How do i build a discounted cash flow model for an Earn Out Plan?

Background and Question Information:

In early 2014, the board of directors of Centennial Pharmaceutical Corporation (CPC) was debating its next move regarding an earnout plan (earnout plan) that was currently in effect for managing one of its business units. The earnout plan had originally been structured for CloneTech management as part of the consideration for the company when Centennial Pharmaceutical bought CloneTech in 2013. The earnout plan served as a performance incentive to CloneTech's management by stipulating bonus payments to them based on the level of CloneTech's earnings during its first four years as a Centennial Pharmaceutical business unit. Centennial Pharmaceutical's board of directors understood the effectiveness of an earnout when acquiring a closely held company. The bonus payments motivated the newly acquired managers to work as efficiently as possible with Centennial Pharmaceutical management and therefore create the most value for themselves and Centennial Pharmaceutical shareholders.

But the earnout plan had recently become infeasible due to Centennial Pharmaceutical's acquisition of PharmaNew. PharmaNew had several lines of business, one of which was Strategic Research Projects (SRP), which performed the same cloning research as CloneTech. Part of the synergies that Centennial Pharmaceutical hoped to realize from PharmaNew would occur by combining the CloneTech and Strategic Research Projects operations. Once that combination was completed, however, it would no longer be possible to directly measure the performance of CloneTech as a searnout planarate entity. If the earnings could not be directly attributable to CloneTech, the original earnout plan could not continue to be in force. Therefore, Centennial Pharmaceutical's board had constructed a revised earnout plan based on the joint performance of CloneTech and Strategic Research Projects and had presented it to CloneTech management for their consideration. Unfortunately, the proposed revision had not been well received by CloneTech management, who felt that their economic position had been materially compromised by the uncertainty of Strategic Research Projects 's future performance.

The Pharmaceutical Industry

The key challenge for a pharmaceutical was to maintain a pipeline of new drugs to bring to the market. A large part of a pharma company's profits was due to the profits of new drugs, which were protected from being copied for 20 years by U.S. patent law. Once a drug lost patent protection and became generic, many of the company's competitors rushed to produce the drug under their own brand names. Such competition usually drove the price down close to the cost of production, leaving the original producer and founder of the drug with a dramatically lower volume and margin. Thus, it was either feast or famine for a pharmaceutical through large profits when it first created a new drug or little to no profits when the drug lost its patent protection. Patents, therefore, served as incentives for pharmas to invest in research that produced lucrative new drugs. Consumers were rewarded with new treatments for ailments, but they had to pay "monopoly rents" to the founder of the drug as long as it enjoyed patent protection. In the long term, however, the low cost of production for a drug eventually rewarded the consumer with the choice of many brands at low prices once the patent protection was lifted.

The challenge for the U.S. drug industry was complicated further by the need to receive approval from the Federal Drug Administration (FDA) for any drug before it could be taken to the market. The approval process often took years to complete sometimes becoming an insurmountable hurdle that prevented the drug from being marketed in the United States. Thus, the drug business was fraught with chances: the chance of discovering a viable drug, the chance of getting FDA approval, and the chance that a competitor might be first to make the same discovery. To combat the odds of not finding the next blockbuster drug, such as Viagra or Celebrex, companies were forced to maintain a constant research effort with a wide spectrum of potential drug breakthroughs. Only a small percentage of research dollars were directly responsible for a successful new drug. With so few drugs reaching the market, it was all the more important for the company to have a large portfolio of potential new drugs in the pipeline at all times. Accordingly, stock analysts looked carefully at R&D budgets and announcements of possible new breakthroughs by pharmaceuticals in order to judge their market value.

CPC

In 2012, Centennial Pharmaceutical was a $20 billion U.S.-based company with 55% of its revenues coming from North America, 25% from Europe, 15% from Asia, and the remaining 5% from 20 countries around the world. The company was growing in North America, but most of its growth was coming from its international markets. For the past several years, Centennial Pharmaceutical had enjoyed strong growth in sales and profits, which had resulted in an A debt rating from Moody's. In the 1990s, however, Centennial Pharmaceutical had run into financial problems resulting from class-action lawsuits in the United States related to the side effects of several of its drugs. In an effort to cut costs and survive the cash-flow losses, management decided to reduce R&D for several years, gambling that they could pick the right areas on which to focus their research efforts and, therefore, not overly compromise the firm's future. Although Centennial Pharmaceutical returned to profitability and settled all the lawsuits for considerably less than expected, the reduction of its R&D budget proved to be a flawed strategy.

In 2002, in an attempt to buy the research that Centennial Pharmaceutical had not been producing internally, management began a strategy of acquiring specialized biochemical research companies, including CloneTech, which was a small privately owned company in Belgium. Like CloneTech, most of the companies acquired by Centennial Pharmaceutical had five to ten principal owners who were scientists in charge of the company's research. All the firms were purchased using a combination of Centennial Pharmaceutical shares and an earnout contract. Centennial Pharmaceutical's board preferred to use an earnout structure for acquisitions that involved a promising, but as yet unproven product. By providing for specific payments to the owner/managers as a function of profit targets, an earnout served to keearnout plan the senior managers/scientists actively involved in the company aware of its full value potential. In this case, as the profits of the newly formed Centennial Pharmaceutical subsidiary met the various profit targets, the CloneTech management team would receive a percentage of the performance pool.

The Earnout Plan

Exhibit 17.1 presents the original earnout plan (earnout plan) utilized in the CloneTech acquisition. The earnout plan stipulated an annual bonus schedule (ABS), which defined bonuses to management based on the earnings levels achieved for each of CloneTech's first four years as part of CPC. For the first year (2013), management could receive 100% of the 2013 bonus (EUR 2 million) by meeting or exceeding target earnings of EUR 10 million. Lower bonuses would be realized for earnings less than EUR 10 million: a bonus of EUR 1.5 million (75% of EUR 2 million) was payable for earnings between EUR9 million and EUR 10 million, and EUR 1.0 million (50% of EUR 2 million) would be distributed for earnings between EUR8 million and EUR9 million. Failure to reach an earnings level of EUR 8 million in the first year would mean no bonuses for management in 2013.

Bonus payments were made each year based on the Annual Bonus Schedule and, if appropriate, the Multiyear Bonus Schedule. Multiyear Bonus Schedule Payments were distributed when the sum of all annual payments to date were less than the Cumulative Bonus Potential for that year.

In addition to the ABS, the earnout plan recognized the risky nature of biotech research with the inclusion of a multiyear bonus schedule (MBS). The Multiyear Bonus Schedule Was a cumulative-earnings feature that allowed CloneTech management to receive bonus payments, in years 2, 3, and 4, which had not been fully distributed in one or more of the prior years. For example, CloneTech management could receive a full bonus of EUR2 million in 2013 and 2014 by earning EUR11 million in 2013 and EUR13 million in 2014. The full 100% bonuses would be distributed each year because earnings exceeded each year's respective target amounts in the ABS. The same bonus dollars, however, could also be realized if CloneTech earned EUR7 million in 2013 and EUR15 million in million in Page 2442014. Under this scenario, management would receive no ABS bonus for 2013 but would earn an ABS bonus of EUR2 million for 2014 plus a "cumulative bonus" of an additional EUR2 million, based on the MBS, for the EUR22 million of cumulative earnings for 2013 and 2014.

The flexibility of the earnout plan was such that CloneTech management could potentially earn the entire EUR8 million bonus pool by rearnout planorting zero earnings for the first three years and EUR53.7 million in the last year. This facet was important because CloneTech had earned only EUR7 million in 2013, which was below the minimum threshold for bonus distributions. Despite having "underperformed" in 2013, CloneTech managers were optimistic that the entire bonus pool remained within reach once the full impact of their research was reflected in future profits. Moreover, their optimism was buoyed by the fact that half of the profits in 2013 had been earned in the fourth quarter alone, which suggested the possibility of a turnaround in the company's performance for the following years. Like most biotechs, CloneTech's historical profits varied substantially, so predicting future earnings was highly problematic.

As CloneTech was finishing its first year as an acquired company, Centennial Pharmaceutical purchased another pharmaceutical company, PharmaNew. PharmaNew was a German-based company with a business unit called Strategic Research Projects (SRP), which was doing the exact same cloning research as CloneTech. Centennial Pharmaceutical believed that much of the value in buying PharmaNew would come from moving CloneTech to the Strategic Research Projects facilities in Hamburg to allow the two groups of scientists to work together. The newly combined business unit would create significant cost savings and allow the combined labs to achieve faster and more productive results. Once the two entities were combined, however, it would no longer be possible to measure CloneTech's performance as a searnout planarate entity for purposes of the earnout agreement. According to the original earnout plan, in the event that CloneTech was consolidated with another business unit, Centennial Pharmaceutical was required to make a good-faith adjustment to the earnout schedule in order to avoid compromising the bonus incentives of CloneTech management.

Exhibit 17.2 presents Centennial Pharmaceutical's revised earnout plan that had been proposed to CloneTech management. The revised earnout plan retained many of the basic features of the original earnout plan. For example, bonus levels were paid according to gradations of target earnings each year, no bonuses were paid below the minimum-earnings level, and a cumulative-earnings feature remained in place.5 The proposal, however, also had a number of important differences from the original earnout plan. In particular, all the earnings targets had been adjusted by adding SRP's expected earnings to CloneTech's earnings targets for the remaining three years. The earnings numbers added to CloneTech's targets were exactly the numbers Centennial Pharmaceutical had used to determine the value of SRP as part of the PharmaNew acquisition. Likewise, the target-earnings figures used in the original earnout plan were exactly the earnings numbers used by Centennial Pharmaceutical to determine the fair price to pay for CloneTech the previous year. Because of the similarities of their research, Centennial Pharmaceutical's investment bankers predicted that both entities would experience 20% earnings growth.

EXHIBIT 17.2 | CloneTech's Revised Earnout Program (in millions of euros)

Bonus payments were made each year based on the Annual Bonus Schedule and, if appropriate, the Multiyear Bonus Schedule. MBS payments were distributed when the sum of all annual payments to date were less than the Cumulative Bonus Potential for year 4. In addition to bonus payments, guaranteed payments of EUR1 million, EUR1 million, and EUR2 million were paid at the end of years 2, 3, and 4, respectively.

Perhaps the most important difference of the revised earnout plan was Centennial Pharmaceutical's proposal to convert EUR4 million of the bonus pool into a series of guaranteed payments over the remaining three years: EUR1 million in year 2, EUR1 million in year 3, and EUR2 million in year 4. Therefore, regardless of CloneTech or SRP's performance, CloneTech management was guaranteed to receive EUR4 million over the life of the revised earnout plan. But in order to realize the full EUR8 million, the combined earnings of CloneTech and SRP together would have to reach the newly defined earnings targets.

The negative reaction of CloneTech management toward the revised earnout plan surprised Centennial Pharmaceutical's board of directors. The board thought they had made a good faith effort to preserve, if not improve, the economic value of its original agreement with CloneTech management; however, the board had not done a formal valuation of the original and revised earnout plans. To do so required a discounted-cash-flow analysis for both contracts (using the current interest-rate data in Exhibit 17.3).