This guest post is written by Mike Gasparro of AxialMarket. You can also view the post on AxialMarket’s blog.

In this blog posting, we explore the concept of accretion/dilution. What is it? How is it calculated? Why and how is it relevant for strategic buyers and what does it mean for sellers negotiating with strategic buyers.

The accretion/dilution concept refers to the impact an acquisition has on the buying firm’s Earnings Per Share (“EPS”). An acquisition is accretive when the combined EPS (known as pro forma EPS) is greater than the buyer’s standalone EPS. An acquisition isdilutive when pro forma EPS is less than the standalone EPS.

For example, suppose analysts expect 3M’s EPS to be $6.12 in 2011. If they were to acquire Company ABC, pro forma EPS in 2011 is now expected to be $6.18 — $0.06 higher than if 3M had not acquired Company ABC. In this case, the deal is $0.06 accretive to 2011 EPS. On the other hand, if after acquiring Company ABC, 3M’s pro forma 2011 EPS is expected to be less than the original $6.12, the transaction is dilutive.

The calculations can get complicated as there are a number of variables which are interrelated. A qualified investment banker/M&A advisor can quickly help with the intricacies and the necessary calculations.

Here are the basics:

• Estimate the Net Income of the Combined Firm – Although simple in theory, the calculation is more complicated than just adding both firms’ net incomes. The combined net income should take into consideration expected synergies. Typical synergies include additional revenue from cross-selling products/services, economies of scale in sourcing and/or elimination of redundant functions. Additionally, the net income has to be adjusted for other transaction related items such as changes in interest expense due to debt being issued, changes in depreciation or amortization deductions due to write-ups or downs in assets, changes in tax rates, etc.
• Calculate the New Share Count - If the strategic buyer is going to finance a portion of the purchase price with stock, they will be issuing new shares which should be added to the current share count.
• Divide the Estimated Net Income of the Combined Firm by the New Share Count – Compare this new pro forma EPS to the buyer’s original standalone EPS to determine whether the transaction is accretive or dilutive.

Accretion/dilution is relevant to a strategic buyer as it can be regarded as a proxy for whether the acquisition creates or destroys value for shareholders. EPS serves as an indicator of a company’s profitability. If a transaction is going to decrease the company’s profitability (i.e. it is dilutive), the value of the buyer should theoretically decrease following the transaction.

However, there are significant limitations to this analysis. First, accretion/dilution is looking at the transaction over a fixed period of time. Strategic buyers generally intend to own an acquired business indefinitely. Additionally, EPS is impacted by numerous accounting decisions (which can be manipulated) and does not necessarily reflect the economic reality or the combined company’s ability to generate cash flow.

We recently participated in a seminar hosted by Investment Dealers’ Digest , “Corporate Development and Strategic Buyers: How to Make M&A Pay for You in Today’s Market.” During the seminar, strategic buyers discussed whether they would acquire a company that was dilutive to earnings. The results were similar to what we have found with our AxialMarket Members: some strategic buyers will not do a dilutive transaction; others require the transaction to be accretive after a certain period time; still others are not concerned with this issue and focus on strategic fit.

As a seller, it’s important for you to be aware of the concept of accretion/dilution, understand the basics, and realize that it can potentially impact decisions made by strategic buyers. However, it’s not the be-all end-all for all buyers. As we discussed in “5 Major Differences Between Strategic and Financial Buyers,” strategic buyers focus heavily on synergies and integration capabilities. So while accretion/dilution may be a factor for some potential strategic buyers, there are many other issues which will influence their decision.

(Image courtesy of Ricardo Carmona)

I received the following question from a reader and wanted to share my answer for a couple of reasons: 1) to make sure I’m giving him the right advice, and b) it seems like a very simple question, but it’s actually a little complex. This second point is the reason I started this journal, because it’s rare that things are as they seem in private equity.

The Question: There is a company with 100 outstanding shares and the market price of each share is $10. Now, if the company issues 10 shares through a private placement at price of say $12. Everything else (i.e. debt, cash etc.) remains same. What will happen to Enterprise Value? Will it increase or decrease? Why? How will EV be affected if the private placement is done at discount to current share price (i.e at $8)?

An Answer:

EV is generally used as a proxy for market value. So it really depends if the issue of shares is adding to the market value of the business. At one extreme, if you issue the shares and set fire to the cash you just raised, then EV will stay the same and your individual shares will just be worth less. At the other extreme, if you buy a distressed competitor for $1, and synergies mean you double the value of your business, then EV will roughly double, meaning your shares will increase in price.

So the important distinction is that we tend to work backwards with the EV equation. That is, we work out EV (often using a multiple of cash flow or earnings), then we subtract net debt to find the equity value. This makes it a “market” valuation. We generally don’t add up the book value or par value of shares and add the book value of debt, because that would be a “book” value and not necessarily represent what people will pay in the market.

So, let’s work through some numbers.

1. If the equity is issued for no reason, just to increase cash for a rainy day, then there is no affect on enterprise value (EV). Theoretically, equity increases, but so does cash, which offsets debt to give net debt. Intuitively, if you sell the business the day after raising the money, the cash is just used to pay back the people that just funded the new issue. Practically, it could be a little different. If you raised money at a premium, the new shareholders will get less back as the new cash is shared between everyone (either by paying down debt or via a capital return). The opposite happens if you issue at a discount.
2. If the equity is issued to invest in the business, then the affect on EV depends on the profitability of the investment. Remember, we’re working with market value. If the “market” values the investment at cost, then it cancels out. If they value the investment at zero, the EV stays the same, the equity value stays the same, but you have more share, so the per share price drops. If they value it above cost, then the opposite happens.

Does this sound right to everyone? Any comments?

I’ve received a few emails asking this question and just realised it’s one of the most popular search terms (that generates traffic to The Private Equiteer). The question, as per the search term, sounds a little ambiguous, so let’s reword it…

The question: should working capital affect an enterprise value calculation.
The answer: absolutely.

Your calculation of a firm’s enterprise value must account for working capital because it affects cash flow. And, anything that affects cash flow, affects returns, and anything that affects returns, affects the value of an investment.

For a full run-down of the nuances of WC vs. EV, check out the Working Capital Series. For a quick and dirty understanding, think about changes in working capital. If you must pay creditors before debtors pay you, there is a drain on cash. All else equal (including revenue), this requires a one time injection of cash to support the perpetual lag in payments. But, if revenue grows (and your working capital profile stays the same), you must inject more cash into the business to support the changes in absolute working capital. This continues as long as growth continues and hence affects the long-term investment value.

I realise this seems somewhat rudimentary, but the popularity of the search term suggests otherwise.

Private equity valuations sound simple enough, so what’s all this talk of pre-money and post-money? How can a business have a different valuation at the same point in time?

It generally comes down to the purpose and use of your investment. There are two broad options:

1. Existing Capital – e.g. buy-out an existing stockholder, retire some debt, etc.
2. New Capital – e.g. invest for growth, invest to make an acquisition, etc.

If you swap your new capital for existing capital (buying out another shareholder or paying down debt), then there’s generally no change to the valuation. However, if you are investing cash as new equity (for growth and/or acquisitions), then you’re increasing the equity value of the business and hence, increasing the EV and overall valuation.

Image: Pre- and post-money not always equal [source: Shutterstock]

A quick example: we value a company with EBIT of $20m using a multiple of 5x. It has debt of $50m, no material amount of cash and therefore, equity value of $50m and EV of $100m.

In scenario 1, I’m paying down $50m debt. This means I’m swapping my $50m of equity for the $50m of debt. This transfer of capital means we now have $100m of equity , but $0 of net debt, so still an EV of $100m. As you can see, the EV and overall value didn’t change.

In scenario 2, I’m investing $50m to make a new acquisition. My investment enters the business as new equity to fund the acquisition. Total equity is now $100m, net debt is still $50m and hence EV is $150m.

In scenario 1, the pre- and post-money valuations were the same, both $100m. In scenario 2, pre-money was $100m, whereas post-money was $150m. This is all due to the new equity injection.

Like most things, there’s a caveat to this. In scenario 1, we swapped different types of capital, which mean they have different risk and return profiles. Most financial analysts would argue the value of the business changed due to the change in capital structure. However, we tend not to go into this detail in private equity for a few reasons (e.g. we’re not operating in efficient markets, our preference equity more closely resembles debt, we do the deals we can irrespective of theoretical nuances, etc.)

So, at least for simplicity, pre- and post-money valuations only differ if new equity is invested in a business.

I’ve harped on a little (or maybe a lot) about how iniquitous and unscrupulous equity ratchets are. I’ve said they misalign interests from the outset and lead to adversarial relationships when triggered. So, are there any equitable ways to structure equity ratchets? And, if not, why do we still use them?

Like most things, there are shades of grey. At one end, we have short-term one-way earnings-based ratchets that go against the mantra of private equity and pin executives to short-term performance. At the other end, we have long-term two-way returns-based ratchets that create much better alignment across the entire stock register.

So, let’s check out these characteristics:

• One-way vs. Two-way - A two-way ratchet simply means that executives aren’t only punished for underperformance, but they’re rewarded for outperformance. A two-way ratchet supplants the need for executive option schemes and further encourages executives to invest their own cold hard cash. The only other consideration here is the rates at which the ratchet moves in each direction (more on this later).
• Shorter-term vs. Longer-term - we can link our one-way ratchet to something that makes more sense for everyone… the exit. We lament public markets for their short-termism, so why do the same by using short-term ratchets? If we are going to align interests and have longer-term investment horizons, then we should use longer-term ratchets and give executives a chance to make a difference.
• Earnings-based vs. Return-based - continuing with the concept of aligning interests, private equiteers are rewarded for returns, not earnings. Higher earnings certainly help boost returns, but there’s much more to a great return, like higher exit multiples and good leverage. If you want executives to maximise your exit return, then it makes sense to incentivise them on the return-side via a ratchet linked to IRR or cash multiple (thanks to a recent reader for this suggestion).

There’s one more consideration for two-way ratchets… the ratchet rate. Should the rate be equal for the downside and upside? Well, it depends. In all fairness it should, but sometimes the ratchet rate is adjusted to bridge valuation gaps. Managers may opt for a higher ratchet rate in exchange for a lower initial valuation, or vice versa. Also, the private equiteer must ensure the upside ratchet rate isn’t so aggressive as to eat into their target return (I’ve seen this happen).

So, it’s best to plot out a range of scenarios before agreeing to a ratchet to make sure that,  a) everyone is sufficiently incentivised, b) your target returns are possible in most scenarios, and c) misalignment and adversarial terms are minimised. Good luck.

The terms of an equity ratchet predicate its value. Often the terms don’t just state that, for example, “our equity will ratchet up 5% if your EBIT falls below $30m in 2010″. Usually, a positive linear scale is used to incrementally ratchet the equity according to a predetermined range of earnings.

This is best demonstrated with an example. So, we have a 70% stake in an investee with 2009 EBIT of $30m. We invest with the proviso that a ratchet applies to 2010 earnings, whereby, for every $100k the EBIT drops below $30m in 2010, our equity ratchets up 0.1%. There is a cap on this to prevent us taking over the entire company in a bad year. The cap is at a maximum of an extra 15% of equity, which translates to a range of $15-30m. Therefore, if EBIT in 2010 drops all the way to $15m, our equity ratchets up 15% to a total of 85%.

The first thing you’ll notice here is that in practice, a ratchet rarely achieves a perfect equilibrium around your original paid multiple. What I mean is, if you invested $105m for your 70% stake (which equals a 5x EBIT multiple), the ratchet doesn’t help you keep your original 5x multiple. If EBIT did drop to $15m and your equity ratcheted up to 85%, then you’re effectively invested at an 8.2x multiple (all else equal and no applicable debt).

You may ask… why can’t the ratchet maintain our original multiple? Put simply, other investors just wouldn’t go for it because the risk of losing their entire stock-holding is very likely. Plus, why do you deserve this protection anyway?

There are many ways you can value this ratchet, but in the example above, you can see with the ratchet your effective multiple is 8.2x if EBIT drops to $15m. Whereas, without the ratchet, the multiple would be 10x. The enterprise values in these two instances differ by about $26.5m. Of course, the ratchet isn’t worth $26.5m because one would hope the probability of EBIT dropping by 50% is less than 100%. If you want to get really technical, you could value the ratchet at each interval and apply a probability to each scenario and then sum the results. But, that’s way too much work and you can’t really use the calculation in negotiations because it draws attention to the fact that ratchets are evil.

With all of this said, I recently posted on the concept of the equity ratchet and the  pros and cons of equity ratchets.

This post belongs to a series on Working Capital (see the contents page here).

There are various methods used to value investees, but private equiteers tend to focus on earnings multiple valuations and discounted cash flow (DCF) valuations. Working capital affects these valuation methodologies in the following two ways:

1. The earnings or cash flow figures may be influenced by changes in working capital (delta) across periods
2. The net debt (specifically cash) position may be affected by the operational working capital requirements of the business

In a discounted cash flow (DCF) valuation, working capital is analysed to help calculate free cash flow (FCF) for each period (see right for equation). These free cash flows are discounted and summed to arrive at a valuation. This is simple textbook stuff, so I want to concentrate on working capital considerations in earnings multiple valuations for the remainder of this post.

Unlike a DCF, an earnings multiple valuation is based on maintainable earnings; that is, the level of earnings that can be maintained indefinitely. If all else is equal, working capital (from an analyst’s point of view, i.e. ex-cash) remains the same across periods and so there is no cash surplus or shortfall between periods. And so, there should be no working capital offset in the maintainable earnings calculation.

You may be thinking, “but we don’t expect earnings to stay flat and so there will be working capital consequences and since different businesses are affected differently as they grow, we need to consider it somewhere.” Well, you need to account for this via the applied price multiple. What does that mean? If the firm’s working capital profile spins off a lot of cash, investors will be willing to pay a higher multiple, and vice versa.

Remember, even though growth may increase the theoretical cash shortfall, growth also generates greater earnings and greater value.

So, the verdict on point 1 (from above) is that the earnings figure used in an earnings multiple valuation should not be adjusted for working capital delta because it is a maintainable estimate. However, you may account for a firm’s working capital profile in the multiple if it is abnormal or if the multiple is already assuming high growth.

The one exception is where you know of a material change to working capital that will create a material difference between current and future earnings figures.

Onto point 2 (net debt position): working capital may affect the enterprise value (EV) because not all cash at bank can be used to repay debt. You may remember from the basic EV calculation that EV equals equity value plus total debt less cash; the idea being that cash can pay down debt. However, you shouldn’t simply assume that all cash at bank is excess cash to pay down debt.

There are numerous examples where cash is needed to support a firm’s operations and hence, is part of its earnings multiple valuation. The simpler way to think about it is, how much cash can I remove from the business without causing disruption? Since an earnings multiple valuation is theoretically based on future earnings, I personally believe that enough cash should be left in the business to support working capital gyrations for the first year.

This doesn’t mean that if cash momentarily dips $2m that the vendor should leave $2m for the new investor. What is does mean is that enough cash should be left to pay the finance/opportunity costs of supporting that $2m working capital requirement for the first year. I think this is fair since you’re valuing the business on future earnings and it will take a momentary investment of $2m to create those earnings.

There are also other scenarios in which vendors should leave cash in the business. In retail businesses for example, if all cash is taken from the tills, the business won’t operate properly. Ipso facto, the money required to adequately fill the tills is operational and included in the earnings multiple valuation (and shouldn’t be considered excess cash). It may be difficult to agree a number in this case, but theoretically I believe the reasoning to be sound.

So, the verdict on point 2 is that not all cash at bank should be thought of as excess cash in a earnings multiple valuation. Any cash required for the operations of the business and/or to subsidise the opportunity costs of cash shortfalls should be left in the business. In an EV calculation, this cash should not be used to reduce debt to arrive at a net debt figure.

This is a long post, but I hope it helps to form your own views on working capital and valuations. It should be a simple topic, but theories seem to change daily; depending which side you’re on in today’s latest deal. If you think I’ve left something out or if you have alternative views, please let me know.

The best way to calculate capex is by gaining full access to a company’s financial accounts, its financial staff and its executives. With this combination, you’ll be able to paint a good picture of the capex necessary to keep the business running at its current levels of cash flow. However, often we must value companies prior to conducting formal due diligence and in these cases, we typically only have access to standard financial statements. This post discusses calculating capex with access only to these statements.

A few basics first:

• Capex is important because it can significantly influence the value of a business
• We can classify capex as either growth or maintenance, but we’re mostly interested in maintenance capex
• Maintenance capex refers to the capex required to keep a business running at current cash flow levels
• Growth capex refers to capex required to grow the business beyond typical cash flows (e.g. acquisitions)
• Financial statements do not have a line item titled maintenance capex
• And, no formula exists to calculate maintenance capex from the financial statements
• Therefore, maintenance capex calculations are mostly estimates

The first place you may think of looking for data to calculate capex is the cash flow statement (within the investment section). There may be a line item for Investments in Equipment (or similar), which defines cash flow related to investments in assets. While this essentially refers to capex, it will likely include capex related to acquisitions and other growth campaigns. The reason we only want maintenance capex is because we’re valuing the business based on its current state and current cash flows.

The second place you may look for evidence is the depreciation line on the P&L statement. Many people use this as a proxy for capex and cite its smoothing effect as an additional advantage (I wrote about this in a recent post on EBITDA vs. EBIT). However, this smoothing, which accounts for many years, may reflect the business as a different beast because it is backward looking. Additionally, depreciation doesn’t account for asset price inflation, which is significant for certain businesses.

So what else can we refer to? Short answer… nothing. In my opinion, the ideal method for calculating capex from the financial statements is to analyse investing cash flows and depreciation over various years to find trends and arrive at an informed estimate. [EDIT] Also check the supplemental notes for more granular information on cash flows and depreciation (thanks, Scott). Here are a few steps I normally follow:

1. Look at the Investment in Equipment line on the cash flow statement, remove acquisition capex, but make sure to add back an amount that will maintain the newly acquired assets. Look at previous years too; you may find a year without growth and with a similar level of profit, hence, evidence of maintenance capex levels.
2. Look at the Depreciation section of the P&L, increase the amount for inflation, and adjust for structural changes such as acquisitions or major growth into other areas. Again, compare with previous years to find (and understand) abnormalities.
3. Compare the above figures over various years to establish a trend and to help make inferences about what capex should be in future years. Avoid suggestions from management that maintenance capex is some fraction of what you’ve calculated; often managers underestimate capex (edit: managers always underestimate capex).
4. Compare your capex to revenue (and earnings) ratios of listed businesses in the same industry. One would expect similar businesses to spend similar amounts on capex to maintain assets and uphold regular levels of service.
5. Test your calculated figures with management and ask them for specific forecasts on large items. You may find cyclical items that run on a cycle not apparent from only 3-5 years of historic financials. Again, overestimate and make sure the investment is viable on those figures because your overestimation will likely become an underestimation.

Calculating maintenance capex can be time consuming and frustrating, but it is imperative that you understand it in detail in valuing a business. I’ve seen many investments fall short of expectations because private equiteers took management capex forecasts as gospel.

The problem with any measure from the P&L statement (such as EBITDA, EBIT and NPAT) is that they rarely represent cash flow. Cash flow is important because we like to understand returns from a cash, rather than paper, perspective. However, measuring maintainable cash flow from the financial statements can be inaccurate and difficult, especially with public companies. Therefore, we’re often relegated to using P&L measures.

With this in mind, the major problem with EBITDA is that it has no provision for capital expenditure. Capex is a major cash item that doesn’t make it onto the P&L statement because capital assets are capitalised to the balance sheet. Some capital-intensive companies have huge capex, so knowing that EBITDA is $10m may be inconsequential. That company’s capital-spend alone could be $9m, leaving cash of only around $1m (all else being equal).

The advantage of EBIT (over EBITDA) is that it somewhat accounts for capex through depreciation. This depreciation figure often represents a smoothed measure of capex since it accounts for items purchased over many years.  So, in short, EBIT is a much better measure of real earnings, even if still a little inaccurate. (These other inaccuracies come from various deviations between cash and accrual accounting.)

For most companies, the disconnection between EBITDA and cash flow is too wide to be of any real use. The only exception I can imagine is using EBITDA in the analysis of businesses within the same industry where capex to revenue ratios are similar. In those cases, it is more feasible to use EBITDA, but still not ideal.

In my last post I accosted general partners (GPs) for sugar-coating valuations. So, to ensure constructiveness, I thought I’d give you my perspective on how a valuation should be conducted in these crazy times. Of course a multiples valuation consists of just earnings and a multiple, but due to recent volatility, there are a couple of important considerations.

These considerations are based on using a fair and likely maintainable earnings figure and using a fair and reasonable market multiple. My method for coming to the earnings figure is to extrapolate the most recent performance using historic seasonality.

1. Understand the monthly seasonality of the earnings – by knowing seasonality of the earnings, we’ll be able to extrapolate a maintainable earnings figure from the most recent actual data. Normally we’d just apply a growth rate to last year’s earnings, but due to high volatility, I only want to use the most recent data to determine maintainable earnings.
2. Find the last three months of performance data – let’s focus on EBIT as a proxy for maintainable earnings since it’s probably most representative of maintainable cash flow (FCF). I say this because recent actual FCF may be higher than maintainable FCF because most businesses have put the brakes on capex and other things that affect FCF.  If expectations are that maintainable earnings will fall even further, don’t ignore it, make the required and fair adjustments.
3. Extrapolate the three month data using seasonality estimates – for example, if our three months worth of earnings data (say March, April and May) has historically accounted for 30% of total earnings, let’s extrapolate that out to a full year. So if the three months of EBIT is $7m and we suspect it will represent 30% of the full year, divide $7m by 0.3 to get about $23m for the forecast of maintainable earnings. Again, make any fair adjustments.
4. Glance over similar listed businesses to choose a multiple – forget recent transactions (unless they’re very recent and in the same industry and of similar size). Don’t get cute with overly geared listed companies with $0.01 share prices trading at multiples of 200x. Also, don’t over-do  the conservatism with companies teetering on the edge of bankruptcy and trading at multiples of 1.5x. Ask yourself, what multiple would I pay for this business right NOW.  If it’s over 5x or 6x EBIT, then chances are you need to get a grip.
5. Calculate the enterprise value - multiply the earnings from 3) by the multiple from 4). This should give a relatively fair EV if the earnings and multiples were themselves fair and conservative. So say we had $23m in maintainable earnings and a multiple of 5x, then our EV is $115m.
6. Adjust to get your equity value – in simple cases, take EV, subtract debt and add back cash. If we say our net debt in our example is $30, then $115m – $30m = $85m. From that total equity value, multiply your percentage share to get the value of your specific equity. So say we own 60% of the company, our equity value is $51m.

There you have it, a quick and dirty, yet conservative, multiples valuation for crazy crazy times.

As a result of the global economic unpleasantness, many investees are having a difficult time and private equity investors are covering this up through lies, damned lies and statistics. Today’s article from Denise Palmieri at peHub talks about improving relations with limited partners (LPs), one of which is a suggestion that private equiteers have some humility and don’t cover up the blatant truth.

I’m receiving many reports from roadshows that say LPs are becoming quite annoyed and distressed at the obvious sugar-coating that’s taking place. Apparently general partners (GPs) are talking about future earnings that are multiples of current earnings and then applying outrageous pre-2008 multiples to those with the explanation that by the time they exit they’ll receive those multiples and hence they should use those multiples now. Please.

When the chickens come home to roost, LPs will only give thought to what was done to combat the downturn and what the result is via the exit. Only negative thought will be given to fictitious earnings and multiples, so why bother? Please show some humility, talk about what actions are being taken, and leave the excuses at home. Like many other firms, my firm has spent an inordinate amount of time on investor relations (weekly updates, roadshows, etc.), but none of that matters if you’re not honest and genuine; they’re not brainless, they can see right through it.

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.

So, a typical deal may sound like… I’ll pay you $x for your business, of which $y is paid now and $z is paid if you meet next year’s EBITDA budget. The $z, which is predicated on future earnings, represents an earn-out. That is, the vendor has to earn that additional capital payment by hitting budget. I’ve written about earn-outs many times before, which you may like to visit before continuing:

• Are earn-outs fair… or just a product of private equity avarice?
• The value-based components of a private equity deal
• Unpaid earn-outs and discontented vendors

But, when the time comes and the business has exceeded its EBITDA target, where does the money come from to pay the vendor for the earn-out? If you’re buying 100% of the business, the vendor doesn’t really care where you get the cash from (as long as it is paid) because they no longer have an interest in the business. However, if the vendor is retaining a share of the business or if there are other shareholders remaining in the business then they will certainly care about the source of funding for the earn-out.

Let’s use an example. If I pay you $100m for 50% of your business, but $20m of that is an earn-out (so $80m up front), you may assume it’s all coming from my own pocket (or the bank’s). But, what if I suggest the company’s cash flow covers the earn-out? Well, since you will still own 50% of the business, you will essentially be paying $10m of your own earn-out.

Now, this isn’t necessarily a deceptive term suggested by the buyer; it’s simply a valuation play. Of course this structure would be disclosed upfront for you to analyse, so all I’m saying here is that it’s an interesting way to adjust value in a deal to meet conflicting expectations. In the above example, you would receive $100m if the business met budget, but theoretically $90m is from my pocket and $10m is from your own. As long as you think of it this way, there’s no issue.