Buyer, Seller Bridge a Gap

It was the kind of standoff that would have prompted less determined negotiators to part: 11 mostly performing commercial property and business loans, an interested buyer who didn't want to pay par for them, and a seller wary of getting short-changed.

But two banks in the Pacific Northwest found a way to work around this sticking point and get on with the business of merging. Their solution put a new twist on the pay-for-performance clauses that have become commonplace in deals between small banks.

On top of the $34 million in stock they were guaranteed by Washington Federal of Seattle, shareholders of South Valley Bancorp may be entitled to as much as $39 million in cash if the Klamath Falls, Ore., company can show that the loans are money good. The terms for the added payout are novel compared with the sweeteners other local sellers received in recent transactions.

Most notably, South Valley has only until the deal's scheduled closing in the third quarter to win the entire payout, which is based on the $39 million face value of the loans in question. If the loans in the pool are repaid in full by then, South Valley gets the maximum incentive offer. If not, then the company is to essentially split any money received from those borrowers over five years with its new owner.

Both parties would have some insurance: Washington Federal, which was concerned about the loans' cash flows and collateral values, would get protection against overpaying for bad assets, while South Valley has a chance to recoup the face value of those credits.

"What we're finding is we have to get a lot more creative to get deals done today," says Rory McKinney, managing director of D.A. Davidson's financial institutions group for the Western United States. (D.A. Davidson advised South Valley in the deal.)

"The earnout," McKinney says, "is a way to bridge the gap between buyer and seller expectations."

South Valley would get 100 cents on the dollar for every loan in the pool that it collects on before closing. After that, it would get 51 cents on the dollar for each loan collected on within five years.

Since the cash for the extra incentive would come directly from the loan repayments, Washington Federal's out-of-pocket acquisition costs should be no more than the $34 million in stock that it agreed to pay for South Valley. The fixed-price portion of the deal is equal to at least 51 percent of South Valley's tangible book value. With the cash incentives, South Valley ultimately could pocket up to 110 percent of tangible book.

Of course, South Valley shareholders may wind up winning either way since they will be owners in the merged entity, which will have a combined 190 branches and $14.4 billion of assets. Washington Federal has been a fairly strong stock, and it pays a dividend.

Incentives on loan collections are becoming more common in deals worth less than $100 million involving sellers in good markets who are saddled with loan or profit problems. There have been a number in the last year on the West Coast, where well-capitalized buyers are eager to expand.

First Independent Investment Group may receive an extra $17 million over 18 months in the sale of its Portland, Ore., bank to Sterling Financial of Spokane, Wash. It received $8 million when the deal closed in March. Gateway Bancorp of Cerritos, Calif., is potentially due up to $2.5 million over three years under its agreement to sell to First PacTrust Bancorp in Pasadena, Calif.