common arguments withrespect 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 duringinterim periods. Examples of common disputes include adownward 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, thesedisputes raise consistency issues. The seller may indicate that itreviews such accounts only periodically and at year-end, so that presenting a balance sheet in accordance with GAAP required theadjustment. The buyer may contend that the seller did notconsistently apply the accounting practices because the seller didnot adjust the accruals downward when it prepared the pre-closingfinancial statements used in negotiations. These issues arise sooften that parties should anticipate them in drafting contracts. Thefollowing chart indicates the most common sources of controversyfor major balance sheet items.

BALANCE SHEET ITEMS AND ISSUES OFTEN INVOLVED IN DISPUTES

Accounts Receivable Allowances

• Adequacy of Allowances

• Consistency of Allowances (methodologyand amount)

• Hindsight Issues

Inventory

• Allowances for Obsolescence

• Excess Inventory

• Interim versus Year-End Count andValuation Procedures

• Application of Standard Costs

Accounts Payable

• Complete Recording

• Cut-Off Procedures and Consistency

• Materiality

Accruals

• Interim versus Year-End RecordingProcedures

• Materiality, Consistency

• Recognition and Treatment of Interim

“Smoothing” of Accruals for AnnualExpenditures

Contingencies

• Management Judgment Issues

• Corporate Provisions

• Statement of Financial AccountingStandards No. 5 – Accounting forContingencies

Revenue Recognition

• Deliveries under Long-Term Production

Contracts• Recording of Revenue under Government,

Construction or Other Long-Term Contracts

• Recording of Revenue and Amortization ofCost Relating to Intangibles

• Deferral and Subsequent Recognition ofIncome

Capitalization Issues

• Capitalization of Development Costs

• Deferral and Subsequent Recognition ofIncome Capitalization of Tangible andIntangible Assets: Amortization Periods

• Consistency

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g. Hindsight.

Often, a buyer may contend that allowances reflected in the closingdate balance sheet (such as those for bad debts) are inadequate andwere therefore not stated in accordance with GAAP. For example, a

buyer may argue that a seller’s $100,000 bad debt allowance wasinadequate because the buyer has learned post-closing that $200,000of accounts receivable are uncollectible. The buyer may have a validargument if it can prove that information justifying a $200,000allowance was available to the seller when it prepared and finalizedthe closing date balance sheet. For instance, the auditors may haveidentified this exposure and recommended an allowance of $200,000.If the buyer does not have reasonable evidentiary indications thatinformation or knowledge existed prior to the preparation of theclosing 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 tocalculate the amount prospectively conforms with GAAP and theseller’s historical practices.

h. Right to Offset.

Though not written into purchase agreements, sellers often claim aright to offset as a defense against paying purchase price adjustments proposed by a buyer that has objected to balances or items in aclosing date balance sheet prepared by the seller. Buyers typicallywill review the closing date balance sheet and identify areas or

accounts that contain, in their view, overstated assets or understatedliabilities. Acceptance of these adjustments would result in purchase price adjustments favorable to the buyer.

Because buyers seek to reduce the purchase price, they may identifyonly those items favorable to them, even though they may be awareof contractually required adjustments that would be unfavorable tothem. For example, in its post-closing review of a closing date balance sheet prepared by a seller, a buyer might note that thevacation liability is under-accrued by $300,000 and that the worker’scompensation liability is over-accrued by $300,000. The buyer mayignore the over-accrual and claim $300,000 in a purchase priceadjustment relating to the under-accrual associated with the vacationliability. This may lead the seller to claim the right to offset anunder-accrual by a corresponding over-accrual. The seller may arguethat this right to offset must exist to prevent the buyer fromselectively objecting to the closing date balance sheet. In someinstances, the seller may have been aware of both the over-accrualand under-accrual, but chose not to record the offsetting adjustment.

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

Because agreements seldom provide for rights to offset, it may bedifficult for the trier of fact to ascertain the intent of the parties anddecide whether to adjust the purchase price in the event the parties donot settle the issue. Careful drafting can reduce uncertainty withregard to offsets.

3. Issues of Control

Issues of control arise in situations in which the party in control of theoperations can potentially manipulate accounting and financial reporting toits benefit through the post-closing adjustment process. For example, in amanagement 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 financialreporting 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 takeadvantage of its control and clean up the balance sheet to the buyer’sdetriment. Buyers recognize this potential and therefore require several provisions in the form of representations, warranties or covenants in thecontract to prevent the sellers from doing so. Buyers are cautioned not to place undue reliance on general covenants, such as the requirement that theseller operate the target in the ordinary course of business between the

signing and the closing. First, this provision at best protects againstmanipulation after the signing (and not before). Second, proving that a practice does not comport with the seller’s ordinary course of business isdifficult. If a particular form of manipulation is feared, carefully craftedrestrictive covenants should be considered. Further, these carefully craftedrepresentations should be bolstered with a post-closing adjustment thatreflects changes occurring in the stub period, regardless whether they occurin the ordinary course or are the result of manipulation.

Conversely, it should be noted that the post-closing adjustment is not asubstitute for thoughtful representations and warranties. If the seller

generates or preserves cash by cutting back on discretionary expenses, theresult will be an increase in cash but not necessarily an offsetting increase inaccounts payable. Thus for example, the seller might decide to cut back onadvertising expenses resulting in a short-term increase in cash but no changein accounts payable. Under a working capital post-closing adjustment, the purchase price will increase even though the business is arguably worse offand in fact may suffer lower revenues in the future because of the failure toadvertise. Thus, the manipulation is rewarded by the post-closing

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

Issues of control are almost inevitably present when the target is a division orsubsidiary of the seller. In this context, working capital is managed centrallyand thus not part of a “closed system.” Thus the opportunity for significantmovements in working capital is present and should be anticipated by carefuldrafting. Similarly, in this situation, the buyer should guard againstdisappearing intercompany assets, such as deferred tax assets.

4. Caps and Floors

Although relatively uncommon, the purchase price adjustment provision maycontain a provision for a “cap,” which is an upper limit on the adjustmentamount 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 shouldconsider 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 ora floor may give rise to a risk that the party thus constrained will turn insteadto contractual remedies in “unwind” provisions, deferred payment provisionsand indemnity provisions.

5. Interplay Between the Post-Closing Adjustment and Indemnification

Carefully crafted acquisition agreements will explicitly deal with the impactthat the post-closing adjustment has on the indemnification provisions of theagreement. Sellers should insist that buyers not be allowed to “double dip” by a recovery first under the post-closing adjustment and then again asindemnification. For example, if an error in the pre-closing date balancesheet line items of inventory or accounts receivable causes a net workingcapital post-closing adjustment, the seller should stipulate that this errorshould not also give rise to indemnification for a breach of the representationthat 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, andinsist upon collection the full loss, offset by the amount of the post-closingadjustment.

6. Dispute Resolution: Designation of Independent Accountants

Because it is not uncommon for disagreements to arise in the determinationof the post-closing adjustment, the parties often agree upon a disputeresolution 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 todesignate a firm of independent accountants to review the closing datefinancial statements. These accountants may act as auditors (who review thefinancial data and provide an audit of the information) or as arbitrators (whomake a determination as to the proper resolution of the disputes that have

arisen regarding the closing date financials). If the identity of theindependent accountants is not stipulated by the parties, the parties shouldspecify the procedure for their selection.

The lawyers drafting the provision should state whether the independentaccountants are to examine only the disputed line items, or whether they mayreview 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 BarAssociation (the “Committee”), provides for submission only of the “issuesin dispute” to the independent accountants, effectively eliminating thisuncertainty. Model Stock Purchase Agreement , § 2.6(a). Likewise, the Model Asset Purchase Agreement with Commentary, published in 2001 bythe Committee, provides only for the submission of “issues remaining indispute” after negotiations between the parties to the independentaccountants. 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 thethird-party accountants for review. They may provide that they will split theamount 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 writtensubmissions:?

• Will the arbitration be final and binding?

• What time frame allowing for negotiations should precede thearbitration 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 heldresponsible.

7. Mechanisms to Ensure Payment of the Adjustment Amount

The parties may place part of the purchase price in escrow to ensureexpedited payment of an adjustment amount. If a promissory note has beenused to finance the sale, the parties may agree to increase or decrease, asappropriate, 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 theacquired company reaching certain milestones during a specified period after theclosing. The benchmarks used are typically financial, such as net revenues, netincome, a cash flow measure or earnings per share. Non-financial benchmarks areappropriate in some circumstances. When the benchmark being measured reaches anegotiated threshold, an earnout payment is triggered.

Earnouts (as opposed to typical post-closing purchase price adjustments) are mostoften 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 asource from which they can offset indemnification claims. An earnout also may beattractive to a buyer desiring to bridge a financing gap.

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

Earnouts are used in transactions large and small, involving acquisitions of privateand, 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 ofthe 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 benon-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 orrestructure the target, misappropriate future value to the wrong party or motivate theearnout’s recipients to focus on short-term goals that will maximize the earnout.Further, earnouts have great potential for engendering later disputes about thecontingent payment. Disputes often arise when the seller suspects that the buyer isusing 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 someunforeseen 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, manylegitimate, should cause counsel for the buyer and the seller to carefully craft theearnout provisions. The Model Asset Purchase Agreement with Commentary contains as an attachment a separate earnout agreement that provides draftingguidance. 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. Inchoosing milestones, and in drafting the acquisition agreement, the partiesshould 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; netincome; 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 tosellers, since they will not be affected by operating expenses oracquisitions. The buyer’s post-closing accounting practices willlikely have less impact on revenue than other items. Buyers are morelikely to agree to a revenue–based benchmarks if costs of goods soldand overhead have little variability. Generally, however, buyersoppose revenue-based benchmarks because they provide no incentiveto the earnout recipients to control expenses, and may provide anincentive to generate short-term sales that may prove to beunprofitable. Buyers generally favor net income benchmarks on theground 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 toallay sellers’ concerns about net income measures. EBIT andEBITDA reflect the cost of goods and services, selling expenses andgeneral and administrative expenses, and thus are more difficult tomanipulate. They are additionally desirable because they exclude

interest, taxes, depreciation and amortization, which may vary basedon the buyer’s capital structure or the way in which the acquisition isfinanced. Finally, for a transaction that is initially valued using amultiple of post-closing cash flow, the use of EBIT or EBITDA forthe earnout is logical to determine what is in essence deferred purchase price.

Regardless of the financial benchmark chosen, the parties shouldcarefully analyze the potential of the earnout to distort the incentivefor producing long-term, sustainable growth. For example, as notedabove, a revenue target may tempt the earnout recipients to bookunprofitable business. An earnout based on cash flow or incomecould incentivize the earnout recipient to slash expenses (e.g.marketing and advertising costs) to bolster short-term profitability atthe expense of long-term growth.

b. Non-Financial Benchmarks

Non-financial benchmarks often are used in acquisitions ofdevelopment-stage companies. These companies may be difficult tovalue, due in part to their high growth rates, and are particularlysuited 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 givingoperational focus to the target.

A non-financial benchmark could be completion by the company of acore product or new product, inclusion of a favorable article in a publication that meets specific criteria or the receipt of a “besttechnology” 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, I NSIGHTS,August 1996.

2. The Formula for Calculating the Payment Amount

For financial benchmarks, the parties may stipulate the flat amount ofconsideration to be paid if the threshold is met. More typically, the buyerwill pay the seller a specified percentage of the amount by which the target’s performance surpasses the threshold. For example, the buyer may make anannual payment to the seller equal to a percentage by which the target’sEBITDA 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 EBITDAfor a previous year will reduce the payment otherwise due for the currentyear. An often difficult negotiation ensues regarding whether payments are prorated if the threshold is only partially achieved. This negotiation issometimes settled by establishing a minimum hurdle before any payment will

be made and providing a sliding scale or proration after that hurdle isachieved. For non-financial thresholds, the parties must agree upon anamount of cash consideration or a number of shares of stock that will bedelivered for each milestone that is met. In any event, the payout is oftencapped 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, thedivision into which the target is absorbed or some other source.

Lenders will often consider the recipient of an earnout an equity holder andseek 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 itsobjection known early in the negotiation. On the other end of the spectrum,the seller may demand credit enhancement (for example a letter of credit) forthe earnout. These negotiations will turn on the leverage of the parties andthe financial position of the buyer.

3. The Length of the Earnout Period

Most earnout periods conclude after the expiration of a specified length oftime – generally between two and five years after the closing The

appropriate length will be determined based on how long it will take tomeasure 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'semployment. Because earnouts may affect the flexibility of the post-closingoperation of the target, and few subsequent purchasers of a business willaccept assets burdened by an earnout, it is usually advisable to the purchaserto 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 andrecords for the target, division or other source of the earnoutthroughout the earnout period. The buyer should covenant that these

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financial records will be made available for review upon reasonablenotice.

The buyer and its accountants typically will make the initialdetermination of whether the milestones have been reached. Theseller then will review the calculations and challenge them ifnecessary. In certain situations, it may be appropriate to require thatthe results of the earnout period be audited.

b. Accounting Issues

For financial milestones, the parties should stipulate with as muchdetail as possible the accounting principles that will be used tocalculate whether the thresholds have been met. As noted above,GAAP embraces a wide range of acceptable accounting practices, andis consistently in a state of flux. The ability to manipulate the resultsof an earnout through adjustment to GAAP is often legitimately of

great concern to the seller. Particular care in delineating thecalculation principles should be used if the threshold is a non-GAAPfinancial measure, such as EBIT or EBITDA. The parties thus shouldincorporate into the acquisition agreement a description of theaccounting principles to be employed. Listed below are specificaccounting issues that may arise:

(1) Consistency of Practice in Post-closing Accounting

A problem may arise in the form of movement of revenue andexpenses 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 thisregard should not vary from prior practice. Special care must be taken, however, if the target was fundamentally different inthe hands of the seller than the way it will be treated by the buyer (e.g., if the seller was an S corporation or compensationexpense of the target as a C corporation was artificially high).Diligence into the pre-sale accounting policies of the sellerwill clarify past practice and reveal any areas of potentialdispute. The parties should consider specifying whetherchanges 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 iscalculated.

• 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, Goodwilland Other Intangible Assets, effective June 30, 2001, parties also almost always added back goodwillamortization in calculating an earnout based on netincome. SFAS No. 142 eliminates the amortization ofgoodwill for calendar year companies for (a) goodwillacquired after June 30, 2001, and (b) for goodwill existingon June 30, 2001, after December 31, 2001. Instead,SFAS No. 142 requires an annual impairment test basedon a comparison of the fair value of each reporting unitthat houses goodwill acquired to the carrying amount ofthe reporting unit’s assets, including goodwill. Partiesshould consider the impact of the annual impairment testsin determining the earnout with respect to a transaction.

• When net income, EBIT or EBITDA are used as the performance measures, the seller should ascertain whatadministrative or general overhead expenses the buyer willallocate to the target after closing and determine howthose expenses will impact the post-closing figures. Forexample, the allocation of corporate headquarters’expenses and services allocated among affiliates should becarefully considered.

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

• The seller’s counsel also may argue that indebtednessresulting from the acquisition allotted to the target afterclosing should be excluded when calculating the earnout.If interest is excluded, care should be taken to excludeexpenses 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 gainsand losses.

• Intercompany transactions between the target and the buyer or its affiliates also require adjustment to reflect theamounts 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 ifcharacterized as a management fee) is actually adistribution of profits, the payment should not be treatedas an expense in the calculation of the earnout.

• While most exclusions from the earnout calculation aredemanded by the seller, the purchaser should considerwhether exclusions are appropriate. In some situations itmay be appropriate for synergies arising out of thecombination to be excluded from the earnout. Particularlyif the buyer intends to use the target as a platform forfuture acquisitions, revenue, income or cash flow fromthese acquisitions may need to be excluded in the earnoutcalculation.

(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 taxpayergroup, or become a part of the buyer’s consolidated taxreporting group. The seller’s counsel should assure that payments made by the target pursuant to the agreement or as amember of the group do not have unanticipated effects on theattainment of the earnout thresholds.

(4) Accounting Treatment of the Contingent Consideration

When Linked with Future Employment

A difficult accounting issue arises in those transactions inwhich contingent consideration is linked with the continuedemployment of the seller’s management. In transactions inwhich the contingency is based on the future earnings of theseller and the management of the seller enters intoemployment contracts with the new entity, the question ariseswhether 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 particularlyrelevant to acquisitions of small businesses.

In 1995, the FASB’s Emerging Issues Task Force reached aconsensus on this issue in EITF 95-8, Accounting forContingent 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 forcontingent consideration based on earnings:

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• reasons for contingent payment provisions;

• the formula for determining contingentconsiderations;

• treatment of the contingent payment for tax purposes;

• linkage of payment of contingent considerationwith continued employment;

• a composition of the shareholder group; and

• other arrangements with shareholders, such asnoncompetes, consulting agreements and leases.

The determination as to whether payment of contingentconsideration represents purchase price or compensation is based on facts and circumstances. The EITF notes that if acontingent payment arrangement is automatically forfeited ifemployment terminates, a strong indicator exists that thearrangement is, in substance, compensation. The EITF goeson to note, however, that the absence of linkage betweencontinued employment and payment of contingentconsideration does not necessarily imply that the payment of acontingency represents purchase price. Another factor is the proportionality of the seller’s right to receive earnout paymentcompared to the seller’s ownership interest. If proportionalityexists, the earnout is more likely to be characterized as adeferred payment. If proportionality is lacking, then theearnout 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 treatedconsistently as to avoid re-characterization. “As a thresholdmanner, an earnout should be treated as compensatory only ifthe seller actually performs services for the buyer after thesale or gives an economically meaningful covenant not tocompete.” Kimberly Blanchard, The Taxman Cometh, supra,at 60.

The same principles that are relevant for the accountingcharacterization 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 theearnout period may be treated, not as a capital gains, but asordinary income.

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(5) Other Issues to be Considered

Other potential areas for variation that should be addressedinclude inventory valuation methods (LIFO versus FIFO, aswell as the manner of treating inventory as obsolete),depreciation schedules, accounting for retirement and welfare benefits and reserves for bad debts. The parties shouldcarefully consider whether there are matters of heightenedconcern or specific to the target's industry, often mandatingthat the parties specify the accounting methodology to beused.

5. Form of Payment of Earnout Obligation

Cash is often used as the earnout payment, but not infrequently thecontingent consideration is stock. The use of cash may be a problem whenthe 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 variousvaluation, securities and tax issues. The purchaser may be required tospecify the maximum number of shares that will be issued as part of theearnout arrangement for securities and tax reasons that are detailed below.

a. Valuation Issues

The parties to the acquisition agreement must determine the date as ofwhich 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 theacquisition price caused by a run-up in the stock price betweenclosing and the issuance.

The seller runs the risk that the buyer will issue additional commonstock during the earnout period that is priced lower than the market price or the per share value assigned in the acquisition. Counsel forthe seller may suggest a provision designed to protect against dilutionof 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 orexempt from registration. Affiliates of the target who receive stockand affiliates of the buyer must abide by the selling restrictions ofRules 145(d) and 144, respectively, of the Securities Act.

Practitioners should examine Rule 144(d)(3)(iii), under which theearnout stock may be deemed to have been acquired at the time of thetransaction’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 thesecurities subject only to conditions other than the payment of furtherconsideration for such securities. An agreement to remain employedor not to compete entered into in connection with a transaction, orservices 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 sharesissued as deferred consideration commenced on the date the targetshareholders elected to receive payment in shares rather than cash).

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

c. Related Tax Questions

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

Similar to escrow payments, amounts paid to the seller in yearsfollowing the year of sale generally will be taxed on the installment

method described above. The specific treatment will depend onwhether there is a stated maximum earnout amount or simply a periodover which the earnout payments will be made.

With respect to otherwise tax-free transactions, the Original IssueDiscount Rules of Section 483 of the Internal Revenue Code requirethat some portion of the deferred consideration, if made in stock,must be allocated to interest, reportable as such by the seller anddeductible as such by the buyer. The remaining portion of the stockis generally treated as additional tax-free consideration emanatingfrom 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 properlymanaged after the closing In situations in which the seller’smanagement team will not be retained post-closing, the seller likelywill 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 majordecisions made during the earnout period. The seller will likelydemand that the target be operated as a distinct business entity ordivision so that its results can be verified. The seller may require thatthe buyer adequately fund the target during the earnout period so thatit will be able to capitalize on opportunities presented to it. It is notuncommon for the seller to establish minimum absolute fundinglevels. The earnout may be crafted to acknowledge the parties’agreement or intent to exploit specified opportunities. Any limitationof the buyer’s freedom to run the target as circumstances requirelikely will be resisted.

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

Less commonly, the seller’s management will continue to operatethe target post-closing. In this situation, the buyer’s risk is that theseller’s management team will operate the business so as to unfairlymaximize the payout amount. Counsel for the buyer should attemptto provide appropriate controls over the target, including amechanism 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 companyconsistent with past practice subject to certain exceptions, or the buyer might agree to restrictive covenants that prevent the target fromtaking specified actions (such as making large expenditures) duringthe 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 evaluatingthe principles of good faith and fair dealing, a court may imply termsto honor the parties reasonable expectations. In Horizon, the sellerhad remained on staff as president of the new entity in an attempt torealize the $5.2 million earnout. The earnout was defined in theagreement as part of the purchase price. The seller had been assuredthat he would be given autonomy as president and that he had arealistic opportunity to receive the earnout. However, upon acquiring

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Horizon, the buyer interfered with business operations and preventedthe 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 omittedfrom the text of the contract. In determining whether to imply terms

in an agreement, the court noted that the proper focus was on “whatthe parties likely would have done if they had considered the issueinvolved.” The court stated that the jury could have readilyconcluded that the parties would have agreed, had they thought aboutit, that the buyer would not be permitted to undermine the president’sauthority, to abandon the companies brand name, or to mandate production of a rival product thereby impairing the realization of theearnout. 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 groundrules.

In another recent earnout case, Richmond v. Peters, et al., 155 F.3d1215 (6th Cir. 1998), plaintiff sold his business to defendant with the price and payments to be determined, in substantial part, by referenceto the profits of the continuing business in excess of a base-levelamount. The agreement between them provided that the business wasto 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, thetrial court ruled that Ohio law imposed no fiduciary duty upondefendant and that plaintiff had presented no evidence that defendanthad breached any provision of the agreement.

The court held that the facts of the case should be reviewed withrespect to the contract claim. It is significant, however, that the trialcourt found, and the appellate court agreed that, at least under Ohiolaw, the earnout agreement created no implied fiduciary duty betweenthe parties.

7. Payment of Earnouts to Public Shareholders

Payment of earnouts to public shareholders of a seller that does not survivethe transaction can be a logistical problem. One common solution is toestablish a paying agent to disburse earnout payments to the seller’s formershareholders. This paying agent may handle any disputes with the buyerduring 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 withan earnout, the parties should consider establishing a committee to act on behalf of the persons who were shareholders of the seller at the closing. Thecommittee would speak for the shareholders on matters relating to theearnout and indemnification. The provisions establishing the committeeshould delineate its powers and how it can act. Funds should be set aside tocover the expenses of the committee and its counsel. Often, the acquisitionagreement simply will specify that the buyer will communicate with thecommittee, or shareholders’ representative, post-closing. In such case, theobligations of the committee to the shareholders will be addressed in aseparate 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 saleshould it take place. A similar problem arises when a third party acquires the buyer during the earnout period. As suggested above, the lawyers for theseller may suggest that the third party buyer be obligated to pay off some orall 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 bemerged 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 difficultyarises when the buyer acquires additional, similar businesses during theearnout period. In these situations, the buyer and seller must work withaccountants to formulate a plan for segregating the financial statements thatform the basis of the target’s earnout thresholds. This segregation can preclude the buyer from achieving the economies of scale and synergies itanticipated in consummating the acquisitions. One solution is to assess thefinancial performance of the whole group and, for purposes of calculating theearnout, assign to the target its pro rata share of the overall amount.Alternatively, some buyers pay off the sellers during the earnout period toend the arrangement early.

11. Averaging Periods of Strong Performance With Weak Performance

The parties must decide whether performance well above threshold levels inone 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 theearnout provision are well advised to consider the appropriate form ofdispute 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 formergenerally is faster, less expensive and a better forum within which to dealwith complex financial issues. However, the growing perception thatarbitrators render “split the baby” decisions that attempt to satisfy both sideshas caused some advisors to favor litigation as a more predictable source ofappropriate outcome. If litigation is favored, jurisdiction and venue should be specified. All provisions regarding dispute resolution should be detailedand carefully crafted anticipating all plausible scenarios.

13. Registration Issues for Earnout Rights

Under certain circumstances earnout rights may be deemed securities underthe Securities Act. To prevent the necessity of registration, acquisitionagreements usually prohibit any transfer of the right to the earnout paymentand assert that the right is not an investment contract or other type ofsecurity.

In a series of no-action letters, the SEC evaluated whether or not specificearnout agreements constitute a security.

1 The SEC emphasized that the facts

of any particular situation must be evaluated closely, but it concentrated onthe following factors when deciding that a particular earnout did not constitute a security:

• The earnout right was granted to the sellers as part of theconsideration 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 oflaw; and

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

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); LifemarkCorp., 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 ascertainthe legality of the arrangement under the regulatory laws applicable to thetransaction. For example, under the federal self-referral statute (commonlyknown as “Stark”) a hospital may not pay for a physician practice it acquiresin installments or through an earnout (assuming the physicians will refer tothe hospital after the transaction). The prohibition’s rationale is to eliminatea physician’s motivation to refer to the hospital, thereby enhancing thefinancial strength of the hospital so it can pay the earnout. Otherindustry-specific requirements may affect the ability to structure acquisitionswith earnouts.

V. CONCLUSION

There are many forms of consideration paid in acquisitions, all with their own advantagesand disadvantages. The most common forms of payment are cash, stocks, promissory notes,the assumption of indebtedness or some combination thereof. The parties should pay closeattention to the accounting, tax, securities laws and practical consequences of each form ofconsideration. 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 whenthere is fundamental agreement between the parties as to the purchase price, if there is lagtime 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, butmay also be useful in other scenarios such as a performance incentive. Parties should takegreat care in crafting the earnout. They should specify, in detail, the nature of the hurdlegiving rise to the earnout obligation, the accounting methods that will be used inascertaining whether the earnout has been achieved, the inclusions and exclusions from theearnout calculation and who will determine whether the earnout threshold had been met. Itis essential that all possible scenarios be explored as the earnout is crafted to avoid futureconflict.

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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., K REB, K EVIN D., PERKS, BENJAMIN, W. AND R IORDAN, THOMAS K., Mergers, Acquisitions, and Divestitures: The Nature of Disputes and the Role of the Financial

Expert, LITIGATION SERVICES HANDBOOK -THE R OLE OF THE FINANCIAL EXPERT

HARPER , R OBERT 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)

K LING, 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 I NSTITUTE (1998)

MALT, R. BRADFORD, Corporate Mergers and Acquisitions: Discussion Outline of Purchase

Price Considerations, 20TH A NNUAL 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, I NC.

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

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

(October 2004)

THOYER , JUDITH R. AND K ORRY, ALEXANDRA D., Drafting and Negotiation of Agreements

Relating to the Sale of a Division, Advanced Doing Deals, PRACTISING LAW I NSTITUTE (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 I NSTITUTE (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 ProportionateInterest 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 adjustmentsshall 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 andappropriate, 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 theexception 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 renewalseffected 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 ofadjustment 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 tomatters 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 Statementof 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 estimateof 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 NetWorking 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 LimitedPartners 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 ofReadjustments 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 theEstimated 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 byTenants 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 thisSection 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 costsshall be borne exclusively by , the Accredited Investors, if applicable, and the Purchaser intheir respective proportionate shares under the Limited Partnership Agreement.

2





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(the “Dispute Period”). In the event that the Purchaser does not advise the Vendors that itdisputes 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 partiesfor the purposes of this Agreement and any Working Capital Shortfall shall be paid bythe 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 WorkingCapital of the Corporation as of the Reorganization Date (prior to commencement of thePurchaser Restructuring Plan) (the “Working Capital Statement”). Such Working CapitalStatement 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 suchWorking Capital Statement shall be paid by the Purchaser, provided that, should theWorking Capital of the Corporation as set forth in the Working Capital Statement (asfinally determined) be less than 98% of the Vendors’ Working Capital Amount, theVendors shall pay the cost of the preparation of the Working Capital Statement. It ishereby acknowledged and agreed that the Vendors shall reflect a contingent liability in

the amount of $____________ on the Vendor’s Balance Sheet, in connection with theActions disclosed to the Purchaser hereunder. It is further expressly acknowledged thatthe Vendor’s Balance Sheet shall include, as a contingent liability, a provision for baddebt in respect of any Accounts Receivable which the Vendors believe may beuncollectible as at the Reorganization Date. Notwithstanding anything herein contained,and provided that the Vendors have complied with their obligations relating to the baddebt provision as outlined above, and further provided that the Vendors have not breached the representations contained in Paragraph 4.14 hereof, the Vendors shall haveno liability to the Purchaser hereunder in the event that any Accounts Receivable are notcollected.

1.3 The parties shall have a period of fifteen (15) days from the date on which the WorkingCapital Statement is received from Deloitte & Touche, as provided in Section 1.2, toreview the same. If no objection to the Working Capital Statement is given by one partyhereto to the others within such fifteen (15) day period, the Working Capital Statementshall 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 ofthe Corporation, as calculated based on the Working Capital Statement. If any partyobjects to the Working Capital Statement within such fifteen (15) day period by givingnotice 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 thedate such notice is given.

1.4 If all matters in dispute are resolved by the parties, the Working Capital Shortfall shall bethe amount agreed upon by the parties. If the parties cannot resolve all matters in disputewithin such fifteen (15) day period, all unresolved matters shall be submitted toarbitration for resolution in accordance with the provisions of Section ___, and theWorking 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 PurchasePrice 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 orotherwise relating to the transactions described herein, the Purchaser shall cause theSuccessor Partnership to execute and deliver at the Time of Closing a guarantee issued bythe Successor Partnership, which guarantee shall be secured by a general securityagreement 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 ofthe Successor Partnership, which guarantee and security agreement shall be in a formacceptable to the Vendors and the Purchaser, each acting reasonably. The said securityinterest 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 inrespect of financing to complete the transactions contemplated in this agreement orfinancing 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 anaggregate of $_______________). The Vendors hereby covenant and agree that theyshall 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 actingreasonably.

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 aggregateGross Sales of the Successor Partnership (before taking into account any salesattributable 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 andending 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 EBITDAof the Successor Partnership (before taking into account the EBITDA attributableto 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, providedthat 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 30

th, 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 ofParagraph 1.7 hereof shall affect any payments due under the Promissory Note duringany period prior to the effective date of such reduction.

1.8 Notwithstanding anything herein contained, in the event that the 1st Year EBITDAAmount 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 byapplying 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 theSuccessor 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 ofthe parties hereto as the parties hereto may mutually agree. The Purchaser shall, andshall 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 necessaryor 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-operationand assistance as the auditors may require in order to complete said audit. The saidauditor shall complete the audit and deliver an audited statement of EBITDA of theSuccessor Partnership for the period from May 1st, 2004 to April 30th, 2005 (the“EBITDA Statement”) within one hundred and twenty (120) days of April 30 th, 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 theEBITDA 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 partieshereto, and the EBITDA of the Successor Partnership for the period from May 1st, 2004to April 30

th, 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 tothe other parties setting out in reasonable detail the nature of such objection, the partiesagree to attempt to resolve the matters in dispute within fifteen (15) days from the date ofsuch 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 amountagreed upon by the parties. If the parties cannot resolve all matters in dispute within suchfifteen (15) day period, all unresolved matters shall be submitted to arbitration inaccordance with the provisions of Section 13.17, and the EBITDA of the SuccessorPartnership for the period from May 1st, 2004 to April 30th, 2005 shall be the amountdetermined 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 anamount is payable to the Vendors pursuant to such paragraphs. For the purposes ofSection 1.6, the Purchaser shall deliver to the Vendor internally prepared annual financialstatements of the Successor Partnership by June 30

th 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 LongTerm Liabilities on the Closing Date. On the Closing Date and subject to completion ofthe transaction contemplated by this Agreement, the Purchaser and the Vendors shallcause the Corporation to pay in full the Long Term Liabilities on such date by directingthe Vendor's Solicitors to use a portion of the Escrow Amount to pay the Long TermLiabilities 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 Sharesis 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 tomanage the Successor Partnership from the Reorganization Date to February 28th, 2006as 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 equalto the aggregate of the following amounts:

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

(b) for the Inventory, the value thereof as determined based on the provisions setforth 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 amountthereof, 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 thesamples) located in the Leased Premises, (ii) all Inventory (other than the samples) located at theWarehouse, (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 inaccordance 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 andPurchaser. The Inventory so counted shall be valued at the Cost Price thereof, and the aggregateCost Price of the Inventory so counted (the "Inventory Purchase Price") shall be paid by thePurchaser to the Vendor, by certified cheque, bank draft or other means of immediately availablefunds as follows:

(a) at the Closing, the Vendor shall deliver a statement to the Purchaser setting outthe Cost Price of all Inventory in respect of which the Vendor shall have paid the supplierthereof 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 respectof the Inventory Purchase Price relating to all Inventory described in the Vendor'sInventory Statement, equal to the Cost Price thereof, as reflected on the Vendor'sInventory Statement (the "Estimated Purchase Price for Inventory"). For the purposesof the calculation of the Estimated Purchase Price for Inventory, the quantity of allMoving Inventory shall be deemed to be that reflected in the Vendor's purchase orderdocumentation 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 thewritten request of the Purchaser, the Vendor shall deliver to the Purchaser all of thedocumentation and records used by the Vendor to produce the Vendor's InventoryStatement (including without limitation, all of the documentation and records used tocalculate 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 theCost 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 inorder to verify the amount payable for all Inventory described in the Vendor's InventoryStatement; and

(d) in respect of any portion of the Inventory (save and except for such Inventory thatthe 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 theVendor providing to the Purchaser satisfactory evidence: (i) that it has paid the subjectsupplier for said Inventory, and (ii) as to the calculation of the Cost Price of suchInventory.

The Vendor and the Purchaser agree that subsequent to Closing, they shall make anyadjustments between them to the amounts paid by the Purchaser to the Vendor forInventory 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 orsubsequent to the Date of Closing for any reason whatsoever, including withoutlimitation, due to the Vendor having sold the subject Inventory prior to the Date ofClosing;

(b) any Inventory for which the Purchaser paid the supplier thereof directly andwhich was delivered to the Vendor prior to Closing, but which the Purchaser did notreceive from the Vendor on or subsequent to the Date of Closing for any reasonwhatsoever, including without limitation, due to the Vendor having sold the subjectInventory prior to the Date of Closing; and

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

Such adjustments shall be paid by certified cheque, bank draft or other means ofimmediately 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 Dateof 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 orafter the Date of Closing (in this paragraph the "Post-Closing Period") are for the account of thePurchaser. 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, prepaidrent, security deposits, taxes (including contribution by tenants to property taxes)common area maintenance charges, utility charges, business taxes, merchants' associationand 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 Expensesor are otherwise not the responsibility of the Vendor as provided herein, the Purchasershall, 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 whichthey may be owing (other than amounts being contested in good faith by the Vendor, asdescribed in Schedule 6.17 hereof), which amounts are in relation to the operation of theBusiness 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' associationand 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 proofof 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 ofthe Purchaser hereunder;

(c) in the event that, subsequent to the Closing, the tenant under a particular Leasereceives an amount from the landlord of said Lease or from a third party, which amountis in respect of the operation of the Business during the Pre-Closing Period, and providedthat 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 theamount of said receipt;

(d) in the event that, subsequent to the Closing, it is determined that the tenant undera 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 duringthe 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 thePurchaser 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 percentagerent liability relating to any particular Lease shall (save and except as may be otherwiseexpressly 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 achievedduring the period in respect of which the subject percentage rent relates which is fromand 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 Assetsshall be equal to the aggregate of (i) the amount finally determined in accordance with Section3.7 hereof in respect of the Accounts Receivable, (ii) the amount finally determined inaccordance with Section 3.7 hereof in respect of the Inventory, (iii) the amount finallydetermined in accordance with Section 3.7 hereof in respect of the Prepaid Expenses, (iv) theamount 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 pricefor 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 theexecution of this Agreement by all the parties hereto, to be held by the Escrow Agent inaccordance with the terms of the escrow agreement (the “Escrow Agreement”) annexedhereto as Schedule “3.5(a)”);

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

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

(d) as to the balance of the Purchase Price, such amount shall be paid by thePurchaser to the Vendors by certified cheque or in immediately available funds at theTime 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 theamount 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, lessthe amount set out in paragraph 3.7(a)(v) is hereby referred to as the “EstimatedValue 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 Vendorfor the Accounts Receivable, Inventory, Prepaid Expenses and Fixed Assets and the finalamount 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 Dateof Closing, for delivery to the Vendors and the Purchaser within 45 days following theDate 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 inaccordance with generally accepted accounting principles and consistent with past practice but with no reserve made for uncollectible Accounts Receivable; (ii) theInventory shall be physically counted as of 12:01 a.m. on the Closing Date and valued inaccordance with generally accepted accounting principles and consistent with past practice; (iii) only those Prepaid Expenses of the type and nature that have been reflectedas an asset of the Vendors on their balance sheets in accordance with generally acceptedaccounting principles and consistent with past practice shall be calculated; (iv) the

amount for Fixed Assets shall be the aggregate of $__________ and the value of anyFixed Assets purchased during the Interim Period (but excluding, at the option of thePurchaser, those purchases during the Interim Period in breach of the covenants of theVendors contained herein) less the value of any Fixed Assets sold during the InterimPeriod; and (v) the amount for Assumed Indebtedness shall be determined in accordancewith generally accepted accounting principles and consistent with past practice. Forthese purposes, the Vendors and Purchaser covenant and agree to give the Auditorsaccess to all of the books and records of the Businesses as they may reasonably requireand shall instruct the Auditors to perform such tests and reviews as they deem necessaryor appropriate in order to provide an audit opinion in respect of the items set out in theStatement. The parties hereto shall instruct the Auditors to cooperate with

representatives of the parties as the Statement is being prepared and to keep the partiesapprised as to the status of the preparation thereof. Forthwith thereafter, the Vendors andthe Purchaser shall review and, if in agreement with the matters therein contained,approve the Statement. All costs of the Auditors associated with the preparation andfinalization of the Statement shall be borne by the Vendors. If either the Purchaser or theVendors shall have any objections to any part of the Statement then such party shall setforth such objections in writing with reasonable particularity in a notice to be delivered tothe 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 thePurchaser 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 thePurchaser 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. Thedecision 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 forclerical errors or omissions. The Arbitrator shall be determined in accordance withArticle 15 hereof. The Arbitrator shall determine the party or parties responsible for thefees and expenses of the Arbitrator. The amount of the Accounts Receivable, determinedas aforesaid, shall be subject to adjustment, if any, in accordance with paragraph (c) below. The amount of the Inventory, Prepaid Expenses, Fixed Assets and AssumedIndebtedness 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 theaggregate amount collected by the Purchaser on account of the Accounts Receivable onor before the date which is 90 days following the Closing Date is less than the valueascribed to such Accounts Receivable in the Statement, determined as aforesaid, theamount payable by the Purchaser for the Accounts Receivable, in accordance with theterms hereof shall be reduced by an amount equal to such deficiency. The Purchasershall use its best efforts to collect all of the Accounts Receivable in a timely fashion, in amanner consistent with past practice, and shall provide the Vendors with a report, within10 business days of the end of each month, detailing the outstanding AccountsReceivable. Any payment received by the Purchaser with respect to the AccountsReceivable 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 personmaking such payment. The Vendors shall have the inspection rights provided for inSection 9.7 in order to, among other things, verify the amount of Accounts Receivablecollected 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 thePurchaser, free and clear of any Encumbrance, to the Vendors as soon as practicablefollowing such date. The Vendors covenant and agree to inform the Purchaser of themanner in which the Vendors intend to pursue the collection of those AccountsReceivable assigned back to the Vendors prior to taking any such action. The partieshereto covenant and agree to cooperate with each other in connection with the collectionof 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, asfinally determined, (iii) the Prepaid Expenses, as finally determined, and (iv) the FixedAssets, as finally determined, less the Assumed Indebtedness, as finally determined, isless than the Estimated Value of the Accounts Receivable, Inventory, Prepaid Expensesand Fixed Assets Net of Assumed Indebtedness then the Holdback Amount shall beadjusted accordingly and paid by the Escrow Agent to the Vendors and/or the Purchaserin accordance with the Escrow Agreement. In the event that the Estimated Value of theAccounts Receivable, Inventory, Prepaid Expenses and Fixed Assets Net of Assumed

3



Indebtedness exceeds the Final Amount by more than the Holdback Amount, then thedifference (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 thePurchaser 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 thisAgreement 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 AccountsReceivable, Inventory, Prepaid Expenses and Fixed Assets Net of Assumed Indebtedness,then the difference shall be forthwith paid by certified cheque or wire transfer by thePurchaser 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 thePurchased 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 inrespect 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”), whichamount shall be paid in accordance with the provisions of Section 2.5 and shall be subject toadjustment 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 beadjusted 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, calculatedusing the Post-Closing Statements, subject to the Unbilled WIP Adjustment, to be prepared anddelivered to the parties pursuant to Subsection 2.4(a), shall be more than $___________, thePurchase Price shall be increased by the amount of such excess and the Purchasers shall pay tothe Vendors an amount equal to the amount of such excess in accordance with Section 2.6. If theaggregate of the Purchase Price NBV and the Purchase Price EBIT, calculated using the saidPost-Closing Statements, subject to the Unbilled WIP Adjustment, shall be less than$_________, 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 withSection 2.6. For greater certainty, if the aggregate of the Purchase Price NBV and the PurchasePrice EBIT, calculated using the said Post-Closing Statements, subject to the Unbilled WIPAdjustment, 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 becollected within 180 days after the Adjustment Date (the “A/R Collection Period”). If, by theopening of business on the 180th day after the Adjustment Date, less than 97% of the totalamount of the A/R has been collected by the Purchasers or the Corporation, then the PurchasePrice shall be decreased and reduced by the amount of the uncollected A/R. In the event of suchdownward 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/RCollection Period, but which is collected prior to the third anniversary date of the Date ofClosing (the “Delinquent Receivables”), which amount shall be net of any costs of collectionincurred 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 threeyears following the Adjustment Date, any accounts receivable relating to the period of operationsof the Corporation prior to the Adjustment Date, but which accounts receivable were notincluded on the Post Closing A/R List (the “Collected Unlisted Receivables”), the Purchasersshall pay to the Vendors, the amount of any such Collected Unlisted Receivables, net of anycosts of collection incurred in collecting the said Collected Unlisted Receivables, (including thenet amount of any income, sales or similar taxes incurred or payable in connection with theCollected Unlisted Receivables) (the “Unlisted Receivables Purchase Price Increase”). In theevent that any amounts remain owing under the Promissory Note at the time that any CollectedUnlisted Receivables are collected, the Principal Vendor’s Pro Rata Share of the UnlistedReceivables Purchase Price Increase related thereto shall be added to the last amounts payableunder the Promissory Note, and the Purchasers shall pay to each Ancillary Vendor its respectivePro 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 arecollected, the Purchasers shall pay to each Vendor its respective Pro Rata Share of the UnlistedReceivables 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, allof 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-ClosingWIP List that is not invoiced and billed by the 60 th day after the Adjustment Dateshall not be included in determining the amount of WIP as at the Adjustment Datefor the purpose of any calculation or determination hereunder based on the Post-Closing Statements, including the calculation of the Net Book Value and EBITAdjustment; and

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(ii) If the aggregate amount of all WIP listed in the Post-Closing WIP List andcollected by the opening of business on the 181

st calendar day after the respective

actual date of billing of each WIP listed in the Post-Closing WIP List is less than97% 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 60

th

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 ofsuch downward adjustment to the Purchase Price, it is expressly agreed that thePurchase Price shall be increased by 50% of the amount of any Uncollected WIPA/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 saidUncollected WIP A/R (including the net amount of any income, sales or similartaxes 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, inthat the total increase (if any) to the Purchase Price arising from the said adjustments shall be netof 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 deliverto the parties and to the Purchasers’ Accountants the Post-Closing Statements andcalculation of the Unbilled WIP Adjustment in accordance with the provisions hereof. Ifthe Purchasers have any objections to any part of the Post-Closing Statements orcalculation of the Unbilled WIP Adjustment, then the Purchasers shall set out in suchobjections 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 thePurchasers and the Purchasers’ Accountants. Such 10 Business Day period is referred toherein as the “Objection Period”. If the Purchasers deliver an Objection Notice withinthe 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 PrincipalVendor of the Objection Notice, the matters in dispute shall be submitted to a Floridaoffice of Ernst & Young jointly designated by the Principal Vendor and Purchasers or, ifno Florida office of Ernst & Young is thus jointly designated or willing to serve, then toanother independent U.S. firm of certified public accountants that is jointly selected bythe Accountants and the Purchasers’ Accountants for resolution. The firm of certified public accountants appointed as foresaid to determine the matters in dispute is hereinreferred to as the “Expert”. The decision of the Expert shall be rendered as soon as

3



possible but in any event within 10 Business Days of its engagement and shall beconclusive 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 notobjected to by the Purchasers within the Objection Period, or, if objected to, resolved inwriting 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 partieshereto, 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 tohave 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 tothe Principal Vendor stating that the Purchasers accept the Post-ClosingStatements and calculation of the Unbilled WIP Adjustment, as delivered by theAccountants, and (B) 11:59 o’clock p.m. (U.S. EasternTime) on the last day of theObjection 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 11:59o’clock p.m. (U.S. EasternTime) on the last day of the Objection Period, the firstto occur of:

(A) the Business Day on which the last of the objections made by thePurchasers are resolved in writing by the Purchasers and the PrincipalVendor without the necessity of proceeding to the Expert to resolve suchobjections; 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 thePost-Closing Statements as finally determined in accordance with thisSection 2.4(a), together with their audit report in respect of the Post-ClosingStatements 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 informationrelating 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 andaccounts 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 ofthe Post-Closing Statements and calculation of the Unbilled WIP Adjustmentshall 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 theExpert 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 Vendorshall instruct and cause the Accountants to prepare and deliver to the parties andto 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 instructand cause the Accountants to prepare and deliver to the parties and to thePurchasers’ Accountants a calculation setting forth that part of the A/RAdjustments (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 Vendorshall instruct and cause the Accountants to prepare and deliver to the parties andto the Purchasers’ Accountants a calculation setting forth the amount of the WIPAdjustment (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 WIPA/R, the Principal Vendor shall instruct and cause the Accountants to prepare anddeliver to the parties and to the Purchasers’ Accountants a calculation setting forththat part of the WIP Adjustments required to be made pursuant to the Subsection2.3(c)(ii) relating to the collected Uncollected WIP A/R;

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

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

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

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Objection Notice within the Calculation Objection Period, and the matters at issueare not resolved by the Purchasers and the Principal Vendor in writing within 10Business Days following receipt by the Principal Vendor of the CalculationObjection Notice, the matters in dispute shall be submitted to a Florida office ofErnst & 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 forresolution. The firm of certified public accountants appointed as foresaid todetermine 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 beconclusive 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 CalculationObjection Period applicable to such calculation, or, if objected to, resolved by thePurchasers and the Principal Vendor in writing without the necessity of

proceeding to the Calculation Expert to resolve matters in dispute shall beconclusive 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 thelatest of the following dates:

(i) the first to occur of: (A) the giving of written notice by the Purchasers tothe 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 beforesuch 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 CalculationObjection Period applicable to the calculation, the first to occur of:

(A) the Business Day on which the last of the objections made by thePurchasers are resolved in writing by the Purchasers and the PrincipalVendor without the necessity of proceeding to the Calculation Expert toresolve 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, ifappointed, shall be provided with all reasonable access to the books, records andother information relating to the Corporation and the Subsidiary as theAccountants, the Purchasers’ Accountants or Calculation Expert, as applicable,may reasonably request, from time to time, for the purpose of reviewing alltransactions and financial books, records and accounts required in connection

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

The fees and expenses of the Accountants in connection with the matters in thisSection 2.4(b) shall be borne by the Vendors. The fees and expenses of thePurchasers’ Accountants for reviewing and participating in the matters referred toin this Section 2.4(b) shall be borne by the Purchasers. The fees and expenses ofthe Calculation Expert in connection with the matters referred to in thisSection 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 PrincipalVendor, 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 EstimatedPurchase Price shall be paid and satisfied at the Time of Closing by the Purchasers to theVendors as follows:

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

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

(i) provide for interest to accrue on the principal amount outstandingthereunder 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 followinginstalments:

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

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

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

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

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

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

(ii) the Escrow Agent shall pay fifty (50%) percent of the Escrow Funds paidto it pursuant to Section 2.5(c)(i) (“Tranche 1 Funds”) to the Ancillary Vendorsat 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 withthis Agreement; provided that, in the event that the Net Book Value and EBITAdjustment result in the Ancillary Vendors having to make a payment to thePurchasers in accordance with the provisions of Subsection 2.6(b) hereof, theamount of such payment shall be deducted from such portion of the AncillaryVendors Closing Payment as is described in this Subsection 2.5(c)(ii) hereof, andthe amount so deducted shall be paid by the Escrow Agent to the Purchasers. Inthe event that the amount of the payment the Ancillary Vendors are required tomake to the Purchasers is in excess of the amount described in this Subsection2.5(c)(ii), the excess amount shall be deducted from the amount which wouldotherwise 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 tomake 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 Subsections2.5(c)(ii) and (iii) hereof, no payments shall be made by the Escrow Agent to theAncillary Vendors under Subsections 2.5(c)(ii) or (iii) hereof and under theEscrow Agreement, and all amounts held by the Escrow Agent shall be paid to thePurchasers.

(iii) the Escrow Agent shall pay the other fifty (50%) percent of the EscrowFunds paid to it pursuant to Section 2.5(c)(i) (“Tranche 2 Funds”) to theAncillary Vendors at the time that the A/R Adjustments contemplated bySubsection 2.3(b) are made or upon it being finally determined that no suchadjustments are required in accordance with this Agreement; provided that, in the

event that the said A/R Adjustments result in the Ancillary Vendors having tomake a payment to the Purchasers in accordance with the provisions ofSubsection 2.6(b) hereof, the amount of such payment shall be deducted fromsuch portion of the Ancillary Vendors Closing Payment as is described in thisSubsection 2.5(c)(iii) hereof, and the amount so deducted shall be paid by theEscrow Agent to the Purchasers. In the event that the amount of the payment theAncillary Vendors are required to make to the Purchasers is in excess of theaggregate 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 Subsections2.5(c)(iii) hereof or under the Escrow Agreement and all amounts held by theEscrow Agent shall be paid to the Purchasers.

At the Time of Closing, the Principal Vendor, the Purchasers and the Escrow Agent shallenter into an escrow agreement (the “Escrow Agreement”), pursuant to which theEscrow 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 tothe Ancillary Vendors on the 10

th day after the anticipated date (to be set out in the

Escrow Agreement) on which the Net Book Value and EBIT Adjustment is finallydetermined (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 theTranche 1 Release Date, or (B) based upon such final determination, the Tranche 1 Fundsare 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 PrincipalVendor or the Purchasers prior to the Tranche 1 Release Date. If the Escrow Agentreceives such notice from the Principal Vendor or the Purchasers, the Escrow Agent shallnot release the Tranche 1 Funds to the Ancillary Vendors on the Tranche 1 Release Dateunless jointly directed by the Principal Vendor and the Purchasers to do so, and thePurchasers and the Principal Vendor shall jointly direct the Escrow Agent, by no laterthan the 5

th 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 tothe 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) arefinally determined (or finally determined not to be required) in accordance with thisagreement (the “Tranche 2 Release Date”), unless: (A) such final determination withrespect to such A/R Adjustments has not been made at least 10 days prior to the Tranche2 Release Date, or (B) based upon such final determination, the Tranche 2 Funds are notexclusively payable to the Ancillary Vendors, and, in the case of either (A) or (B), theEscrow Agent receives a notice in writing to that effect from either the Principal Vendoror the Purchasers prior to the Tranche 2 Release Date. If the Escrow Agent receives suchnotice from the Principal Vendor or the Purchasers, the Escrow Agent shall not releasethe 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 theTranche 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 toSection 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 certifiedcheque, bank draft or other means of immediately available funds within 10 days aftersuch determination.

(b) In the event that the amount paid on account of the Purchase Price pursuant toSection 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 bededucted from the next instalment payable under the Promissory Note. The AncillaryVendors’ Pro Rata Share of such downward adjustment shall be paid by the AncillaryVendors to the Purchasers in the manner provided in Section 2.5(c)(ii) and 2.5(c)(iii), tothe 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 underthe 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 tothe amount of such excess, by certified cheque, bank draft or other means of immediatelyavailable funds. In the event that the Ancillary Vendors’ Pro Rata Share of anydownward adjustment under Section 2.6(b) is in excess of the Escrow Funds held by theEscrow Agent, each Ancillary Vendor shall forthwith pay over to the Purchasers anamount 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 bearsto the aggregate Purchase Price payable to all Ancillary Vendors, as set out inSchedule 2.2 hereof), by certified cheque, bank draft or other means of immediatelyavailable 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 thePrincipal Vendor an irrevocable standby letter of credit issued by a Canadian chartered bank orU.S. bank acceptable to the Principal Vendor (the "Issuing Bank"), acting reasonably, andconfirmed 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, theterm "Principal Amount" shall have the meaning defined in the Promissory Note), as suchPrincipal Amount is adjusted in accordance with the terms of the Promissory Note and thisAgreement, that will be outstanding at the Time of Closing, and which letter of credit may bedrawn upon, to the extent of any amount due and payable under the Promissory Note that thePurchasers have failed to pay when due (including, without limitation, amounts due byacceleration 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) inthe 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 thePromissory Note), and which letter of credit shall remain outstanding and securing thePromissory 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 “Letterof Credit”). It is expressly agreed by the Purchasers and the Principal Vendor that the Letter ofCredit shall include provisions specifying that: i) partial draws shall be allowed under the Letterof Credit, and each partial draw shall have the effect of reducing the face amount of the Letter ofCredit in the amount of such partial draw (subject to upward or downward adjustments of thePrincipal Amount as provided in clause ii) below); ii) the face amount of the Letter of Creditshall be adjusted upward or downward, on a dollar for dollar basis, to the extent that thePrincipal Amount owing under the Promissory Note is adjusted upward or downward inaccordance with the provisions of this Agreement and the Promissory Note, iii) the face amountof the Letter of Credit shall be adjusted downward, on a dollar for dollar basis, to the extent thatthe 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 Creditreferenced in clause ii) above), iv) any upward or downward adjustments to the face amount ofthe 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 ofsuch upward or downward adjustment, or in such other manner as the Issuing Bank and theConfirming Bank may require and which is mutually acceptable and agreed to in writing thePurchasers and the Principal Vendor, each acting reasonably (the "Joint Notice"). Each of thePurchasers, jointly and severally, and the Principal Vendor hereby covenant and agree to submita 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 otherwisefinally 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 Bankand the Confirming Bank in accordance with the covenant contained in the preceding sentence ofthis Section 2.7 shall constitute an Event of Default (as defined in the Promissory Note), with theconsequence of accelerating the Promissory Note as provided therein and entitling the PrincipalVendor immediately to draw upon the Letter of Credit in the full accelerated amount of thePromissory 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 Noticeto the Issuing Bank and the Confirming Bank in accordance with the covenant contained in thisSection 2.7 shall entitle the non-breaching party or parties to obtain injunctive or other equitablerelief in a court of competent jurisdiction, compelling such breaching party or parties forthwithto submit the Joint Notice in compliance with such covenant in this Section 2.7, it beingstipulated and agreed among the parties that failure or refusal by either the Principal Vendor orthe Purchasers timely to comply with such covenant to submit the Joint Notice hereunder willconstitute irreparable harm to such other party or parties. A draft Letter of Credit provided bythe Issuing Bank shall be presented by the Purchasers to the Principal Vendor for the PrincipalVendor’s review and approval (acting reasonably) by no later than 7 days prior to the ClosingDate, 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 PrincipalVendor 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 arecollected 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 istherefore 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 ofExpense 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 theVendors 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 fromeach Tenant and the amount owed by each Tenant or to each Tenant (as the case may be) onaccount 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 onor 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 calendaryear, 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 theVendors 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 CapitalAdjustment 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 CapitalAdjustment, then the Vendors shall pay the amount of such excess to the Purchaser.

Documents

Purchase Price Adjustment