October 30, 2017 Vital Signs - Earnouts - Silent death, nicks, mandate

Over the last few months Vital Signs has mostly been about investment banking topics versus healthcare initiatives and developments. Most of that is by design as I'd like to see what TrumpCare looks like. That will drive a lot of what goes forward from initiatives such as telemedicine, pay-for-performance, palliative care, consolidation, what has been a growth industry, opioids, etc.

I'll stick with investment banking themes, but I've pasted in some articles about different initiatives which are designed to hobble and ultimately topple ObamaCare. This is a continuation of what has been happening since ObamaCare was passed. I have an undergrad degree in political science and philosophy and a J.D. so I find this kind of policy stuff and strategy fascinating.

But, let's discuss earnouts. In theory earnouts help bridge value gap expectations between a seller and a buyer. Sounds great!

Viewed another way, an earnout is a call option on litigation. If the earnout happens, everyone is generally ok. If it doesn't happen, the daggers and lawyers come out.

I've looked around and found a pretty straightforward useful discussion of earnouts and their issues. I've added comments after each of the four criterion.

"Has a buyer made you an offer that includes an earnout?

Valuation and deal structure are key in achieving a successful M&A transaction. To bridge potential differences in valuation expectations between seller and buyer, and to position the company for strategic growth in the near future, the deal structure may include earnout provisions. In an earnout, part of the purchase price is paid to the seller at a specified future date after the closing, based upon the company achieving specific performance goals.

While earnouts are most commonly employed when there is a gap between what the buyer is willing to pay and what the owner believes the business is worth, they are also used to share in the potential risk of future (albeit short-term) growth that can't be easily accounted for by using a simple EBITDA multiple. In essence, an earnout allows the buyer to mitigate risk while positioning the seller to benefit from company growth after the sale closes, and receive payment if/when the company achieves specific goals.

Deal negotiations are typically spirited, and deal structure often complex. Earnout negotiations can put new partners at odds with one another if the earnout structure is difficult to measure, or if the likelihood of success is diminished because growth objectives for the company over the next year or two change and negatively affect an owner's ability to achieve the earnout. Navigating this terrain requires a managed process and tenured banker experience to avoid a potential deal derailment. Professional expertise can help a business owner avoid costly mistakes and ensure their deal structure is reasonable, achievable and fair. Even when working with an investment bank, it is prudent as an owner to remain attentive to these four criteria:

1. Keep it simple--Earnouts should not be linked to complex financial models. They should be based upon easy-to-understand goals such as: sales revenue, EBITDA targets, new customers secured, or other reasonable and easy to measure targets. This makes it easy to determine whether the objective has been met, and helps eliminate the chance that either party will later feel taken advantage of in the new partnership. JHL - don't use anything that can be manipulated by accounting gimmicks. GAAP-compliant isn't an adequate protection. EBITDA may be an issue as "new" costs, expenses, and allocations can arise. Try to pick a metric that both parties value and that is easy to count. The b-school case book study of a well-aligned earnout is when AMC bought Jeep and there was an earnout based on units of Jeeps sold. I had a client who accepted an earnout on software development of some features that he had control over and which the seller wanted. Remember that the seller will want a commitment for all the resources necessary to earn the earnout and the buyer will want to commit to virtually nothing.
2. Confined to a reasonable length of time - Many owners accept that they will be required to roll over some equity and stay actively engaged in their company after they sell. However, part of their rationale for selling the company was to have the opportunity to diversify their assets and pursue other activities. Therefore, earnout timelines should be focused on the near-term performance of the company over a period of one to two years. Some earnouts are structured to allow the owners to reduce their level of involvement in the company over time to allow them more personal and business flexibility. JHL - Most of my sell-side clients are willing to stay on for some period of time ranging from 1-3 years. Most don't retain an ownership interest in the sale. If they stay, they will control less and less of the business as time goes on. I strongly urge that earnouts are completed within a year. The passage of time is not a seller's ally.  
3. Realistically attainable--The ultimate value of the company should be based upon reasonable growth projections founded on both historical and projected growth. Earnout provisions should also be linked to objectives that are reasonable and attainable. This will protect the owner and provide a reasonable opportunity to complete the earnout as expected. Too often earnout provisions are not clearly structured and include unrealistic timelines. This can create confusion as to what is being measured and for how long, thereby making it all but impossible for the owner to earn the money outlined in the sales agreement. JHL - Keep earnouts simple in metrics and short in duration. I usually represent sellers so the obvious point about duration is that someone else will be running your company and why should their actions affect my client?   
4. Get as much "cake" as possible - Your business is worth a certain value today. You should be paid that value when the deal closes and that value should not include an earnout. Cash is cake; contingent payments, like earnouts, are frosting. With the assistance of an experienced investment banker, owners can secure as much cash (cake) as possible when the deal closes, with the earnout as frosting on the deal, not a major percentage of the transaction. Far too often, owners accept deals with lots of frosting and very little cake. When you sell, negotiate for a Bundt cake--where a thin layer of icing is drizzled on top! JHL - Unless the earnout is a slam dunk in the eyes of my client, I advise my clients to look at what they will receive at close and consider whether that will be adequate consideration from the sale if they receive nothing more. I advise against my clients accepting an earnout generally, or, if they'll accept an earnout, I advise against any earnout in excess of 10% of the sales price. And, everything should be wrapped up in one year with the earnout not being subordinate to anything the buyer uses to finance or structure the acquisition. I advise against letting the buyer's problems become my client's problems.   

While structuring and managing earnouts can be difficult, in some cases it is the most effective tool (and might be the only way) to bridge the valuation gap between the buyer and seller. Skillful negotiation is the key to achieving proper deal structure and obtaining full valuation. Owners should remember that cash is king, and earnouts play a secondary role in helping close the deal."

URL: https://www.inc.com/brent-earles/the-role-of-earnouts-in-m-amp-a-transactions.html

ONWARD EVER

A death by a 1,000 cuts: The GOP's goal is to bury ObamaCare without leaving any fingerprints. ObamaCare just hasn't been crippled completely enough. As to whether folks will blame the GOP for killing ObamaCare, I try not to forget that 25% of the US population thinks that the Sun orbits the Earth. (URL: https://www.npr.org/sections/thetwo-way/2014/02/14/277058739/1-in-4-americans-think-the-sun-goes-around-the-earth-survey-says) 

"Consumers interested in buying insurance coverage on the Affordable Care Act exchanges are confused, unprepared and misinformed. 

That's according to designated navigators who help people sign up for coverage on the ACA's insurance marketplace. They have their work cut out for them this year.

Many consumers don't know that open enrollment kicks off Nov. 1. Some aren't even aware the exchanges exist any longer, having been inundated with messages from lawmakers that the marketplace is imploding.

"Are they still going to be able to afford to use their care? Is the tax credit going to help them, because they're hearing things about a double-digit increase to premiums?" said Shelli Quenga, director of programs for the Palmetto Project, South Carolina's lead navigator group, regarding the type of questions navigators are receiving. "There's a lot more confusion."

That uncertainty, coupled with a series of actions the Trump administration has taken in the months leading up to open enrollment, means the fifth open-enrollment period is shaping up to be the most challenging since the ACA was implemented.

...

The combination of confused consumers, higher premiums and a federal administration that would like to see Obamacare dead leads many experts to believe enrollment will falter, creating financial headaches for hospitals and insurers. Insurers alone will have to eat $1 billion in costs this year because the Trump administration scrapped cost-sharing reduction subsidies.

For its part, the federal government hasn't set an enrollment goal as the previous administration did. "Our target this year is to have a seamless open enrollment for consumers. The numbers we think will take care of themselves," CMS Deputy Administrator Randy Pate said in a statement emailed by a spokesperson. In 2017, 10.3 million people got coverage through the exchanges.

If fewer people sign up for coverage and they become uninsured, that spells trouble for hospital finances. Uncompensated care at hospitals fell to $35.7 billion in 2015, its lowest point since 2007, thanks to fewer uninsured patients. "If you now have a situation where enrollment is going to go down, while I don't think it'll necessarily be felt immediately by hospitals ... if more folks become uninsured, it will soon thereafter have an impact," said Dan Grauman, CEO of consultancy Veralon.

This year's enrollment period was drastically shortened from three months to 45 days, though some state-based marketplaces have extended their deadlines.

Those with coverage this year through HealthCare.gov will be auto-enrolled into a plan unless they choose another, and, unlike in previous years, they won't have time to switch if they don't like what's selected for them, navigators said. That's because auto-enrollment happens at the end of the enrollment period, Dec. 15."

URL: https://www.modernhealthcare.com/assets/interactive/openenrollment_preview/?

Nicks nix: Here's another way to dismantle the minimal efficacy of health insurance coverage. I've noted that it sucks to be poor. If you are poor, don't get sick. Universal health care is the norm in industrialized nations. I wonder what we know that they don't.

"The CMS proposed a rule late Friday that would allow states to define the minimum essential health benefits that health insurers selling plans on the Affordable Care Act exchanges are required to offer. Health insurance experts say such a change would lead to skimpier health plans on the individual and small group insurance markets and higher out-of-pocket costs for consumers.

The CMS proposed rule would give states greater latitude in choosing which benefits insurers must cover. It would allow states to choose a benchmark plan from wider pool of existing plans, including health plans from other states. The benchmark plan defines just what essential benefits other plans must cover.

The CMS' goal with the change is to give states more flexibility that could potentially lead to more affordable health plan options in 2019. But the agency acknowledged that some consumers could get the short end of the stick in the arrangement.

"Consumers who have specific health needs may be impacted by the proposed policy," the CMS said. "In the individual and small group markets, depending on the selection made by the state in which the consumer lives, consumers with less comprehensive plans may no longer have coverage for certain services. In other states, again depending on state choices, consumers may gain coverage for some services."

The ACA requires health plans on the individual and small group markets to cover 10 minimum essential health benefits including emergency services, hospitalization, prescription drug coverage, maternity care and care for mental health and substance abuse disorders.

"What this rule does is it creates a process where states can really sort of weaken the package of the essential health benefits," said Dania Palanker, assistant research professor at Georgetown University's Center on Health Insurance Reforms.

States could also opt to build their own menu of essential health benefits from scratch, as long as the benefits aren't too generous. The 10 essential health benefits would have to be in line with that of a "typical employer plan" in the large or small group market with more than 5,000 enrollees. At the same time, the proposed rule would bar states from making their essential health benefits any more generous than they are currently.

"The floor is the worst employer plan that they can find that covers 5,000 people," Palanker said."

URL: https://www.modernhealthcare.com/article/20171030/NEWS/171039987

Killing me softly: This won't happen this go-around, but gutting the individual mandate all at once, versus incrementally as has been done, is the cleanest kill shot for ObamaCare, even more than eliminating subsidies. Think about how insurance works: it's not rocket science.

"President Trump on Wednesday suggested using the GOP tax bill to repeal ObamaCare's individual mandate.

"Wouldn't it be great to Repeal the very unfair and unpopular Individual Mandate in ObamaCare and use those savings for further Tax Cuts," Trump tweeted.

...

Asked Wednesday about the president's tweet, Senate Majority Whip John Cornyn (R-Texas) threw cold water on the idea.

"I think tax reform is complicated enough without adding another layer of complexity," Cornyn told The Hill.

...

The Congressional Budget Office has estimated that repealing the mandate would save the government $416 billion over a decade.

The mandate requires people, with some exceptions, to pay a fine to the IRS if they do not have health insurance.

Experts have said repealing the mandate would result in massive premium spikes and a major increase in the number of uninsured people.

It could also send ObamaCare exchanges into a "death spiral" because it would discourage healthy younger individuals to sign up for insurance."

URL: https://thehill.com/policy/healthcare/358201-trump-suggests-repealing-obamacare-mandate-in-tax-bill?

OBITER DICTUM

Beauty is a short-lived tyranny. - Socrates

To be is to do. - Immanuel Kant

I don't necessarily agree with everything I say. - Marshall McLuhan

Q: How do you kill a room full of snakes? A: One at a time. - JHL

An unexciting truth may be eclipsed by a thrilling lie. - Aldous Huxley

I hate small towns because once you've seen the cannon in the park there's nothing else to do. - Lenny Bruce

Nearly all men can stand adversity, but if you want to test a man's character, give him power. - Abraham Lincoln

See you in a few weeks.