A deal in Oregon last week introduced a new twist on pay-for-performance clauses in small bank mergers.

Shareholders of South Valley Bancorp may be due up to $39 million in cash on top of the $34 million in stock they are guaranteed in the Klamath Falls banks' sale agreement Wednesday with Washington Federal (WAFD) of Seattle.

The terms of that extra $39 million — which dealmakers call a "payout" or "earnout" — are novel compared with sweeteners offered to sellers in other transactions recently in Oregon and California.

Most striking: South Valley has only until the deal's scheduled closing in the third quarter to win that entire payout. It gets that full amount if a pool of questionable loans is paid back in full by then. If not, South Valley is to essentially split any money received from those borrowers over five years with its new owner.

How come?

Washington Federal does not want to pay par for 11 mostly performing commercial property and business loans with a face value of $39 million. It is worried about their cash flow and collateral values, among other things. South Valley is wary of selling them at a steep discount.

Both would have some insurance: Washington Federal would get protection against overpaying for bad assets and South Valley has a chance to receive 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 in the Western U.S. D.A. Davidson advised South Valley in the deal. "The earnout 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 that pool collected before closing. After that, it would get 51 cents on the dollar for each loan collected within five years.

Since future cash payments are to come directly from repayments in that pool, Washington Federal's out-of-pocket payment to South Valley should be no more than the $34 million in stock it has agreed to dole out.

South Valley, in turn, has the incentive to retire as many of those loans as possible before closing via paydowns and refinancings. It also would get to participate in their upside potential after the deal closes.

The terms basically establish a price acceptable to both parties, McKinney says.

The deal has a fixed price to be paid in stock of at least 51% South Valley's tangible book value.

With cash payments, South Valley could ultimately fetch up to 110% its tangible book.

South Valley shareholders may win either way since they are being paid in shares of the merged entity, which is to have 190 branches and $14.4 billion of assets. It is already a plus for South Valley shareholders that Washington Federal is a fairly strong stock and pays a dividend; its stock finished Monday nearly unchanged at $16.73.

Earnouts are becoming more common in deals worth less than $100 million involving sellers in good markets 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 of its Portland bank to Sterling Financial (STSA) of Spokane, Wash. It received $8 million when the deal closed in March.

Gateway Bancorp of Cerritos, Calif. is due payouts worth up to $2.5 million over three years in its sale agreement in June with First PacTrust Bancorp (BANC) in Chula Vista. That deal has not closed.

South Valley's deal has a longer earn-out period than those deals. The potential total payouts in those other deals also were not contingent on how many loans were retired by closing.

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