Viacom and Harmonix: The Earn-Out That Cost Three Times the Price

What happened

Viacom paid $175 million in cash for Harmonix in October 2006, with an uncapped earn-out on top that had been a courtesy to the founders. Rock Band shipped a year later and was a hit, which turned that courtesy into the largest open number on the deal. Viacom paid $150 million for 2007 performance alone. In October 2008 Harmonix amended its distribution agreement so the publisher took wider rights and lower fees from 2009, and by February 2009 Viacom was telling investors the 2008 earn-out would come in below the 2007 one.

The case, start to finish

Everything the founders earned after closing ran through two words of a definition nobody spent the last afternoon on.

A bridge over a disagreement

In October 2006 Viacom paid $175 million in cash for Harmonix Music Systems, with $12 million of it parked in escrow for eighteen months. That was the part both sides could agree on. The part they could not agree on was what a games studio is worth before the game ships. The standard answer is an earn-out: the buyer pays less today, the sellers take a share of what the next two years produce, and a formula fills in the blank later.

Harmonix's formula was 3.5 times the amount by which a defined term called Gross Profit exceeded $32 million in 2007 and $45 million in 2008, and it was uncapped. The agreement also said plainly that Viacom had no duty to run the business so as to ensure or maximize those payments. Read that from inside the room in 2006 and it looks generous to one side and cheap to the other: a big multiplier on a studio that had not proved it could clear the thresholds at all.

Then Rock Band shipped

Rock Band arrived in November 2007 and was a hit. Viacom's own filings record Rock Band and Rock Band 2 selling over 3.8 million bundles domestically in 2008. That year Viacom paid $150 million for the 2007 performance, described in its filings as subject to adjustment, and the weight in that phrase sits entirely on the last word.

An uncapped multiplier turns commercial success into an obligation nobody sized, and it prices every argument at three and a half to one. Gross Profit was defined as each product's Net Revenue minus its Direct Variable Costs, a category that expressly included distribution fees and third-party royalties. So when Harmonix and Electronic Arts amended their distribution agreement in October 2008, giving EA wider rights and lower fees from 2009 while leaving the 2008 fee untouched, that was never a private matter between a studio and its distributor. It was an input to a payment formula.

By December 2010 Viacom had sold Harmonix, having taken a $230 million goodwill impairment on it and roughly $30 million of charges on legacy Rock Band assets, and booked a $14 million loss on disposal. The business was gone. The earn-out was not.

Eight hundred and thirty million dollars of one cost line

By September 2011 both readings were on file and they did not overlap. Viacom's position was that roughly $130 million of the $150 million already paid had not been earned and that nothing was owed for 2008, which puts the whole earn-out near $20 million. The shareholder representative claimed a further $700 million, which puts it near $850 million.

What separated them was whether the cost of unsold inventory could be subtracted from net revenue: plastic guitars and discs manufactured, boxed, and still sitting in a warehouse. Goods made and goods sold are not the same number, and here the difference was worth roughly $300 million. On December 19, 2011 BDO USA, the Resolution Accountants the merger agreement itself had named, ruled that unsold inventory costs were not deductible and fixed the 2008 year at $298,813,095.

Viacom's fallback, an inventory write-down instead, was refused partly because Viacom had not identified it in its own 2008 Earn-Out Statement. The procedure for raising an argument turned out to be as binding as the argument. Delaware's courts declined to disturb the determination, and separately dismissed the sellers' complaint about the EA fee renegotiation: the agreement had said Viacom need not maximize the earn-out, and it meant it.

What was actually being negotiated

The earn-out came to about $533 million, roughly three times the closing price, on a studio Viacom had already sold. It took a $383 million pre-tax charge in fiscal 2012 and $12 million of interest in fiscal 2013. No amount of diligence on the studio would have found that number. It was never in the studio; it was in the contract.

The transferable part is unglamorous. Thresholds and multipliers are what people argue about across a table, because those are the figures that feel like the deal. What moves the money is the definition underneath: which costs may be subtracted, who prepares the statement, what has to appear in it to remain arguable later, and who decides when two sides read the same sentence differently. The hours left at the end are better spent on what the metric excludes than on where it starts. And note the one clause that worked exactly as written: the sentence saying the buyer need not maximize the payment protected the party who put it there. Clear language always protects somebody. The question to ask before signing is which of you.

Timeline

• Oct 2006 Viacom pays $175 million in cash at closing for Harmonix, with $12 million of it held in escrow for 18 months. On top of that sits an uncapped earn-out: 3.5 times the amount by which Harmonix’s "Gross Profit", a term defined inside the merger agreement, exceeds $32 million in 2007 and $45 million in 2008. The agreement does not require Viacom to run the business so as to ensure or maximize those payments.
• Nov 2007 Rock Band ships and is a hit. The earn-out, which was a negotiating courtesy to the founders a year earlier, is suddenly the largest open number on the deal. And 3.5x on an uncapped base means every dollar of argument about the definition is worth three and a half dollars of cash.
• 2008 Viacom pays $150 million "subject to adjustment" for 2007 performance. Rock Band and Rock Band 2 sell over 3.8 million bundles domestically that year, per Viacom’s own 10-K.
• Oct 2008 Harmonix and Electronic Arts amend their distribution agreement: EA gets wider rights and lower fees from 2009, while the 2008 fee is unchanged. Distribution fees were a "Direct Variable Cost", a subtraction inside the Gross Profit definition, so the fee level was never a side deal. It was an input to the earn-out.
• Feb 2009 Viacom tells investors in its fiscal 2008 10-K that the 2008 earn-out "is expected to be less than the 2007 earn-out payment."
• Dec 2010 Viacom sells Harmonix, having taken a $230 million goodwill impairment on it earlier that year plus roughly $30 million of charges on legacy Rock Band assets, and books a $14 million loss on disposal. The business is gone. The earn-out is not.
• Sept 2011 Viacom’s fiscal 2011 10-K states its position: approximately $130 million of the $150 million already paid "was not earned," and nothing is owed for 2008. The shareholder representative claims a further $700 million.
• 19 Dec 2011 BDO USA, the Resolution Accountants named in the merger agreement, rule that the costs of UNSOLD inventory may not be deducted from net revenue, and fix the 2008 earn-out at $298,813,095. Viacom’s filings put the additional amount owed across both years at $383 million.
• 2012–2013 Viacom takes a $383 million pre-tax charge in fiscal 2012 and $12 million of interest in fiscal 2013. Delaware’s courts decline to disturb the determination, holding that what was inside the arbitrator’s remit was for the arbitrator to decide. Separately, the sellers’ claim that Viacom should have negotiated lower 2008 distribution fees is dismissed: the agreement said Viacom need not maximize the earn-out, and it meant it.

You're in the owner's chair

October 2006. You are buying a games studio for $175 million cash, and the founders want a share of the upside from a game that has not shipped. You have agreed on an uncapped earn-out at 3.5 times Gross Profit above a threshold. There is one afternoon of drafting time left. What do you spend it on?

• Define, line by line, which costs may be subtracted in the earn-out
• Push the thresholds up — $32M and $45M are low for a business you just paid $175M for
• Add a covenant requiring the buyer to run the business so as to maximize the earn-out

What the same earn-out was worth, depending on how one cost line was read

• Viacom's filed position (unsold inventory deductible): 20 $ millions — total earn-out across 2007 and 2008
• What the Resolution Accountants determined, Dec 2011: 533 $ millions — total earn-out across 2007 and 2008
• The sellers' claim: 850 $ millions — total earn-out across 2007 and 2008

$175 million was the price both sides agreed on at closing. The number they could not agree on afterwards ranged from a ninth of that to nearly five times it. Figures from Viacom’s Forms 10-K (FY2011, FY2013) and the Delaware Supreme Court opinion confirming the 2008 year at $298,813,095.

Business model

An earn-out is a bridge over a disagreement about the future. The buyer will not pay today for a game that has not shipped; the sellers will not hand it over for the price of a studio that has not proved itself. So both sides sign a formula and let the next two years fill in the blank. The formula is a contract term, not an accounting fact, and it can be worth more than the business it is attached to.

Revenue model

For the sellers, the entire economics of the deal after closing ran through one line: 3.5 times Gross Profit above a threshold. Gross Profit was defined in the merger agreement as the sum of each product’s Net Revenue minus its Direct Variable Costs, a category that expressly included distribution fees and third-party royalties. Everything that mattered financially to the founders for two years was decided by what did and did not fall inside those words.

Cost structure

The costs that fed the formula were the contested ground. Distribution fees paid to EA were one of the largest post-merger expenses Harmonix incurred, and they were subtractive. Third-party music royalties were subtractive. The fight that decided the case was over a cost that was not obviously either: Viacom deducted the cost of unsold inventory from net revenue: boxes of plastic guitars and discs sitting in a warehouse. Goods sold and goods made are not the same number, and roughly $300 million of the deal turned on that distinction.

Strategic challenge

Rock Band succeeded far beyond what either side priced in 2006, and an uncapped multiplier turned that success into an obligation nobody had sized. By the time the amounts were real, the two parties were no longer partners, the studio had already been sold, and the only thing left connecting them was a paragraph written in an afternoon four years earlier.

Key decision

Viacom’s decision to take its position on the definition and defend it rather than settle: it argued that unsold inventory cost was deductible, and when that failed argued in reply that it could instead take an inventory write-down. The Resolution Accountants refused to consider the write-down, in part because Viacom had not identified it in its own 2008 Earn-Out Statement. The procedure for raising an argument was as binding as the substance of it.

What worked

The acquisition itself, commercially. Viacom bought a studio for $175 million and it produced one of the defining games of the console generation; the fiscal 2008 filings show the scale of it. And the drafting worked exactly as written for one party: because the agreement said Viacom had no duty to run Harmonix so as to maximize the earn-out, the sellers’ later complaint about the EA fee renegotiation had no contractual hook. Clear language protects whoever wrote it into the document.

What failed

The definition of the metric. On a purchase price of $175 million, the parties’ filed positions on the earn-out were roughly $20 million and $850 million, a spread of $830 million over how one category of cost was counted. The determination landed at about $533 million across the two years, three times what Viacom paid at closing, on a business it had already sold a year earlier. No amount of diligence on the studio would have found that number, because it was not in the studio. It was in the contract.

Risk factors

Uncapped multipliers on a metric the buyer controls the bookkeeping for; a gross-profit definition that lists what is subtractive without saying what is not; a resolution process whose scope is fixed by the parties’ opening statements, so a good argument raised late is simply unavailable; and the structural conflict that the buyer decides how to run the business while the sellers own a share of the result.

Lesson summary

In an earn-out, the metric definition is the deal. Thresholds and multipliers are what people argue about in the room; what actually moves the money is which costs may be subtracted, who prepares the statement, and what has to appear in it to be arguable later. Spend the afternoon on the definition, not the threshold. Here it was worth more than the entire purchase price.

Key data

• $175 million ($12M escrowed for 18 months) Cash at closing, Oct 2006
• 3.5 × Gross Profit above $32M (2007) and $45M (2008), uncapped Earn-out formula
• $150 million, "subject to adjustment" Paid in 2008 for 2007 performance
• ~$130M of that "was not earned"; nothing owed for 2008 Viacom's filed position (FY2011 10-K)
• A further $700 million Sellers' claim
• A further $383M; the 2008 year alone $298,813,095 Resolution Accountants, 19 Dec 2011
• ~$533 million — about 3× the closing price Total earn-out
• $383M pre-tax in fiscal 2012, plus $12M interest in fiscal 2013 Charges taken

Sources & basis

The company here is real and named, and nothing about it was invented to make the story land. The list below is where each fact came from — public filings, court records, published reporting — so you can open a source and check it against the sentence that used it.

1. Viacom Inc. Form 10-K, fiscal 2008 (filed 12 Feb 2009) — $175M initial consideration, the "defined gross profit metric," the $150M payment for 2007, and 2008 Rock Band unit sales View source ↗
2. Viacom Inc. Form 10-K, fiscal 2011 (filed 10 Nov 2011) — Viacom’s ~$130M position, the sellers’ $700M claim, the December 2010 sale of Harmonix, the $230M goodwill impairment and $14M loss on disposal View source ↗
3. Viacom Inc. Form 10-K, fiscal 2013 (filed 14 Nov 2013) — the December 2011 determination that Viacom owed an additional $383 million, against the $700 million sought View source ↗
4. Viacom Inc. Form 10-K, fiscal 2014 (filed 13 Nov 2014) — the $383 million pre-tax charge in fiscal 2012 and $12 million of interest in fiscal 2013 View source ↗
5. Winshall v. Viacom International Inc. (Del.) — merger terms: $175M at closing, 3.5× Gross Profit above $32M/$45M, the $12M escrow, the Gross Profit definition, and the absence of any duty to maximize the earn-out View source ↗
6. Viacom International Inc. v. Winshall (Del. 2013) — BDO’s ruling that costs of unsold inventory may not be deducted, the refusal to consider the late inventory write-down, and confirmation of the 2008 earn-out at $298,813,095 View source ↗