Let’s say you’re an entrepreneur with a business that has ongoing EBITDA of $20m and you want to sell your business for 5x EBITDA. However, I’m a private equiteer and I only want to pay 4x EBITDA for your business. So, how do we bridge the gap? Or more importantly, how do I create the perception of a bridged gap?

(By the way, this is hardly deceptive because anyone will see it for what it is. The reason it works is that it creates a higher top-line figure that appeals to egos and emotions of both entrepreneurs and advisers.)

Just to recap, you want $100m (5x) for your business and I want to pay $80m (4x). One method I can use to get to your headline number of $100m is by constructing an earn-out. I’ve talked about earn-outs ad nauseam in previous posts (see funding earn-outs, are earn-outs fair), but here’s a quick and dirty use for them.

My offer to you will look something like this:

My firm, Acme Private Equity, proposes to pay up to $100m for 100% of your business. This includes an upfront payment of $80m and an earn-out of $20m. You will receive the earn-out if your EBITDA reaches $25m in the next financial year.

What I’ve done is offered $100m, but with conditions. The main condition being that your ongoing EBITDA increases from $20m to $25m. So really, I’m offering to pay $100m for a business with EBITDA of $25m, which is a multiple of 4x; the multiple I wanted to pay in the first place. If EBITDA stays at $20m, I don’t have to pay the earn-out. So, I’ve only paid $80m, which is still only 4x EBITDA.

Being honest with ourselves though, if the earn-out is paid, I am actually paying 5x for the business. This is because the extra $5m of EBITDA was created under my watch and I shouldn’t be paying anyone for earnings created while I owned the business. So sure, I’m paying you 5x. But, I protected myself on the downside and I received a guaranteed $5 EBITDA increase (if EBITDA didn’t increase, I would have only paid 4x). Either way you look at it, this scenario is better than me just flat out paying you $100m on $20m of EBITDA; better for me, not you.