When Home Bancshares Inc. of Conway, Ark., was in talks to buy Centennial Bancshares in Little Rock this year, negotiations hit a snag because Centennial's managers thought it was worth more than the buyer was willing to pay.
So Home Bancshares came up with this proposal: It would pay about $22.6 million up front for the $199 million-asset Centennial and put $3 million in escrow to be paid if Centennial's loan portfolio meets Home's expectations. More significantly, Home would pay a $4 million "earnout" if Centennial's lenders meet certain targets within a year of the deal's closing.
It is uncommon, but not unheard of, for a buyer to hold back a portion of its payment while it evaluates the seller's loan portfolio, but observers said that earnout provisions are rare in banking circles. However, the observers said that the provisions could become more popular if sellers continue to demand more than what buyers are willing to shell out.
John Allison, Home's chairman and chief executive officer, said that the deal's structure bridges the gap between buyer and seller expectations. It would protect the $2.2 billion-asset Home from overpaying while giving Centennial time to prove its worth, and if Centennial meets its benchmarks, its shareholders "will get paid accordingly."
Jon Arfstrom, an analyst with Royal Bank of Canada's RBC Capital Markets Corp., said a side benefit of the agreement is that it should prevent Centennial's bankers from defecting to rivals. Many of the bank's executives and lenders are also shareholders, and if they want their share of the $4 million earnout, they will stick around, he said.
Earnout provisions are "pretty common in the insurance industry and pretty common in industries where the personnel is critical to ongoing performance," said Jefferson Harralson, a bank analyst with KBW Inc.'s Keefe, Bruyette & Woods Inc. "Those attributes also fit bank acquisitions, so it would make sense banks would go toward an earnout type of structure."
Dan Bass, the managing director with Carson Medlin Co. in Houston, said the structure could help get deals done.
"From a seller's perspective, they might not initially like it, because they would like to get their money and run, but if they think about it, they could actually get more money if they are confident in their abilities," he said.
Earnout agreements are fairly common in deals where bankers buy other types of companies, such as insurance firms and investment advisory firms, Mr. Bass added.
Home's deal for Centennial, announced late last month, is expected to close in January. Centennial would retain its name, charter, and balance sheet for at least a year, after which Home would determine whether or not merge it with one of its five subsidiary banks.
Centennial is projected to make about $1.7 million this year. Mr. Allison said its shareholders would receive the full $4 million earnout if its earnings rose by $270,000, or about 16%, from that level next year. If the earnings fell short, the shareholders would receive less.
He stressed, though, that Centennial's management could not sell bonds or other assets that would produce a one-time gain to reach the earnings target.
"It's only re-occurring core earnings that count," he said.
Mr. Allison is no stranger to earnout agreements. Though this would be the first he has executed as a banker, he struck one such deal in the early 1990s when he was the president of Spirit Homes, a manufactured housing builder.
If Home paid the full price up front for Centennial and the acquisition did not meet projections, Home's stock would suffer, he said.
"And as the largest shareholder I don't want the stock diluted," he said.
Observers said that earnout agreements have their limitations — they would not make much sense be for bankers looking to retire, and if the top executives are not also owners, they would have little incentive to agree to an earnout provision.
"It would logically work in a situation where management owns a large percentage or all of a company," said Clark Locke, a vice president and the head of Texas investment banking operations for Hovde Financial Inc.
Also, observers said that earnout provisions can also pose some accounting challenges: Balance sheets often are combined in acquisitions, so the parties would need to come up with some method for measuring the seller's performance.
