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 earnout. I’ve talked about earnouts ad nauseam in previous posts, 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 earnout of $20m. You will receive the earnout 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 earnout. So, I’ve only paid $80m, which is still only 4x EBITDA.
Being honest with ourselves though, if the earnout 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.
Earnouts are used for two reasons: 1) to close value gaps between buyer and seller, and 2) to align interestes between buyer and seller.
Any closure of a value gap is only perceived, not real. A private equity firm will appear to pay more by introducing an earnout that increases the top line price, but due to time value of money, the firm may be paying even less.
Interests align because part of the price becomes contingent on the aligned actions of the seller during the earn-out period. It stops, for example, the seller from competing against the business immediately or slacking off or anything else that may negatively affect performance.
The purpose of an earnout is to close valuation gaps. For example, if theagent of a business expects a lower price, the client can advance an earnout (contingent on upcoming earnings) to abate the value difference while appearing to commit to a lower price.
While this appears that the client is in aftereffect paying added for the business, technically if they pay the abounding price, they’re accomplishing so for a aggregation with greater balance than at current. Also, the adjournment of the transaction (sometimes as abundant as 5 years) reduces the amount of the accidental transaction due to the aftereffect of time on money. Keeping this in mind, the client appears to be paying added for the business, but in absolute agreement it could be abundant less.
This is a follow on from my post about the amplifying effects of diminishing sales, which was just a simple explanation about how a 20% earnings drop could lead to a 60% value drop. A likely consequence of this phenomenon is that a plethora of vendors under earn out agreements will now be counting their chickens and discounting their eggs. Whereas not long ago they had visions of majestic chateaux on la Côte d’Azur, they now mostly have visions of decimated pension funds and impossible earn out targets.
There are a number of ways to look at unpaid earn out targets, some optimistic and some pessimistic. Firstly, unpaid earn outs can still be a boon for private equity firms because, in an absolute sense, they’re paying less for the business than otherwise (although, in a relative sense they could be paying a higher multiple if earnings fall enough). However, this is only beneficial if sales return to budgeted levels and a track record of maintainable earnings is restored.
Unfortunately, the probable reality is that maintainable earnings have dropped and earn outs may not have been large enough to protect private equity firms. The saving grace is that this should be a short-term issue for great businesses and they should be able to pick up market share and return to status quo. But, this is reserved only for great businesses; it’s all about product/service differentiation, financial discipline, low-moderate gearing, a dynamic management team and a proactive private equity partner. Without all of these qualities, investees may find these are tougher times than expected.
With all of that said, this is business and business is cyclical. I could insert many clichés here about wheat and chaff, men and buys, good and bad apples, etc., but there’s not much point dwelling. The most beneficial take away is that private equity firms must always invest in the best businesses if they want to maintain reputation and edge.
Earn out is a appellation acclimated by Private Equity and adventure basic investors to call a blueprint by which the administration of a aggregation earns a allotment of the company’s allotment basic by accomplishing after-effects aloft pre-determined levels. It is as well acclimated to call the transaction to shareholders affairs their shares in a aggregation area the transaction is accidental on the accomplishment of assertive accomplishment belief (e.g. aggregation profits) over a defined period, usually afterward the closing of the sale.
It is generally acclimated if baby companies in high-growth, high-tech or account private equity industries are sold. The acquirer about pays 60–80% of the acquirement amount up foreground with the absolute 20–40% structured as an earn out and paid out over time as the acquired aggregation achieves assertive levels of sales or profitability.
A accepted affection of abounding acquisitions, an earnout stipulates that the aboriginal owners of a business are paid for the auction of their company, afterward which they are contractually answerable to break with the aggregation through a alteration period, and they are private equity provided with the allurement to accept a ascertainable aftereffect on the company’s banking accomplishment traveling forward. Accomplishing or beyond a assertive akin of accomplishment – belief are about set over a aeon of several years – agency the aboriginal owners will acquire a abundant beyond accumulation from the sale.
For buyers, an earnout can action private equity the client adjoin overpaying for a aggregation that doesn’t end up advancing or growing in the way its aboriginal owners expected. It can as well bland the aeon of buying transition. Because a lot of earnout clauses private equity are angry to the company’s accomplishment (measured in sales, earnings, or some added benchmark) over a three-to-five-year period, that’s the timeline you should be cerebration about your company’s bloom aural afore embarking on negotiations. If your aggregation had a track-record of assuming at or beyond forecasts in the past, this actuality should accord you added negotiating power.